The Governance of Contractual Relations: Uncertainty

The proposed match of governance structures with transactions considers only two of the three dimensions for describing transactions: asset specificity and frequency. The third dimension, uncertainty, is assumed to be present in sufficient degree to pose an adaptive, sequential decision problem. The occasion to make successive adaptations arises because of the impossibility (or costliness) of enumerating all possible contingencies and/or stipulating appropriate adaptations to them in advance. The effects on economic organization of increases jn uncertainty above that threshold level have not, however, been considered.

As indicated earlier, nonspecific transactions are ones for which continuity has little value, since new trading relations can be easily arranged by both parties. Increasing the degree of uncertainty does not alter this. Market governance (classical contracting) thus holds across standardized transactions of all kinds, whatever the degree of uncertainty.

Matters change when asset specificity is introduced. Since continuity now matters, increasing the degree of parametric uncertainty makes it more imperative to organize transactions within governance structures that have the capacity to work things out.” Failure to support transaction-specific assets with protective governance structures predictably results in costly haggling and maladaptiveness. Efforts to restore a position on the shifting contract curve may be forgone for this reason. The intrusion of behavioral uncertainty, which is associated with unique events, compounds the difficulties.

Indeed, though it is extreme and even implausible in many trading situa- tions, it is not strictly essential for the original disturbance to which an adaptation is sought to have exogenous origins. As discussed in Chapter 7, Section 4, one of the parties to a bilateral trade can contrive to introduce a disturbance that alters the profit prospects of the other. An even more blatant example would be for one party to make false state of the world declarations. Thus suppose that a contract stipulates that X will be delivered under θ1, and X + δ under θ2, where θ1, and θ2 refer to state realizations. If it is difficult for third parties to discern which state actually obtains, buyers may falsely assert that θ2 obtains. Although such blatant opportunism may be rare, it nevertheless illustrates the problems that arise when trading parties possessing the behavioral attributes of human nature as we know it are joined, by reason of asset specificity, in a bilateral trading situation.

Transactions with mixed investment attributes pose especially interesting organizational problems. Unless an appropriate market-assisted governance structure can be devised, such transactions may “flee” to one of the polar extremes as the degree of uncertainty increases. One possibility would be to sacrifice valued design features in favor of a more standardized good or service. Market governance would then apply. Alternatively, the valued design features could be preserved (perhaps even enhanced) and the transaction assigned to internal organization instead. Sometimes, however, it will be feasible to devise nonstandard contracts of the kinds discussed in Chapters 7 and 8. Where that is done (and is not prohibited by public policy), bilateral contracting relations between nominally autonomous contracting agents can often survive the stresses of greater uncertainty.

Reductions in uncertainty, of course, warrant shifting transactions in the opposite direction—although such shifts may be delayed if the assets in question are long-lived. To the extent that uncertainty decreases as an industry matures, which is the usual case, the benefits that accrue to internal organization (vertical integration) presumably decline. Accordingly, greater reliance on market procurement is commonly feasible for transactions of recurrent trading in mature industries.

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

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