Transaction Cost Economics: A Cognitive Map of Contract

The field of specialization with which transaction cost economics is most closely associated is industrial organization. A number of the leading ap- proaches to the study of industrial organization and the relation that transaction cost economics bears to.them are examined here.

Industrial organization examines contract in terms of the purposes served. What are the parties trying to accomplish? Here as elsewhere in industrial organization, monopoly and efficiency purposes are usefully distinguished. The cognitive map shown in Figure 1-1 begins with this distinction.

1. The Monopoly Branch 

All of the approaches to contract shown in Figure 1 — 1, monopoly and effi- ciency alike,-are concerned with the same puzzle: What purposes are served by supplanting classical market exchange—whereby product is sold at a uniform price to all comers without restriction—by more complex forms of contracting (including nonmarket modes of economic organization)? The monopoly approaches ascribe departures from the classical norm to monopoly purpose. The efficiency approaches hold that the departures serve economizing purposes instead.

FIGURE I -1. Cognitive Map of Contract

The four monopoly approaches to contract are grouped under two head- ings. The first examines the uses of customer and territorial restrictions, resale price maintenance, exclusive dealing, vertical integration, and the like in relation to buyers. The second is concerned with the impact of such practices on rivals.

The “leverage” theory of contract and the price discrimination in- terpretation of nonstandard contracting both focus on buyers. Richard Posner (1979) associates leverage theory with the (earlier) “Harvard School” approach and price discrimination with the “Chicago School approach to antitrust economics. Leverage theory maintains that original monopoly power can be extended and that nonstandard contracting practices accomplish this. Although leverage theory is largely discredited among economists, it maintains ah appeal to many lawyers and continues to find its way into legal briefs16 and court opinions.

The price discrimination approach to nonstandard contracting maintains that original monopoly power is unchanged. Price discrimination is merely a means by which latent monopoly power is actualized. This interpretation of nonstandard contracting has been advanced by Aaron Director and Edward Levi (1956) in conjunction with tie-in sales and by George Stigler (1963) in relation to block booking. Tie-in sales and block booking are purportedly devices by which sellers are able to discover underlying product valuation differences among consumers and to monetize consumers’ surplus.

The other two monopoly approaches examine nonstandard contracting practices in relation to rivals. They are expressly concerned with the enlargement of monopoly power by large established firms in relation to smaller actual or potential rivals. The barriers to entry literature, which is prominently associated with the work of Joe Bain (1956), is in that tradition. The early work in the area has come under considerable criticism, much of it originating with the Chicago School. The main problems with the early work are that it was static and did not carefully identify the essential preconditions for entry barrier arguments to go through. The more recent literature on strategic be-havior relieves many of the objections. Investment and information asym- metries are expressly introduced. Intertemporal attributes are recognized; and reputation effect features are developed. The use of nonstandard contracting as a means of “raising rivals’ costs” (Salop and Scheffman, 1983) is an especially intriguing possibility.

The recent strategic behavior literature excepted, all the monopoly ap- proaches to contract work within the neoclassical framework, where the firm is regarded as a production function. Inasmuch as the natural boundaries of the firm are therein defined by technology, any effort by the firm to extend its reach by recourse to nonstandard contracting was presumed to have monopoly purpose and effect.12 This “applied price theory” approach to industrial organization was the prevailing postwar orientation. As Coase observed (1972, p.61), it informed both of the leading industrial organization texts— the one by Joe Bain (1958); the other by George Stigler (1968). The inhospitality approach to antitrust law enforcement, to which I referred in 1.1, was similarly oriented. Much of the strategic behavior literature, by contrast, is more closely associated with the governance structure conception of the enterprise (see Chapter 14). So as to highlight this important monopoly distinction, the dashed curve (denoted PF) in Figure 1-1 separates the earlier production function approaches from the more recent strategic conception of contract.

2. The Efficiency Branch

Most of what I refer to as the New Institutional Economics is located on the efficiency branch of contract. The efficiency branch of contract distinguishes between those approaches in which incentive alignments are emphasized and those which feature economies of transaction costs. The incentive alignment literature focuses on the ex ante side of contract |New forms of property rights and complex contracting are thus interpreted as efforts to overcome the incen- tive deficiencies of simpler property rights and contracting traditions. Ronald Coase (1960), Armen Alchian (1961; 1965), and Harold Demsetz (1967; 1969) are prominently associated with the property rights literature.20 Leonid Hurwicz (1972; 1973), Michael Spence and Richard Zeckhauser (1971), Ste- phen Ross (1973), Michael Jensen and William Meckling (1976), and James Mirrlees (1976) opened up the agency approach.

The property rights literature emphasizes that ownership matters, where the rights of ownership of an asset take three parts: the right to use the asset, the right to appropriate returns from the asset, and the right to change the form and/or substance of an asset (Furubotn and Pejovich, 1974, p. 4). Upon getting the property rights straight, it is commonly assumed (often implicitly; sometimes explicitly) that asset utilization will thereafter track the purposes of its owners. This will obtain if (1) the legally sanctioned structure of property rights is respected and (2) human agents discharge their jobs in accordance with instructions.

