Interfirm Exchange: Some Qualifications

As previously noted (Chapter 2, Section 3.3), business reputation is a valuable resource that is not to be squandered, and firms sometimes develop experience-rating systems in which they pool information with respect to their contractual dealings with common suppliers or customers (Leff, 1970). To describe interfirm exchange in strictly antagonistic terms is accordingly too strong: only a qualified caveat emptor relation normally prevails among contracting parties (Kessler and Fine, 1964, p. 441). Businessmen operating in competitive industries in a high trust culture who insist on contractual completeness and exacting execution will find that such transactional attitudes result in excessive costs and render their businesses nonviable.

The differences between business, academic, and legal attitudes toward contracts have been examined by Macaulay (1963). He finds, in general, that mterfirm contracts are often much more casual documents and are enforced much less exactingly than is commonly supposed. Also, contractual attitudes differ both as between different management functions within the enterprise and as between businessmen and outsiders.

Within the firm, sales managers and purchasing agents are less concerned with the details and enforceability of contracts than are the financial people and the inside lawyer (or house counsel). Macaulay cites one businessman to the effect that “you can settle any dispute if you keep the lawyers and accountants out of it. They just do not understand the give-and-take needed in business” (1963, p. 61). But even financial types and the house counsel are apt to have a more relaxed attitude about contracting than are outside lawyers or academic economists — who, anxious that the worst of all possible consequences consistent with the terms of the agreement will obtain, are unsettled by informal assurances that “everything will work out.”

These differences between outsiders  and businessmen partly reflect a common tendency among specialists to interpret issues in terms that complement their particular expertise. This is reinforced by their selective exposure to contracting. (Outside counsel, for example, is apt to be called on only when unusual and difficult contracting issues develop.) But the major difference is that outsiders often have little appreciation either for the costs of transactions or the range of informal sanctions that businessmen have access to. Just as vertical integration is made attractive by the  prospect of eco- nomizing on transaction costs, so also may incomplete contracting with informal enforcement serve an economizing purpose. Writing comprehensive contracts (at least those that are specific to a particular item and therefore go beyond what the lawyers refer to as “boiler plate” provisions) is itself expensive. Insisting on exacting contract performance is also costly. Not only can the resulting arbitration and litigating expenses be great, but secondary costs may be generated as well. The contract is apt to be reduced to a minimum-performance document; what could have been a semicooperative venture is turned instead into an “antagonistic horse trade” (Macaulay, 1963, p.64).

The informal sanctions to which businessmen have access also warrant consideration. Repeated personal contacts across organizational boundaries support some minimum level of courtesy and consideration between the parties (Macaulay, 1963, p. 63). In addition, expectations of repeat business discourage efforts to seek a narrow advantage in any particular transaction. Finally, there is a matter of general business reputation to be concerned with, both at the personal and firm levels. Individual aggressiveness is curbed by the prospect of ostracism among peers, in both trade and social circumstances. The reputation of a firm for fairness is also a business asset not to be dissipated. A poor reputation may require concessions, such as greater price discounts on subsequent deals, for the firm to remain viable (Macaulay, 1963, p. 64).

It cannot be safely concluded, however, that business trust is so great and pervasive that the costs of interfirm contracting are negligible. For one thing, where the item in question is not a list price item (or if ad hoc terms are to be arranged) the terms of trade must be negotiated and this can be expensive. Thus, even if contingencies are ignored, haggling over price and terms of delivery may occur. But the contract itself may not be simple. If trading risks are great, the parties to the exchange are commonly prepared to bear additional cost in the form of explicit contingent planning and enforcement expenses. Macaulay notes in this connection that “complexity of the agreed performance over a long period” contributes to “greater contractual expense” (1963, p. 65), and that additional contractual expense is also incurred where the “degree of injury in case of default is thought to be potentially great” ( 1963, p. 65). More generally, the trading risk problem reduces to one of small-numbers bargaining in the face of uncertainty. As the discussion in earlier chapters reveals, an appreciation for the problems of interfirm contracting requires an understanding of the variety of ways in which a small-numbers condition can develop and a sensitivity to the subtleties of information exchange.

To be sure, trust is important and businessmen rely on it much more extensively than is commonly realized. Interfirm trading nevertheless incurs bargaining costs and trading risks which might be mitigated if instead the transaction were to be integrated, in which case interests are more thoroughly harmonized and a wider variety of sanctions for policing transactions are thereby made available. Thus, although Macaulay’s ( 1963) and Leff’s (1970) treatments of quasicontractual relations between firms are important and provide useful perspective, the basic argument of the preceding chapters, which relies merely on systematic incentive and control differences between internal and interfirm organization, is not vitiated on this account.

Richardson’s discussion of interfirm cooperation ought also to be cited in this connection. As he puts it: “We must not imagine that reality exhibits a sharp line of distinction; what confronts us is a continuum passing from transactions, such as those on organized commodity markets, where the cooperative element is minimal, through intermediate areas in which there are linkages of traditional connection and good will, and finally to those complex and interlocking clusters, groups and alliances which represent cooperation fully and formally developed” ( 1972, p. 887) . His numerous examples of intermediate forms of cooperative interfirm behavior illustrate the point.

I nevertheless urge that focusing on the significant differences between normal sales and hierarchical relations is useful. For one thing, if the basic differences between these transactional modes can be identified and explicated, terms of reference will emerge that will permit the cooperative properties of intermediate forms of contracting to be more accurately assessed. Furthermore, suppose that all contracts were assigned to the mainly autonomous contracting, mainly hierarchical, or ambiguous categories, and frequency distributions for contracts of each type were drawn with respect to the degree of cooperation. I submit that while the resulting distributions would overlap, the modal degree of cooperation for the hierarchical distribution would surely exceed that for the autonomous distribution. The “relevant” contracts, for the purpose of this book, are those which cluster around these modes.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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