The organizational failures framework: Opportunism and Small Numbers

1. General

Opportunism extends the conventional assumption that economic agents are guided by considerations of self-interest to make allowance for st™ eg,c behavior. This involves self-interest seeking with guile and has profound implications for choosing  between alternative contractual relationships. Such strategic interaction has been discussed in other contexts by other writers; Schelling’s (1960) and Coffman’s (1969) treatments are especially notable.

Opportunism is to be distinguished from both stewardship behavior an instrumental behavior. Whereas stewardship behavior involves a trust relation m which the word of a party can be taken as his bond, instrumental behavior is a more neutral mode in which there is no necessary self- awareness that the interests of a party can be furthered by stratagems of any sort (Goffman, 1969, p. 88). Opportunistic behavior differs from both ecause it involves making “false or empty, that is, self-disbelieved, threats and promises An the expectation that individual advantage will thereby be realized (Goffman, 1969, p. 105).                                                                                                                                       ^

Advantages that are due to (1) pre-existing and fully disclosed pro- ductive conditions (for example, a unique location or differential skill) that obtain at the outset should be distinguished from advantages which esult from (2a) selective or distorted information disclosure or (2b) self- disbelieved promises regarding future conduct. Advantages of the first type do not involve opportunism. Rather, parties are simply realizing returns to which their pre-existing position entitles them; no special concern over the form which a contract takes develops on this account.

e strategic manipulation of information or misrepresentation of intentions, however, are to be regarded as opportunistic and do have com-parative institutional significance for assigning transactions to one mode of organization instead of another. Opportunism of the (2b) kind is of special importance in this connection. Thus, if opportunism of the second kind were missing, then self-enforcing promises to the effect that “I solemnly pledge to execute this contract efficiently and to seek only fair returns at the contract renewal interval” could be extracted as a condition of being awarded the initial contract and, except as it affects the terms struck during the original negotiations, opportunism of the (2a) kind would vanish as well. Accordingly, the importance of assigning transactions to one mode of organization rather than another would be negligible.

By assumption, however, self-enforcing commitments of this kind can- not be secured. At least some of the agents who accede to such terms do it casually, in a self-disbelieved way. Since these types cannot be distinguished ex ante from sincere types (see the discussion of information impactedness below), relying on such promises exposes sales contracts to hazards during contract execution and at the contract renewal interval. Lest such contracts be inefficiently executed, an effort must be made to anticipate contingencies and spell out terms much more fully than would otherwise be necessary. Also, inasmuch as corners can be cut on even a detailed agreement in ways that are difficult to discern ex post, the agreement needs to be monitored. Internal organization may thus arise because it pemits economies to be realized in initial contracting and/or monitoring respects.

But merely to harbor opportunistic inclinations does not imply that markets are flawed on this account. It is furthermore necessary that a small- numbers condition prevail. Absent this, rivalry among large numbers of bidders will render opportunistic inclinations ineffectual. Parties who attempt to secure gains by strategic posturing will find, at the contract renewal interval, that such behavior is nonviable. Opposite parties will arrange alternative trades in which competitive terms are satisfied.

When, however, opportunism is joined with a small-numbers condition, the trading situation is greatly transformed . All of the types of difficulties associated with exchange between bilateral monopolists in stochastic market circumstances now appear. The transactional dilemma that is posed is this: it is in the interest of each party to seek terms most favorable to him, which encourages opportunistic representations and haggling. The interests of the system, by contrast, are promoted if the parties can be joined in such a way as to avoid both the bargaining costs and the indirect costs (mainly maladaptation costs) which are generated in the process.

What is of special interest to the analysis here is that while frequently a large-numbers condition will appear to obtain at the outset, this may be illusory or may not continue into contract renewal stages. The illusion is that implicit homogeneity assumptions may not be satisfied. Nonhomogeneity coupled with information impactedness conditions gives rise to serious transactional difficulties – as the discussion of the insurance problem in the preceding chapter indicates and as Akerlofs examination ol the used car market reveals (1970, pp. 489-492).

Much more germane to my interests here, however, is that large- numbers homogeneity conditions which obtain at the outset may no longer hold at the contract renewal interval. If parity among suppliers is upset by first-mover advantages, so that winners of original bids subsequently enjoy nontrivial cost advantages over nonwinners, the sales relationship that eventually obtains is effectively of the small-numbers variety. The argument has relevance not only for examining when separable components will be made internally rather than purchased, but also when the work flow between successive individuals will be exchanged under an employment rather than a sales relationship.

2. An Example


Arrow illustrates  the problems of small-numbers exchange by refer-ence to a lighthouse exampe (1969, p.58). He abstracts from uncertainty by assuming that the lighthouse keeper knows exactly when each ship has need for his services. Furthermore, Arrow assumesttaonly one ship will be within range of the lighthouse at  any one time, so that exclusion is pis slble by turning off the light to a nonpaying ship. An exchange problem nevertheless arises because there is only a single seller and a Single buyer “and no competitive forces to driver the two into competitive equilibrium” (1969, p.58).

