Contractual Man: Behavioral Assumptions

Many economists treat behavioral assumptions’ as a matter of convenience. This reflects a widely held opinion that the realism of the assumptions is unimportant and that the fruitfulness of a theory turns on its implications (Friedman, 1953).2 As noted earlier, however, Bridgeman urges that an understanding of the actions of men requires more self-conscious attention to the study of how the minds of men work (1955, p. 450). Iredell Jenkins concurs. He observes that “human institutions—including law—inherit their major problems and purposes from the general condition of man” and holds that the study of mind and of social process is needed to get at the roots (1980, p. 5). As Coase puts it, “Modem institutional economics should study man as he is, acting within the constraints imposed by real institutions. Modem institutional economics is economics as it ought to be” (1984, p. 231).

Transaction cost economics characterizes human nature as we know it by reference to bounded rationality and opportunism.3 The first acknowledges limits on cognitive competence. The second substitutes subtle for simple self- interest seeking.

1. Rationality

Three levels of rationality are usefully distinguished. The strong form con- templates maximizing. Bounded rationality is the semistrong form.4 The weak form is organic rationality.


Neoclassical economics maintains a maximizing orientation. That is un- objectionable, if all of the relevant costs are recognized.19 The maximizing tradition does not, however, encourage such recognitions. Instead, the role of institutions is suppressed in favor of the view that firms are productiop func- tions, consumers are utility functions, the allocation of activity between alter- native modes of organization is taken as given, and optimizing is ubiquitous (DeAlessi, 1983). Contingent claims contracting of the Arrow-Debreu kind is an especially ambitious form of maximizing. The occasion to study alternative means of contracting vanishes upon assuming that comprehensive intertemporal trading of this kind is feasible. The world being reduced to a single gigantic once-for-all higgle-haggle (Meade, 1971, p. 166), technology, initial endowments, and risk preferences and perceptions are fully determinative.


Bounded rationality is the cognitive assumption on which transaction cost economics relies. This is a semistrong form of rationality in which economic actors are assumed to be “intendedly rational, but only limitedly so” (Simon, 1961, p. xxiv). Note the simultaneous reference to both intended and limited rationality. That conjunction has been resisted by both economists and other social scientists, albeit for different reasons. Economists object to it because limits on rationality are mistakenly interpreted in nonrationality or irrationality terms. Regarding themselves as they do as the “guardians of rationality” (Arrow, 1974, p. 16), economists are understandably chary of such an approach. Other social scientists demur because reference to intended rationality makes too great a concession to the economists’ maximizing mode of inquiry. The upshot is that bounded rationality invites attack from both sides.

Transaction cost economics acknowledges that rationality is bounded and maintains that both parts of the definition should be respected. An economizing orientation is elicited by the intended rationality part of the definition, while the study of institutions is encouraged by conceding that cognitive competence is limited.

Comprehensive contracting is not a realistic organizational alternative when provision for bounded rationality is made (Radner, 1968). If mind is the scarce resource (Simon, 1978, p. 12), then economizing on claims against it is plainly warranted. Respect for limited rationality elicits deeper study of both market and nonmarket forms of organization. Given limited competence, how do the parties organize so as to utilize their limited competence to best advantage? Views to the contrary notwithstanding, the set of issues on which economic reasoning can usefully be brought to bear is enlarged rather than reduced when bounds on rationality are admitted.

Economizing on bounded rationality takes two forms. One concerns decision processes, and the other involves governance structures. The use of heuristic problem-solving—both in general (Simon, 1978) and in conjunction with specific problems, such as Ruble’s cube (Heimer, 1983)—is a decision process response. Transaction cost economics is principally concerned, however, with the economizing consequences of assigning transactions to governance structures in a discriminating way^Confronted with the realities of bounded rationality, the costs of planning, adapting, and monitoring transactions need expressly to be considered. Which governance structures are more efficacious for which types of transactions? Ceteris paribus, modes that make large demands against cognitive competence are relatively disfavored.6


The weak form of rationality is process or organic rationality, the type of rationality with which modem evolutionary approaches (Alchian, 1950; Nelson and Winter, 1982) and Austrian economics (Menger, 1963; Hayek, 1967; Kirzner, 1973) are associated. But whereas Nelson and Winter deal with evolutionary processes within and between firms, the Austrian approach is concerned with processes of the most general kinds—the institutions of money, markets, aspects of property rights, and law being examples. As Louis Schneider puts it, such institutions “are not planned. A general blueprint of the institutions is not aboriginally in anyone’s mind. [Indeed], there are situations in which ignorance . . . works more ‘effectively’ toward certain ends than would knowledge of and planning toward those same ends” (1963, p. 16). Although transaction cost economizing is surely an important contributor to the viability of the institutions with which Austrian economics is concerned, and a joinder of the two approaches would be useful, the research agenda of organic rationality and transaction cost economics are currently rather different. They are nevertheless complementary; each can expect to benefit from the insights of the other (Langlois, 1982, p. 50).

