Contractual Man: Dimensions

Transaction cost economics maintains that there are rational economic reasons for organizing some transactions one way and other transactions another. But which go where and for what reason? A predictive theory of economic organi- zation requires that the factors responsible for differences among transactions be identified and explicated.

The principal dimensions with respect to which transactions differ are asset specificity, uncertainty, and frequency. The first is the most important and most distinguishes transaction cost economics from other treatments of economic organization, but the other two play significant roles.

1. Asset Specificity 

An awareness of the condition that is herein described as asset specificity can be traced at least to Alfred Marshall. The contracting and organizational ramifications, however, went unremarked. Indeed, the quasi-rent condition to which Marshall referred played a lesser rather than a greater role as neoclassical economics progressed.

To be sure, Michael Polanyi’s remarkable study of “personal knowledge” included several illustrations of industrial arts and craftsmanship in which the skills in question are so deeply embedded in the experienced workforce that they can be known or inferred by others only with great difficulty— if at all (Polanyi, 1962, pp. 52-53). Jacob Marschak likewise recognized that assets can be idiosyncratic and expressed concern with the readiness of economists to accept or employ assumptions of fungibility:  “There exist almost unique, irreplaceable research workers, teachers, administrators: just as there exist unique choice locations for plants and harbors. The problem of unique or imperfectly standardized goods … has been indeed neglected in the textbooks” (Marschak, 1968, p. 14). It was widely believed that those Uniqueness conditions were rare and/or unimportant, however. The nuances to which Polanyi and Marschak referred could thus safely be relegated to footnotes.

That viewpoint has been dramatically reversed in the past decade. Al- chian, who once held otherwise,” now contends that “the whole rationale for the employer-employee status, and even for the existence of firms, rests on [asset specificity]; without it there is no known reason for firms to exist.”22 23 24

The proposition that the idiosyncratic attributes of transactions have large and systematic organizational ramifications first appeared in conjunction with the study of vertical integration (Williamson, 1971). Transactions that are supported by investments in durable, transaction-specific assets experience “lock in” effects, on which account autonomous trading will commonly be supplanted by unified ownership (vertical integration). Thus although there may be large, numbers of qualified bidders at the outset, if the “winner of an original contract acquires a cost advantage, say by reason of . . . unique location or learning, including the acquisition of undisclosed or proprietary technical and managerial procedures and task-specific labor skills,” bidding parity at contract renewal intervals will be upset—with the result that (comparative or remediable) ex post contracting strains predictably develop if discrete contracting is attempted (Williamson, 1971, p. 116).


Asset specificity arises in an intertemporal context. As set out in the contractual schema in Chapter 1, parties to a transaction commonly have a choice between special purpose and general purpose investments. Assuming that contracts go to completion as intended, the former will often permit cost savings to be realized. But such investments are also risky, in that specialized assets cannot be redeployed without sacrifice of productive value if contracts should be interrupted or prematurely terminated. General purpose investments do not pose the same difficulties. “Problems” that arise during contract execution can be solved in a general purpose asset regime by each party going his way. The following issue thus needs to be evaluated: Do the prospective cost savings afforded by the special purpose technology justify the stra ic hazards that arise as a consequence of their nonsalvageable character?

A tradeoff is thus posed and needs to be evaluated. Unlike earlier treatments of economic organization, transaction cost economics is centrally concerned with that condition. Also, the nature of the tradeoff is not invariant but varies systematically with the governance structure to which the transactions in question are assigned. A comparative organizational assessment of tradeoffs is thus needed. It is common to distinguish between fixed and variable costs, but this is merely an accounting distinction. More relevant to the study of contracting is whether assets are redeployable or not (Klein and Leffler, 1981). Many assets that accountants regard as fixed are in fact redeployable, for example, centrally located general purpose buildings  and equipment. Durable  but mobile  assets such  as general purpose trucks and airplanes are likewise redeployable. Other costs that accountants treat as variable often have a large nonsalvageable part, firm-specific human capital being an illustration. Figure 2-2 helps to make the distinction.

Thus costs are distinguished as to fixed (F) and variable (V) parts. But they are further classified as to the degree of specificity, of which only two kinds are recognized: wholly specific (k) and nonspecific (v). (That only two . specificity classes are distinguished does not imply that assets must be entirely one kind or the other. Semi-specific assets involve a mixture of k and v.) The shaded region at the bottom of the figure is the troublesome one for purposes of contracting. That is where the specific assets are located. Such specificity is responsible for what is referred to as the “fundamental transformation” in Section 3 below.

