Capabilities and Governance the Rebirth of Production in the Theory of Economic Organization

Almost a decade ago, Paul Milgrom and John Roberts (1988, p. 450), two of the leaders in the formalist branch of the New Institutional Economics, made the following observation. ”The incentive based transaction costs theory has been made to carry too much of the weight of explanation in the theory of organizations. We expect competing and complementary theories to emerge theories that are founded on economizing on bounded rationality and that pay more attention to changing technology and to evolutionary considerations.” This paper argues that such theories are now emerging. We survey and synthesize a developing perspective that we label the ”capabilities” view. We argue that this view complements incentive-based theory (1) by considering the problems of imperfect knowledge in production as well as in governance and (2) by considering issues not only of incentive alignment but also of qualitative coordination among holders of specialized, distributed, and often tacit knowledge. Also, focusing on capabilities brings to the fore the idea that routines and similar rule-based forms of institutionalized knowledge may be important building blocks of economic organization. As a result, the capabilities approach arguably connects more fully with the New Institutional Economics, in which rule based guides to action like norms and conventions play a fundamental role, than do approaches that take the transaction as the unit of analysis.