The Governance of Contractual Relations: Efficient Governance

As discussed above, the principal dimensions for describing transactions are asset specificity, uncertainty, and frequency. It will facilitate the argument in this section to assume that uncertainty is present in sufficient degree to pose an adaptive, sequential decision requirement and to focus on asset specificity and frequency. Three frequency classes—one-time, occasional, and recurrent—and three asset specificity classes—nonspecific, mixed, and highly specific—will be considered. To simplify the argument further, the following assumptions are made: (1) Suppliers and buyers intend to be in business on a continuing basis; thus the special hazards posed by fly-by-night firms can be disregarded. (2) Potential suppliers for any given requirement are numerous—which is to say that ex ante monopoly in ownership of specialized resources is assumed away. (3) The frequency dimension refers strictly to buyer activity in the market. (4) The investment dimension refers to the characteristics of investments made by suppliers.

Although discrete transactions are intriguing—for example, purchasing local spirits from a shopkeeper in a remote area of a foreign country one expects never again to visit or refer his friends—few transactions have such a totally isolated character. For those that do not, the difference between onetime and occasional transactions is not apparent. Accordingly, only occasional and recurrent frequency distinctions will be maintained. The two-by-three matrix shown in Figure 3-1 thus describes the six types of transactions to which governance structures must be matched. Illustrative transactions appear in the cells.

The question now is how Macneil’s contracting classifications correspond to the description of transactions in Figure 3-1. Several propositions are suggested immediately: (1) Highly standardized transactions are not apt to require specialized governance structure. (2) Only recurrent transactions will support a highly specialized governance structure.3 (3) Although occasional transactions of a nonstandardized kind will not support a transaction-specific governance structure, they require special attention nonetheless. In terms of Macneil’s three-way classification of contract, classical contracting presumably applies to all standardized transactions (whatever the frequency), relational contracting develops for transactions of a recurring and nonstandardized kind, and neoclassical contracting is needed for occasional, nonstandardized transactions.

FIGURE 3-1. Illustrative Transactions

Specifically, classical contracting is approximated by what is described below as market governance, neoclassical contracting involves trilateral gov- ernance, and the relational contracts that Macneil describes are organized in bilateral or unified governance structures. Consider these seriatim.

2. Market Governance 

Market governance is the main governance structure for nonspecific transactions of both occasional and recurrent contracting. Markets are especially efficacious when recurrent transactions are contemplated, since both parties need only consult their own experience in deciding to continue a trading relationship or, at little transitional expense, turn elsewhere. Being standardized, alternative purchase and supply arrangements are presumably easy to work out.

Nonspecific but occasional transactions are ones for which buyers (and sellers) are less able to rely on direct experience to safeguard transactions against opportunism. Often, however, rating services or the experience of other buyers of the same good can be consulted. Given that the good or service is of a standardized kind, such experience rating, by formal and informal means, will provide incentives for parties to behave responsibly.

To be sure, such transactions take place within and benefit from a legal framework. But such dependence is not great. As S. Todd Lowry puts it, “the traditional economic analysis of exchange in a market setting properly corre- sponds to the legal concept of sale (rather than contract), since sale presumes arrangements in a market context and requires legal support primarily in enforcing transfers of title” (1976, p. 12). He would thus reserve the concept of contract for exchanges where, in the absence of standardized market alternatives, the parties have designed “patterns of future relations on which they could rely” (1976, p. 13).

The assumptions of the discrete contracting paradigm are rather well satisfied for transactions where markets serve as a main governance mode. Thus the specific identity of the parties is of negligible importance; substantive content is determined by reference to formal terms of the contract; and legal rules apply. Market alternatives are mainly what protect each party against opportunism by his opposite. Litigation is strictly for settling claims; concentrated efforts to sustain the relation are not made, because the relation is not independently valued.31

2. Trilateral Governance 

The two types of transactions for which trilateral governance is needed are occasional transactions of the mixed and highly specific kinds. Once the principals to such transactions have entered into a contract, there are strong incentives to see the contract through to completion. Not only have spe-cialized investments been put in place, the opportunity cost of which is much lower in alternative uses, but the transfer of those assets to a successor supplier would pose inordinate difficulties in asset valuation. The interests of the principals in sustaining the relation are especially great for highly idiosyncratic transactions.

Market relief is thus unsatisfactory. Often the setup costs of a transaction- specific governance structure cannot be recovered for occasional transactions. Given the limits of classical contract law for sustaining such transactions, on the one hand, and the prohibitive cost of transaction-specific (bilateral) governance, on the other, an intermediate institutional form is evidently needed.

Neoclassical contract law has many of the sought-after qualities. Thus rather than resorting immediately to court-ordered litigation—with its trans- action-rupturing features—third-party assistance (arbitration) in resolving disputes and evaluating performance is employed instead. (The use of the architect as a relatively independent expert to determine the content of form construction contracts is an example (Macneil, 1978, p. 566).) Also, the expansion of the specific performance remedy in past decades is consistent with continuity purposes—though Macneil declines to characterize specific performance as the “primary neoclassical contract remedy” (1978, p. 879). The section of the Uniform Commercial Code that permits the “seller aggrieved by a buyer’s breach . . . unilaterally to maintain the relation” is yet anotherexample.

3. Bilateral Governance

The two typps of transactions for which specialized governance structure are commonly devised are recurring transactions supported by investments of the mixed and highly specific kinds. The fundamental transformation applies because of the nonstandardized nature of the transactions. Continuity of the trading relation is thus valued. The transactions’ recurrent nature potentially permits the cost of specialized governance structures to be recovered.

