Transaction Cost Economics: A Simple Contracting Schema

Assume that a good or service can be supplied by either of two alternative technologies. One is a general purpose technology, the other a special purpose technology. The special purpose technology requires greater investment in transaction-specific durable assets and is more efficient for servicing steady- state demands.

Using k as a measure of transaction-specific assets, transactions that use the general purpose technology are ones for which k = 0. When transactions use the special purpose technology, by contrast, a k > 0 condition exists. Assets here are specialized to the particular needs of the parties. Productive values wodld therefore be sacrificed if transactions of this kind were to be prematurely terminated. The bilateral monopoly condition described above and elaborated in Chapter 2 applies to such transactions.

Whereas classical market contracting—“sharp in by clear agreement; sharp out by clear performance” (Macneil, 1974, p. 738)—suffices for transactions of the k = 0 kind, unassisted market governance poses hazards whenever nontrivial transaction-specific assets are placed at risk. Parties have an incentive to devise safeguards to protect investments in transactions of the latter kind. Let s denote the magnitude of any such safeguards. An s = 0 condition is one in which no safeguards are provided; a decision to provide safeguards is reflected by an ,s > 0 result.

Figure 1-2: A Simple Contrachting Schema

Figure 1-2 displays the three contracting outcomes corresponding to such a description. Associated with each node is a price. So as to facilitate comparison between nodes, assume that suppliers (1) are risk neutral, (2) are prepared to supply under either technology, and (3) will acceprany safeguard condition whatsoever so long as an expected breakeven result can be projected. Thus node A is the general purpose technology (k = 0) supply relation for which a breakeven price of pt is projected. The node B contract is supported by transaction-specific assets (k > 0) for which no safeguard is offered (s = 0). The expected breakeven price here is p. The node C contract also employs the special purpose technology. But since the buyer at this node provides the supplier with a safeguard, (s > 0), the breakeven price, p, at node C is less than p.

The protective safeguards to which I refer normally take on one or more of three forms. The first is to realign incentives, which commonly involves some type of severance payment or penalty for premature termination A second is to create and employ a specialized governance structure to which to refer and resolve disputes. The use of arbitration, rather than litigation in the courts, is thus characteristic of node C governance. A third is to introduce trading regularities that support and signal continuity intentions. Expanding a trading relation from unilateral to bilateral exchange—through the concerted use, for example, of reciprocity—thereby to effect an equilibration of trading hazards is an example of that last.

This simple contracting schema, which will subsequently be elaborated, applies to a wide variety of contracting issues. It facilitates comparative institutional analysis by emphasizing that technology (fc), contractual gover- nance/safeguards (s) and price- (p) are fully interactive and^are determined simultaneously. Repeated reference to the schema will be made throughout the book. Indeed, it is gratifying that so many applications turn out to be variations on a theme. As Hayek observed, “whenever the capacity of recognizing an abstract rule which the arrangement of these attributes follows has been acquired in one field, the same master mould will apply when the signs for those abstract attributes are evoked by altogether different elements” (1967, p. 50).16

By way of summary, the nodes A, B, and C in the contractual schema set out in Figure 1-2 have the following properties:

  1. Transactions that are efficiently supported by general purpose assets (k = 0) are located at node A and do not need protective governance structures. Discrete market contracting suffices. The world of com- petition obtains.
  1. Transactions that involve significant investments of a transaction- specific kind (k > 0) are ones for which the parties are effectively engaged in bilateral trade.
  2. Transactions located at node B enjoy no safeguards (s = 0), on which account the projected breakeven supply price is great (p¯ > p^). Such transactions are apt to be unstable contractually. They may revert to node A (in which event the special purpose technology would be replaced by the general purpose (k = 0) technology) or be relocated to node C (by introducing contractual safeguards that would encourage the continued use of the k > 0 technology).
  1. Transactions located at node C incorporate safeguards (s > 0) and thus are protected against expropriation hazards.
  2. Inasmuch as price and governance are linked, parties to a contract should not expect to have their cake (low price) and eat it too (no safeguard). More generally, it is important to study contracting in its entirety. Both the ex ante terms and the manner in which contracts are thereafter executed vary with the investment charactristics and the associated governance structures within which transactions are embedded.

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

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