This example Is a version of the bilateral monopoly problem.  As is well-known, the parties have an incentive to exchange the joint profit maximizing  quantity, but they are also inclined to expend considerable resources bargaining over the price at which the exchange is to take place. Only however, to the extern that the parties are joined in recurrent small-numbers bargaining under changing market circumstances is an interesting com-parative institutional choice posed.

Absent recurrent bargaining, a merger agreement has nothing to commend it over a one-shot exchange agreement Absent changing racket circumstances, an exchange agreement, once reached, can be made to hold indefinitely. The advantage of internal organization when recurrent exchange and changing circumstances are joined is that a merger agree-ment both permits adaptation and forecloses future haggling. Recurrent spot contracting, by contrast, is impaired as each party seeks to adjust the terms to his advantage with each change in the data, and complex contin-gent claims contracts are apt to be infeasible.


A problem of lecurring interest throughout the book is the following: Although a large-numbers exchange condition obtains at the outset, it is transformed during contract execution into a small-numbers exchange relation on account of (1) idiosyncratic experience associated with con tract execution, and (2) failures in the human and nonhuman capital markets. The issues here are best addressed in the context of information impacted- ness in Section 3, below.

3. Internal Organization

Internal organization enjoys advantages of three kinds over market modes of contracting in circumstances where opportunism and small- numbers conditions are joined. First, in relation to autonomous contractors, the parties to an internal exchange are less able to appropriate subgroup gains at the expense of the overall organization (system), as a result of opportunistic representations. The incentives to behave opportunistically are accordingly attenuated. Second, and related, internal organization can be more effectively audited. Finally, when differences do arise, internal organization realizes an advantage over market mediated exchange in dispute settling respects. Consider these seriatim.     . ,

Unlike autonomous contractors, internal divisions that trade with one another in a vertical integration relationship do not ordinarily have pre-emptive claims on their respective profit streams. Even though the divisions in question may have profit center standing, this is apt to e exercised in a restrained way. For one thing, the terms under which internal trading occurs are likely to be circumscribed. Cost-plus pricing rules, and variants thereof, preclude supplier divisions from seeking the monopolistic prices which their sole source supply position might otherwise entitle them In addition, the managements of the trading divisions are more susceptible to appeals for cooperation. Since the aggressive pursuu of individual interests redounds to the disadvantage of the system, and as present and prospective compensation (including promotions) can be easily varied by the general office to reflect noncooperation, simple requests to adopt a cooperative mode are apt to be heeded. Altoget er, a more nearly joint profit maximizing attitude and result is to be expected.

The auditing advantage of internal organization in relation to lnteriirm organization is attributable to constitutional and incentive differences which operate in favor of the internal mode. An external auditor is typically constrained to review written records and documents and in other respec s restrict the scope of his investigation to clearly pertinent matters. An internal auditor, by contrast, has greater freedom of action, both to include less formal evidence and to explore the byways into which his investiga-tion leads.  The difference in scope is partly explained by the fact that the internal auditor can be presumed to act in the interests of the firm – which eads into an examination of incentive differences.

Whereas an internal  auditor is not a partisan but regards himself, and regarded by others, in mainly instrumental terms, the external auditor is associated with the ‘’other side1’ and his motives are regarded suspiciously The degree of cooperation received by the auditor from the audited party varies accor ingly. The external auditor can expect to receive only per unctory cooperation. Potential “informants,” who as insiders know which conditions are amiss and why, are unlikely to volunteer informa- ion since, internally, it is apt to be regarded as an act of disloyalty and externally, is an unlikely route to reward. Where, however, audits of operatmg divisions are made by the general office, the same stigma is not attached to such disclosure. Information impactedness conditions are us much more easily overcome in internal than in interfirm trades.

Finally, internal organization is not beset with the same kinds of difficulties that autonomous contracting experiences when disputes arise between the parties. Although interfirm disputes are often settled out of court m an informal fashion (Macaulay, 1963; Leff, 1970), this resolution is sometimes difficult and interfirm relations are often strained. Costly litigation is sometimes unavoidable. Internal organization, by contrast is less given to such disputes (since the parties are more inclined to adapt cooperatively) and is able to settle many such disputes by appeal to fiat -an enormously efficient way to settle instrumental differences. In circumstances, however, where interfirm profitability differences are involved as they are when the transaction takes place between autonomous parties) iat is apt to be an inadmissible conflict resolution device. (Who is to be the arbiter? Is he adequately informed? What are his biases? Can he be bribed?) More generally, internal organization supplants markets (in labor intermediate product, and capital market respects) partly because h assumes and effectively discharges certain quasijudicial functions.

The upshot is that internal organization is less vulnerable to the hazards of opportunism when – either from the outset or, as is more commonly the case, as a result of idiosyncratic experience during contract execution- a small-numbers exchange condition obtains.

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

Leave a Reply

Your email address will not be published. Required fields are marked *