Two types of transaction-specific governance structures for intermediate product market transactions can be distinguished; bilateral structures, where the autonomy of the parties is maintained, and unified structures, where the transaction is removed from the market and organized within the firm subject to an authority relation (vertical integration). Bilateral structures have only recently received the attention they deserve, and their operation is least well understood. The issues are elaborated in Chapters 7 and 8.

Highly idiosyncratic transactions are ones where the human and physical assets required for production are extensively specialized, so there are no obvious scale economies to be realized through interfirm trading that the buyer (or seller) is unable to realize himself (through vertical integration). In the case, however, of mixed transactions, the degree of asset specialization is less complete. Accordingly, outside procurement for those components may be favored by scale economy considerations.

As compared with vertical integration, outside procurement also maintains high-powered incentives and limits bureaucratic distortions (see Chapter 6). Problems with market procurement arise, however, when adaptability and contractual expense are considered. Whereas internal adaptations can be effected by fiat, outside procurement involves effecting adaptations across a market interface. Unless the need for adaptations has been contemplated from the outset and expressly provided for by the contract, which often is impossible or prohibitively expensive, adaptations across a market interface can be accomplished only by mutual, follow-on agreements. Inasmuch as the interests of the parties will commonly be at variance when adaptation proposals (originated by either party) are made, a dilemma is evidently posed.

On the one hand, both parties have an incentive to sustain the relationship rather than to permit it to unravel, the object being to avoid the sacrifice of valued transaction-specific economies. On the other hand, each party appropriates a separate profit stream and cannot be expected to accede readi’y to any proposal to adapt the contract. What is needed, evidently, is some way for declaring admissible dimensions for adjustment such that flexibility is provided under terms in which both parties have confidence. This can be accomplished partly by (1) recognizing that the hazards of opportunism vary with the type of adaptation proposed and (2) restricting adjustments to those where the hazards are least. But the spirit within which adaptations are effected is equally important (Macaulay, 1963, p. 61).

Quantity adjustments have much better incentive-compatibility properties than do price adjustments. For one thing, price adjustments have an unfortunate zero-sum quality, whereas proposals to increase, decrease, or delay delivery do not. Also, except as discussed below, price adjustment proposals involve the risk that one’s opposite is contriving to alter the terms within the bilateral monopoly trading gap to his advantage. By contrast, a presumption that exogenous events, rather than strategic purposes, are responsible for quantity adjustments is ordinarily warranted. Given the idiosyn-cratic nature of the exchange, a seller (or buyer) simply has little reason to doubt the representations of his opposite when a quantity change is proposed.

Thus buyers will neither seek supply from other sources nor divert products obtained (at favorable prices) to other uses (or users)—because other sources will incur high setup costs and an idiosyncratic product is nonfuhgible across uses and users. Likewise, sellers will not withhold supply because better opportunities have arisen, since the assets in question have a specialized character. The result is that quantity representations for idiosyncratic products can ordinarily be taken at face value. Since inability to adapt both quantity and price would render most idiosyncratic exchanges nonviable, quantity adjustments occur routinely.

Of course, not all price adjustments pose the same degree of hazard. Those which pose few hazards will predictably be implemented. Crude escalator clauses that reflect changes in general economic conditions are one possibility. But since such escalators are not transaction-specific, imperfect adjustments often result when these escalators are applied to local conditions. Consider therefore whether price adjustments more closely related to local circumstances are feasible. The issue here is whether interim price adjustments can be devised for some subset of conditions such that the strategic hazards described above do not arise. What are the preconditions?

Crises facing either of the parties to an idiosyncratic exchange constitute .e class of exceptions. Faced with a viability crisis that jeopardizes the relationship, ad hoc price relief may be permitted. More relevant and interesting, however, is whether there are circumstances whereby interim price adjustments are made routinely. The preconditions here are two: first, proposals to adjust prices must relate to exogenous, germane, and easily verifiable events; and second, quantifiable cost consequences must be confidently related thereto. An example may help to illustrate. Consider a component for which a significant share of the cost is accounted for by a basic material (copper; steel). Assume, moreover, that the fractional cost of the component in terms of this basic material is well specified. An exogenous change in prices of materials would in such a case pose few hazards if partial but interim price relief were permitted by allowing pass- through according to formula. A more refined adjustment than aggregate escalators would afford thereby obtains.

It bears emphasis, however, that not all costs so qualify. Changes in overhead or other expenses for which validation is difficult and which, even if verified, bear an uncertain relation to the cost of the component will not be passed through in a similar way. Recognizing the hazards, the parties will simply forgo relief of this kind.

4. Unified Governance 

Incentives for trading weaken as transactions become progressively more idiosyncratic. The reason is that as human and physical assets become more specialized to a single use, and hence less transferable to other uses, economies of scale can be as fully realized by the buyer as by an outside supplier. The choice of organizing mode then turns entirely on which mode has superior adaptive properties. As discussed in Chapter 4, vertical integration will ordinarily appear in such circumstances.

The advantage of vertical integration is that adaptations can be made in a sequential way without the need to consult, complete, or revise interfirm agreements. Where a single ownership entity spans both sides of the transaction, a presumption of joint pro’fit maximization is warranted. Thus price adjustments in vertically integrated enterprises will be more complete than in interfirm trading. And, assuming that internal incentives are not misaligned, quantity adjustments will be implemented at whatever frequency serves to maximize the joint gain to the transaction.

Unchanging identity at the interface coupled with extensive adaptability in both price and quantity is thus characteristic of highly idiosyncratic transactions. Market contracting gives way to bilateral contracting, which in turn is supplanted by unified contracting (internal organization) as asset specificity progressively deepens.

The efficient match of governance structures with transactions that results from the foregoing is shown in Figure 3-2.

FIGURE 3-2. Efficient Governance

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

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