Transaction Cost Economics: The World of Contract

The world of contract is variously described as one of (1) planning, (2) promise, (3) competition, and (4) governance (or private ordering). Which of these descriptions is most applicable depends on the behavioral assumptions that pertain to an exchange and on the economic attributes of the good or service in question.

As developed more fully in Chapter 2, the study of economic organization turns critically on two behavioral assumptions. What cognitive competencies and what self-interest seeking propensities are ascribed to the human agents engaged in exchange? Transaction cost economics assumes that human agents are subject to bounded rationality, whence behavior is “intendedly rational, but only limitedly so” (Simon, 1961, p. xxiv), and are given to opportunism, which is a condition of self-interest seeking with guile. Transaction cost economics further maintains that the most critical dimension for describing transactions is the condition of asset specificity. Parties engaged in a trade that is supported by nontrivial investments in transaction-specific assets are effectively operating in a bilateral trading relation with one another. Harmonizing the contractual interface that joins the parties, thereby to effect adaptability and promote continuity, becomes the source of real economic value.

But for uncertainty, problems of economic organization are relatively uninteresting. Assume, therefore, that uncertainty is present in nontrivial degree and consider the ramifications for contract of differences in bounded rationality, opportunism, and assSt specificity. Assume, in particular, that each of these conditions can take on either of two values: Either it is present in significant degree (denoted +) or it is presumed to be absent (denoted 0). Consider the three cases in which only one of these factors is presumed to be absent and then that in which all three are joined. Table 1-1 shows the four conditions to be compared and the contracting model that is associated with each.

The case where parties are opportunistic and assets are specific but economic agents have unrestricted cognitive competence essentially describes the mechanism design literature (Hurwicz, 1972; 1973; Meyerson, 1979; Harris and Townsend, 1981). Although the condition of opportunism requires that contracts be written in such a way as to respect private information, whence complex incentive alignment issues are posed, all the relevant issues of contract are settled at the ex ante bargaining stage. Given unbounded rationality, a comprehensive bargain is struck at the outset, according to which appropriate adaptations to subsequent (publicly observable) contingent events are fully described .^Contract execution problems thus never arise (or defection from such agreements is deterred because court adjudication of all disputes is assumed to be efficacious (Baiman, 1982, p. 168)). Contract, in the context of unbounded rationality, is therefore described as a world of planning.

Consider alternatively the situation where agents are subject to bounded rationality and transactions are supported by specific assets, but the condition of opportunism is assumed to be absent, which implies that the word of an agent is as good as his bond. Although gaps will appear in these contracts, because of bounded rationality, they do not pose execution hazards if the parties take recourse to a self-enforcing general clause. Each party to the contract simply pledges at the outset to execute the contract efficiently (in a joint profit maximizing manner) and to seek only fair returns at contract renewal intervals. Strategic behavior is thereby denied. Parties to a contract thus extract all such advantages as their endowments entitle them to when the initial bargain is struck. Thereafter contract execution goes efficiently to completion because promises of the above-described kind are, in the absence of opportunism, self-enforcing. Contract, in this context, reduces to a world of promise.

Consider, then, the situation where agents are subject to bounded ra- tionality and are given to opportunism, but asset specificity is presumed to be absent. Parties to such contracts have no continuing interests in the identity of one another. This describes the world where discrete market contracting is efficacious, where markets are fully contestable,15 and where franchise bid-ding for natural monopoly goes through. Inasmuch as fraud and egregious contract deceits are deterred by court ordering, contract, in this context, is described by a world of competition.

Each of the three devices fails when bounded rationality, opportunism, and asset specificity are joined. Planning is necessarily incomplete (because of bounded rationality), promise predictably breaks down (because of oppor- tunism), and the pairwise identity of the parties now matters (because of asset specificity). This is the world of governance. Since the efficacy of court ordering is problematic, contract execution falls heavily on the institutions of private ordering. This is the world with which transaction cost economics is concerned. The organizational imperative that emerges in such circumstances is this: Organize transactions so as to economize on boundédhrationality while simultaneously safeguarding them against the hazards of opportunism. Such a statement supports a different and larger conception of the economic problem than does the imperative “Maximize profits!”

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

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