2. Self-interest Orientation

Three levels of self-interest seeking can also be distinguished. The strongest form, the one to which transaction cost economics appeals, is opportunism. The semistrong form is simple self-interest seeking. Obedience is the weak (really null) form.


By opportunism I mean self-interest seeking with guile. This includes but is limited to more blatant forms, such as lying, stealing, and cheating. Opportunism more often involves subtle forms of deceit. Both active and passive forms and both ex ante and ex post types are included.

Ex ante and ex post opportunism are recognized in the insurance literature under the headings of adverse selection and moral hazard, respectively. The first is a consequence of the inability of insurers to distinguish between risks and the unwillingness of poor risks candidly to disclose their true risk condition. Failure of insureds to behave in a fully responsible way and take appropriate risk- mitigating actions gives rise to ex post execution problems. Both conditions are subsumed under the heading of opportunism.

More generally, opportunism refers to the incomplete or distorted dis- closure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse. It is responsible for real or contrived conditions of information asymmetry, which vastly complicate prob-lems of economic organization. Both principals and third parties (arbitrators, courts, and the like) confront much more difficult ex post inference problems as a consequence. It is not necessary, moreover, that all parties be given to opportunism in identical degree. Indeed, problems of economic organization are compounded if the propensity to behave opportunistically is known to vary’ among members of the contracting population, since now gains can be realized by expending resources to discriminate among types.

Nicholas Georgescu-Roegen’s reference to behavior that deviates from the rules is consonant with this view of human nature. As he puts it:

[O]bservation of what happens in the economic’ sphere of organizations, or between organizations and individuals, [revealsj phenomena that do not consist of tatonnement with given means toward ends according to the rules. They show beyond any doubt that in all societies the typical individual continually pursues also an end ignored by the standard framework: the increase of that (which] he can claim as his… It is the pursuit of this end that makes the individual a true agent of the economic process. [1971, pp. 319-20; emphasis added]

Plainly, were it not for opportunism, all behavior could be rule governed. This need not, moreover, require comprehensive preplanning. Unanticipated events could be dealt with by general rules, whereby the parties agree to be bound by actions of a joint profit-maximizing kind. Thus problems during contract execution could be avoided by ex ante insistence upon a general clause of the following kind: I agree candidly to disclose all relevant information and thereafter to propose and cooperate in joint profit-maximizing courses of action during the contract execution interval, the benefits of which gains will be divided without dispute according to the sharing ratio herein provided.

It is noteworthy that Niccolò Machiavelli’s efforts to deal with “men as they are” (Gauss, 1952, p. 14) makes prominent provision for opportunism. Upon observing that humans have a propensity to behave opportunistically, Machiavelli advised his prince that “a prudent ruler ought not to keep faith when by so doing it would be against his interest, and when the reasons which made him bind himself no longer exist [Legitimate grounds [have never] failed a prince who wished

to show colourable excuse for the promise’ ’ (Gauss, 1952, pp. 92-93). But reciprocal or preemptive opportunism is not the only lesson to be gleaned from an awareness that human agents are not fully trustworthy. Indeed, that is a very primitive response./

The more important lesson, for the purposes of studying economic orga- nization, is this: Transactions that are subject to ex post opportunism will benefit if appropriate safeguards can be devised ex ante. Rather than reply to opportunism in kind, therefore, the wise prince is one who seeks both to give and to receive “credible commitments.” Incentives may be realigned, and/or superior governance structures within which to organize transactions may be devised.- The ramifications are developed more completely in subsequent chapters.

As discussed below, opportunism is a troublesome source of “behavioral” uncertainty in economic transactions—which uncertainty would vanish either if individuals were fully open and honest in their efforts to realize individual advantage or, alternatively, if full subordination, self-denial, and obedience could be presumed. Open or simple self-interest seeking is the motivational assumption on which neoclassical economics relies. It is the semistrong form of self-interest seeking. Obedience is tantamount to non-selfinterest seeking.