Thus, whereas the monopoly branch of contract interprets nonstandard forms of exchange as having monopoly purpose and effect, the property rights literature would inquire whether mistaken property rights assignments were responsible for resource misallocations. Redescribing property rights, possibly in complex (nonstandard) ways, is what explains contractual irregularities. Put differently, discrete market contracting is supplanted by more complex forms of contracting, because that is the way residual rights to control can be placed in the hands of those who can use those rights most productively.

The agency literature, particularly the early agency literature, emphasizes that principals contract in full awareness of the hazards that contract Execution by agents poses. Thus although the separation of ownership from control attenuates profit incentives, that is anticipated at the time separation occurs and is fully reflected in the price of new shares (Jensen and Meckling, 1976). The future therefore holds no surprises; all of the relevant contracting action is packed into ex ante incentive alignments.

Actually, as Michael Jensen’s influential survey points out (1983), the agency literature has developed in two parts. He refers to the one branch as the positive theory of agency. Here, “capital intensity, degree of specializa-tion of assets, information costs, capital markets, and internal and external labor markets are examples of factors in the contracting environment that interact with the costs of various monitoring and bonding practices to determine the contractual forms” (Jensen, 1983, pp. 334-35). The positive branch repeatedly asserts that natural selection processes are reliably efficacious (Fama, 1980; Jensen, 1983, p. 331; Fama and Jensen, 1983, pp. 301,327)— Armen Alchian’s classic but highly nuanced and very cautious statement of the evolutionary approach to economics (1950) being cited as the main authority.

Jensen refers to the second type of agency literature as that of “prin-cipal-agent” (1983, p. 334). This relatively mathematical literature features ex ante incentive alignments in superlative degree. It has come to be known more recently as the mechanism design approach. This line of research is akin to the earlier contingent claims contracting literature but moves beyond it by admitting contracting complications in the form of private information. Complex problems of incentive alignment are posed (which the contingent claims contracting literature had ignored) if full and candid disclosure of private information cannot be assumed. In other respects, however, the mechanism design and contingent claims contracting literatures are very similar: Both resolve all the relevant contracting issues in a comprehensive ex ante bargain;13 and both assume that court ordering is efficacious.14 Again, efficiency rather than monopoly purposes drive the argument.

The transaction cost literature also maintains the rebuttable presumption that nonstandard forms of contracting have efficiency purposes. Greater atten- tion is shifted, however, to the contract execution stage. As shown in Figure 1-1 the transaction cost approach is split into a governance branch and a measurement branch. Of the two, this book places greater emphas.s on the former Both however, are important and in fact are interdependent.

In common with the property rights literature, transaction cost economics agrees that ownership matters. It furthermore acknowledges that ex ante incentive alignments matter. But whereas the property rights and mechanism design approaches work within the tradition of legal centralism, transaction cost economics disputes that court ordering is efficacious’ Attention is shifted instead to private ordering. What institutions are created with what adaptive, sequential decision-making and dispute settlement properties? To ownership and incentive alignment, therefore, transaction cost economics adds the prop- osition that the ex post support institutions of contract matter.

James Buchanan has argued that “economics comes closer to being a ‘science of contract’ than a ‘science of choice’ [on which account] the max- imizer must be replaced by the arbitrator, the outsider who tries to work out compromises among conflicting claims” (1975, p. 229). The governance approach adopts the science of contract orientation but joins the arbitrator with an institutional design specialist. The object is not merely to resolve conflict in progress but also to recognize potential conflict in advance and devise governance structures that forestall or attenuate it.

Transaction cost economics maintains that it is impossible to concentrate all of the relevant bargaining action at the ex ante contracting stage. Instead, bargaining is pervasive—on which account the institutions of private ordering and the study of contracting in its entirety take on critical economic Significance. The behavioral attributes of human agents, whereby conditions of bounded rationality and opportunism are joined, and the complex attributes of transactions (with special reference to the condition of asset specificity) are responsible for that condition.

The measurement branch of transaction cost economics is concerned with performance or attribute ambiguities that are associated with the supply of a good or service. The Alchian-Demsetz (1972) treatment of technological nonseparabilities (team organization) is an example. The issues have since been addressed by William Ouchi (1980b) in the context of work organization and Yoram Barzel (1982) with respect to the organization of markets. A recent interesting application is the study by Roy Kenney and Benjamin Klein (1983) of what they refer to as “oversearching.” They take exception with Stigler’s view that block booking has monopoly (price discrimination) pur- poses and argue instead that it serves to economize on measurement costs.

As indicated, this book deals mainly with the governance branch of transaction cost economics. Measurement aspects are also treated, however— as indeed they must be, as governance and measurement are interdependent.

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

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