FIGURE 2-2. Cost Distinctions

At least four different types of asset specificity are usefully distinguished: site specificity; physical asset specificity; human asset specificity; and dedicated assets. The organizational ramifications, moreover, vary with each. The details are best developed in the context of specific organizational issues—vertical integration, nonstandard contracting, employment, corporate governance, regulation, and the like, which are the subjects of subsequent chapters. Suffice it to observe here that (1) asset specificity refers to durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments is much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated, and I (2) the specific identity of the parties to a transaction plainly matters in these circumstances, which is to say that continuity of the relationship is valued, whence (3) contractual and organizational safeguards arise in support of transactions of this kind, which safeguards are unneeded (would be the source of avoidable costs) for transactions of the more familiar neoclassical (nonspecific) variety. Thus whereas neoclassical transactions take place within markets where ‘faceless buyers and sellers . . . meet . . . for an instant to exchange standardized goods at equilibrium prices” (Ben-Porath,1980, p. 4), exchanges that are supported by transaction-specific investments are neither faceless nor instantaneous. The study of governance owes its origins to that condition.


The importance of asset specificity to transaction cost economics is difficult to exaggerate. Just as the absence of differential risk aversion would diminish if not vitiate much of the recent incentive work on contracting (Akerlof and Miyazaki, 1980; Bull, 1983), so would the absence of asset specificity vitiate much of transaction cost economics.14 It is the source both of striking commonalities among transactions and of numerous refutable implications.

To be sure, asset specificity only takes on importance in conjunction with bounded rationality/opportunism and in the presence of uncertainty. It is nonetheless true that asset specificity is the big locomotive to which transaction cost economics owes much of its predictive content. Absent this condition, the world of contract is vastly simplified; enter asset specificity, and nonstandard contracting practices quickly appear. Neglect of asset specificity is largely responsible for the monopoly preoccupation of earlier contract traditions.

2. Uncertainty


Many of the interesting issues with which transaction cost economics is involved reduce to an assessment of adaptive, sequential *decisipn-making. Contingent on the set of transactions to be effected, the basic proposition here is that governance structures differ in their capacities to respond effectively to disturbances.’To be sure, those issues would vanish were it not for bounded rationality, since then it would be feasible to develop a detailed strategy for crossing all possible bridges in advance.15 It would likewise be possible to adapt effectively using the “general rule” device described above were it not for opportunism. Confronted, however, by the need to cope with both bounded rationality and opportunism, comparative institutional assessments of the adaptive attributes of alternative governance structures must necessarily be made.

As Hayek maintained, interesting problems of economic organization arise only in conjunction with uncertainty: The “economic problem of society ‘ is mainly one of adaptation to changes in particular circumstances of time and place” (Hayek, 1945, p. 524). Disturbances, moreover, are not all of a kind. Different origins are usefully distinguished. Behavioral uncertainty is of special importance to an understanding of transaction cost economics issues.

Although there is a hint in the earlier discussions that uncertainty can have behavioral origins (Williamson, 1975, pp. 26-37), it generally goes unremarked. Even Tjalling Koopmans, whose distinction between primary and secondary uncertainty goes beyond most treatments and who describes the core problem of the economic organization of society as that of facing and dealing with uncertainty (1957, p. 147), does not deal with behavioral issues. Primary uncertainty is of a state-contingent kind, while secondary uncertainty arises “from lack of communication, that is from one decision maker having no way of finding out the concurrent decisions and plans made by others”— which Koopmans judges to be “quantitatively at least as important as the primary uncertainty arising from random acts of nature and unpredictable changes in consumer’s preferences” (1957, pp. 162-63).

The secondary uncertainty to which Koopmans refers is of a rather mnocent or nonstrategic kind, however. There is a lack of communication, but no reference is made to uncertainty that arises because of strategic nondisclosure, disguise, or-distortion of information (note that information distortion involves not a lack of information but the conscious supply of false and misleading signals). Also, the plans to which Koopmans refers are merely unknown. The possibility that parties make strategic plans in relation to each other that are the source of ex ante uncertainty and ex post surprises is nowhere suggested.