Although neoclassical man confronts self-interested others across markets, this merely presumes that bargains are struck on terms that reflect original positions. But initial positions will be fully and candidly disclosed upon inquiry, state of the world declarations will be accurate, and execution is oath- or rule- bound in the manner described above. Accordingly, whereas parties realize all advantages that their wealth, resources, patents, know-how, and so forth lawfully entitle them, those are all evident from the outset. Inasmuch as there are no surprises thereafter, a condition of simple self- interest seeking may be said to obtain. Issues of economic organization thus turn on technological features (e.g. scale economies), there being no problematic behavior attributable to rule deviance among human actors.


Obedience is the behavioral assumption that is associated with social engineering (Georgescu-Roegen, 1971, p. 348). Adolph Lowe puts it as follows: “One can imagine the limiting case of a monolithic collectivism in which the prescriptions of the central plan are carried out by functionaries who fully identify with the imposed macrogoals. In such a system the economically relevant processes reduce almost completely to technical manipulations (1965, p. 142). The full identification to which Lowe refers contemplates stewardship of an extreme kind in which self-interestedness vanishes. Although it is a recurrent theme throughout utopian and related literatures, to project such “mechanistic orderliness” is even more unwarranted than “the basic position of standard economics” (Georgescu-Roegen, 1971, p. 348). Problems of economic organization would nevertheless be, greatly simplified if that condition were satisfied or even closely approximated. Robots have the feature that they satisfy obedience requirements at zero social conditioning cost, albeit within a limited range of responsiveness.

3. Some Comparisons 

The main behavioral assumptions which contingent claims, mechanism design, transaction cost economics, evolutionary (or organic) economics, team theory, and utopian approaches employ are summarized in Figure 2-1. Of special importance is that transaction cost economics pairs a semistrong form of cognitive competence (bounded rationality) with a strong motivational assumption (opportunism). Without both, the main problems of economic organization with which this book is concerned would vanish or be vastly transformed.

Thus there would be relatively little scope for organizational design and analysis if either high-powered or organic rationality prevailed. Comprehensive contracting would rule in the first instance, while conscious efforts give way to evolutionary processes in the second. Were it not for opportunism, moreover, the general clause device—whereby parties agreed to be bound by actions of a joint profit-maximizing kind—would also support ubiquitous contracting. There simply is no occasion to supplant market exchange by other modes of economic organization if promises to behave in a joint profit- maximizing way are self-enforcing and if sharing rules are agreed to at the outset. These issues are discussed further in the Appendix.

FIGURE 2-1. Behavioral Assumptions of Alternative Approaches to Economic Organization

Mechanism design theory couples a variant of unbounded rationality with opportunism. The rationality variai^j^this: ^oinformation impacted- ness condition exists, whereby the principal and agent have knowledge of different and essentially private information and engage in complex contracting. Mechanism design theory is thus located between contingent claims contracting and transaction cost economics in rationality respects. Imputing high-powered computational capacity is consonant with the former, while an information asymmetry condition places it closer to the latter, With respect to self-interest seeking, however, mechanism design and transaction cost economics are wholly congruent. To be sure, there are language differences— mechanism design theory refers to the propensity of human agents to behave opportunistically as “moral hazard”—but both assume deep problems of veracity and truth revelation.21 Inasmuch as information may be disclosed strategically rather than candidly upon request, initial information disparities between the parties will not be assuredly overcome by proposals that all relevant information be pooled. Instead, initial information asymmetries persist. Indeed, additional asymmetries develop as events unfold.

Team theory acknowledges bounded rationality but assumes that agents have identical preferences, which is equivalent to weak form self-interestedness (Marschak and Radner, 1972). Although interesting problems of informational decentralization are thereby posed, the presumed absence of opportunism simplifies matters considerably.

Utopian modes of organization are intendedly humanistic and are gener- ally nonmarket. Whether they are democratic or hierarchical, utopian modes require deep commitment to collective purposes and commonly involve personal subordination. The history of social and economic organization records repeated efforts to craft such structures. But utopian societies are especially vulnerable to the pound of opportunism.9

The new man of socialist economics is endowed with a high level of cognitive competence (hence the presumed efficacy of planning) and displays a lesser degree of self-interestedness (a greater predisposition to cooperation) than his capitalist counterpart. The “cooperation and solidarity” on which socialism is based are “introduced by social planning”, which “not only improves macroeconomic efficiency but [also adds these new qualities] to the economic process” (Horvat, 1982, p. 335).

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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