Contractual Man: The Fundamental Transformation

Economists of all persuasions recognize that the terms upon which an initial bargain will be struck depend on whether noncollusive bids can be elicited from more than one qualified supplier. Monopolistic terms will obtain if there is only a single highly qualified supplier, while competitive terms will result if there are many. Transaction cost economics fully accepts this description of ex ante bidding competition but insists that the study of contracting be extended to include ex post features. Thus initial bidding merely sets the contracting process in motion. A full assessment requires that both contract execution and ex post competition at the contractTenewal interval come under scrutiny.

Contrary to earlier practice,27 transaction cost economics holds that a condition of large numbers bidding at the outset does not necessarily imply that a large numbers bidding condition will prevail thereafter. Whether ex post competition is fully efficacious or not depends on whether the good or service in question is supported by durable investments in transaction-specific human or physical assets. Where no such specialized investments are incurred, the initial*winning bidder realizes no advantage over nonwinners. Although it may continue to supply for a long time, that is only because, in effect, it is continuously meeting competitive bids from qualified rivals. Rivals cannot be presumed to operate on a parity, however, once substantial investments in transaction-specific assets are put in place. Winners in such circumstances enjoy advantages over nonwinners, which is to say that parity is upset. Accordingly, what was a large numbers bidding condition at the outset is effectively transformed into one of bilateral supply thereafter. This fundamental transformation has pervasive contracting consequences.

The reason why significant reliance investments in durable, transaction- specific assets introduces contractual asymmetry between the winning bidder on the one hand and nonwinners on the other is that economic values would be sacrificed if the ongoing supply relation were to be terminated. Faceless contracting is thereby supplanted by contracting in which the pairwise identity of the parties matters. Occasionally the identity of the parties is important from the very outset, as when a buyer induces a supplier to invest in specialized physical capital of a transaction-specific kind. Inasmuch as the value of that capital in other uses is, by definition, much smaller than the specialized use for which it has been intended, the supplier is effectively committed to the transaction to a significant degree. The effect is often symmetrical, moreover, in that the buyer cannot turn to alternative sources of supply and obtain the item on favorable terms, since the cost of supply from unspecialized capital is presumably great.

Ordinarily, however, there is more to idiosyncratic exchange than spe-cialized physical capital. Human capital investments that are transaction- specific commonly occur as well. These evolve during contract execution. Specialized training and leaming-by-doing economies in production operations are illustrations. Except when such investments are transferable to alternative suppliers at low cost, which is rare, the benefits can be realized only so long as the relationship between the buyer and seller is maintained.

Additional transaction-specific savings can accrue at the interface between supplier and buyer as contracts are successively adapted to unfolding events and as periodic contract renewal agreements are reached. Familiarity here permits communication economies to be realized: Specialized language develops as experience accumulates and nuances are signaled and received in a sensitive way. Both institutional and personal trust relations evolve. Thus the individuals who are responsible for adapting the interfaces have a personal as well as an organizational stake in what transpires. Where personal integrity is believed to be operative, individuals located at the interfaces may refuse to be part of opportunistic efforts to take advantage of (rely on) the letter of the contract when the spirit of the exchange is emasculated. Such refusals can serve as a check upon organizational proclivities to behave opportunistically.28 Other things being equal, idiosyncratic exchange relations that feature personal trust will survive greater stress and will display greater adapt-ability.

How to effect these adaptations poses a serious contracting dilemma, though it bears repeating that, absent the hazards of opportunism, the difficulties would vanish—since then the gaps in long-term, incomplete contracts could be faultlessly filled by Vecourse to the earlier described general clause device. Given, however, the unenforceability of general clauses and the proclivity of human agents to make false and misleading (self- disbelieved) statements the following hazards must be confronted: Joined as they are in a condition of bilateral monopoly, both buyer and seller are strategically situated to bargain over the disposition of any incremental gam whenever a proposal to adapt is the other party. Although both have a long-term interest in effecting adaptations of a joint profit-maximizing kind, each also has an interest in appropriating as much of the gain as he can on each occasion to’adapt. Efficient adaptations that would otherwise be made thus result in costly haggling or even go unmentioned, lest the gains be dissipated by costly subgoal pursuit. Governance structures that attentuate opportunism and otherwise infuse confidence are evidently needed.

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

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