Transaction Cost in Law

Ronald Gilson advances the novel and controversial view that business lawyers should be thought of as “transaction cost engineers” (1984). Such an approach ascribes value enhancement to the job of transaction design, which is a theme advanced repeatedly in this book.15 It emphasizes and gives content to the affirmative side of lawyering. Transaction cost economics will figure more prominently if those views are adopted (Gilson, 1984, pp. 127-29).

Transaction cost economics also resonates with Robert Clark’s recent methodological commentary on legal scholarship. Thus Clark favors an “in- terdisciplinary study of legal evolution” that is more microanalytic than the usual historical accounts of legal change. Such an approach “should be more institutional and doctrinal than is some of the interesting recent theoretical work by economic analysts on the evolution of the common law: its analysis of systems of legal rules and nonlegal practices should be detailed in its systematic attention to particular institutions and doctrines” (Clark, 1981, p. 1238, emphasis added).

That aspects of antitrust, regulation, corporate governance, and labor law all benefit from adopting a microanalytic point of view in which transaction costs are emphasized is, I hope, evident from earlier chapters. More can and 1 am sure will be done—to refine extant applications and address additional issues—in each of those areas. My remarks here, however, focus on the research needs of transaction cost economics in the area of contract— which, after all, is the unifying concept of organization that illuminates all of those areas.

1. The Governance Mix 

Although contract law scholarship has repeatedly and vigorously taken exception to the fiction that contracts are enforced literally and that disputes are routinely presented to and settled by the courts (Llewellyn, 1931; Macaulay, 1963; Macneil, 1974; Galanter, 1981; Kronman, 1985), this tradition retains a firm grip on legal and, even more, on economic research. That is partly explained by the fact that the fiction of pure legal centralism is an enormous analytical convenience. But the absence of a well-specified alternative theory of contract is probably the main culprit.

Recent economic scholarship has, however, made headway with models of contract in which court ordering is eschewed altogether. Pure private ordering maintains that the parties cannot turn to the courts or to other third parties but must look to the self-enforcing features of the contract alone (Telser, 1981; Klein and Leffler, 1981). The hostage model in Chapter 7 is in that tradition. Albeit instructive, this rival tradition is also a fiction. Contract in practice is rarely located at either of those extremes.

To be sure, it is sometimes argued that models of polar extremes are wholly adequate.17 But the relevant test, presumably, is whether middle- range phenomena can better be understood and refutable implications derived by studying these matters directly. As matters stand at present, contracts in the middle range are notoriously intractable. But if that is where the main contracting action resides, more attention to mixed transactions is arguably warranted.18 Transaction cost economics should help to inform such an undertaking.

The basic strategy is that described and employ^ in earlier chapters. Thus if transactions differ in their attributes.jf^gbvernance structures are aligned to the needs of transactions in a discriminating way, and if private ordering and court ordering can be used in combination rather than separately, then the study of contract will benefit from an effort to identify the mix of private and public structures that best serve the purposes of the parties (Kron- man, 1985). Deep knowledge of institutional structures, as well as the objective needs of contract, will be needed to conduct the exercise (Gilson, 1984).

2. Contract Law Doctrine 

Llewellyn observes: “In no legal system are all promises enforceable; people and courts have too much sense“ (1931, p. 738). That is evidently supported by considerations of fairness: “When we approach constructive conditions bottomed on the unforeseen, [n]ot agreement, but fairness, is the goal of the inquiry. This holds of impossibility, and of frustration; it holds of mistake” (p. 746). The contract exceptions to which Macneil refers presumably have similar origins:

A less than total commitment to the keeping of promises is reflected in countless ways in the legal system. The most striking is the modesty of its remedial commitment; contract remedies are generally among the weakest of those the legal system can deliver. But a host of doctrines and techniques lies in the way even of those remedies: impossibility, frustration, mistake, manipulative interpretation, jury discretion, consideration, illegality, duress, undue influence, unconscionability, capacity, forfeiture and penalty rules, doctrines of substantial performance, severability, bankruptcy laws, statutes of frauds, to name some; almost any contract doctrine can and does serve to make the commitment of the legal system to promise keeping less than complete. |Macneil, 1974. p. 73]

Although I am persuaded that the fairness to which Llewellyn refers motivates each of those doctrinal matters, those doctrines also reflect consid- erations of efficiency. The basic argument is this: As between a contracting regime in which agreements are strictly enforced, at the insistence of either party, and a regime where insistence upon strict enforcement by one party would impose “undue” hardship on the other, the latter regime will be preferred— assuming that undue hardship exceptions can be distinguished without difficulty.

Such an approach to contract invites the courts to develop contract law doctrines in which exceptions to the normal presumption of strict enforcement are provided. It asks that contracts be embedded in a governance structure in which the parties have greater confidence. Upon realization that the contracting process will be i.mpaired (some contracts will not be reached; other agreements will be negotiated only at great expense) if the private net benefit calculus is everywhere permitted to be fully determinative in the ex post period, the contracting population asks that literal enforcement be prohibited where the requisite conditions obtain. The object is to effect compromise, conciliation, or forgiveness where outcomes judged to be harsh or punitive would otherwise result. Although that can be (and is) interpreted as an effort by the people and the courts to review promise with reference to fairness and justice, the provision for such exceptions is also consonant with an extended efficiency rationale. Embedding contract in a framework in which outliers arc truncated yields efficiency benefits of the above-described systems kind.

Inasmuch as there are numerous sources of contract disappointment, and not all are accorded relief, the critical question is, Which hardships are undue? Very preliminary efforts to deal with that query are reported elsewhere (Williamson, forthcoming). Suffice it to observe here that while appeal to transaction cost reasoning helps to organize the issues, a great deal remains to be done before doctrinal consistency and clarity can be claimed.

3. Contracting in Its Entirety

It is rudimentary that people cannot have their cake and eat it too. Insistence upon studying contracting in its entirety serves to avoid that fallacy—which comes up repeatedly in the study of contract. Consider Charles Fried’s treatment of Batsakis v. Demotsis, where “the defendant, desperate for money soon after the German occupation of Greece, borrowed an amount of Greek currency, which in those chaotic circumstances mavhave been the equivalent of as little as fifty dollars, against her promise toTepay two thousand dollars plus normal interest from funds she controlled in the United States (Fried, 1981, p. 109). Fried declares that such a bargain is “offensive to decency”, and asserts that “Batsakis had a duty to share with his destitute countrymen.” Fried hesitates “not at all to deny the bad Samaritan his unjust profit” (1981, pp. 109-11).

Such a view of contract may withstand scrutiny if the special preconditions to which it applies can be carefully delimited. It comes close, however, to inviting borrowers to have their cake (a timely loan) and eat it too (ex post reform of terms in their favor). Upon realization that loans will be subject to such reform, bad Samaritans will decline to make them4 Unless we are prepared to compel Batsakis to share, which Fried is unwilling to do (1981, p. I l l ) , such an approach to contract will deny resources to those in the dire ex ante straits to whom Fried would thereafter accord ex post contract relief.

Suppose, arguendo, that the merits of contracting in its entirety are granted. Surely, however, there are limits to that approach to contract enforcement. When does the reasoning break down?

Some of the issues here are raised, but are scarcely disposed of, by my discussion of corporate governance dilemmas at tjie end of Chapter 12. The issues also overlap those that arise in attempts to bring order into the study of contract doctrine, as discussed in 3.2 above. But a sharper appreciation for the limits of contracting in its entirety will benefit by considering disequilibrium contracting issues of the kind discussed in section 4.5 below.

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

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