Uncertainty of a strategic kind is attributable to opportunism and will be referred to as behavioral uncertainty. Such uncertainty is presumably akin to what Ludwig von Mises refers to as case probability, where “case probability is a peculiar feature of our dealing with problems of human action. Here any reference to frequency is inappropriate, as our statements always deal with unique events” (1949, p. 112; emphasis added).25 Thus even if it were possible to characterize the general propensity of a population to behave opportunistically in advance and perhaps even to screen for trustworthiness, knowing that one is dealing with a trader who comes from one part of the opportunism distribution rather than another does not fully describe the uncertainties that arise on this account. Those added uncertainties can be evaluated only upon projecting the devious responses (and own replies) that opportunism introduces. And those can be evaluated only in conjunction with the particulars of the contract. Even knowledge of particulars, moreover, does not preclude surprises. The capacity for novelty in the human mind is rich beyond imagination.26 The issues here are nicely put by Leif Johansen, who observes that the study of economic behavior between motivationally complex economic agents is complicated by the fact that the “ranges of possible mes-sages, offers, threats, etc. which can be given during the process, including the timing of moves, are hard to delimit. Imagination and ability to surprise the opponents may be important points, and very often the ‘agenda’ will be expanded during the process” (1979, p. 511). Surprise moves often elicit complex replies. Bounded rationality limits are quickly reached—since the entire decision tree cannot be generated for even moderately complex problems (Feldman and Kanter, 1965, p. 615).

To be sure, behavioral uncertainties would not pose contractual problems if transactions were known to be free from exogenous disturbances, since then there would be no occasion to adapt and unilateral efforts to alter contracts could and presumably would be voided by the courts or other third party appeal. Insistence on original terms would thus everywhere be observed. The ease of enforcing contracts vanishes, however, once the need for adaptation appears (or can be plausibly asserted). Questions of the following kind arise: Should maladaptations to changed circumstances be tolerated lest efforts to effect an adaptation give rise to complex behavioral responses by opposite parties with the prospect of realizing net losses? Can a governance structure that attenuates such behavioral uncertainties be devised?20 Such issues do not arise within the context of primary uncertainty but are nontheless germane to the study of economic organization.


The influence of uncertainty on economic organization is conditional. Specifically, an increase in parametric uncertainty is a matter of little consequence for transactions that are nonspecific. Since new trading relations are easily arranged, continuity has little value, and behavioral uncertainty is lrrevelant. Accordingly, market exchange continues and the discrete contract-ing paradigm holds across standardized transactions of all kinds, whatever the degree of uncertainty.

That is no longer so for transactions that are supported by idiosyncratic investments. Whenever assets are specific in nontrivial degree, increasing the degree of uncertainty makes it more imperative that the parties devise a machinery to “work things out”—since contractual gaps will be larger and the occasions for sequential adaptations will increase in number and importance as the degree of uncertainty increases. Also, and relatedly, concerns over the behavioral uncertainties referred to above now intrude.

A further discussion of the governance ramifications is best deferred to Chapter 3. Suffice it to observe here that (1) the interaction effects between uncertainty and asset specificity are important to an understanding of economic organization, and (2) empirical analysis of transaction cost features is complicated as a result.

3. Frequency 

Adam Smith’s famous theorem that “the division of labor is limited by the extent of the market” is mainly thought to have neoclassical cost ramifications. Investments in specialized production techniques the costs of which could be recovered in a large market may be unrecoverable if markets are small, whence general purpose plant and equipment and procedures will be observed in small markets. Similar reasoning carries over to the study of transaction costs. The basic proposition in the latter connection is this: Specialized governance structures are more sensitively attuned to the governance needs of nonstandard transactions than are unspecialized structures, ceteris paribus. But specialized structures come at a great cost, and the question is whether the costs can be justified. This varies with the benefits on the one hand and the degree of utilization on the other/

The benefits of specialized governance structures are greatest for transac- tions supported by considerable investment in transaction-specific assets. The reasons are those described previously. Whether the volume of transactions processed through a specialized governance structure utilizes it to capacity is then the remaining issue. The cost of specialized governance structures will be easier to recover for large transactions of a recurring kind. Hence the frequency of transactions is a relevant dimension. Where frequency is low but the needs for nuanced governance are great, the possibility of aggregating the demands of similar but independent transactions is suggested. Court ordering is commonly supplanted by arbitration in such circumstances: Both permit aggregation, but the latter is more oriented to the continuity needs of asset specific transactions.

More generally, the object is not to economize on transaction costs but to economize in both transaction and neoclassical production cost respects. Whether transaction cost economies are realized at the expense of scale economies or scope economies thus needs to be assessed. A tradeoff framework is needed to examine the production cost and governance post ramifications of alternative modes of organization simultaneously. Rudimentary apparatus of this kind is developed in Chapter 4.

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

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