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The new institutional economics and a model of contract
Journal
of Economic
Behavior
and Organization
11 (1989) 75-89.
THE NEW INSTITUTIONAL ECONOMICS CONTRACT
North-Holland
AND A MODEL OF
Jim LEITZEL* Vanderbilr
Received
Unirersify,
December
Nashrille,
1986. final version
TX 37235, USA
received
March
1988
This paper presents a model of contract that incorporates many of the features identified in the New Institutional Economics. Concepts such as ‘transaction costs’, ‘bounded rationality’, ‘opportunism*, and ‘asset specificity’ have natural interpretations in the framework of the model. The model makes explicit provision for damage measures for breach of contract, permitting a reexamination of some New Institutional ideas when court ordering is possible. It is demonstrated that an explicit provision for the legal background has a profound effect on New Institutional reasoning, and should be taken into consideration in developing policy towards non-standard contracting.
1. Introduction The New Institutional Economics, with its focus on transaction cost analysis, has furthered our understanding of exchanges that do not take place in perfectly competitive markets. These gains, however, are tempered by the absence of a formal structure within which new propositions can be analyzed systematically. This paper presents a model of contract that attempts to provide such a formal structure. The contract model serves as a framework for interpreting common notions of the New Institutional Economics. Damage measures for breach of contract are explicitly considered, allowing for a reexamination of New Institutional propositions when contracting parties have recourse to the courts. This analysis suggests that in looking for potential efficiency sources for non-standard contracting, the damage measure for breach of contract should not be ignored. A contracting approach is general, in that virtually any transaction can be ‘I would like to thank Neil de Marchi and anonymous referees for thoughtful comments. Some of the ideas in this paper have grown out of my Ph.D. dissertation, ‘An InformationTheoretic Model of Incomplete Contracts’. I would like to thank my committee members, Daniel A. Graham, Chair, Robert F. Conrad, Neil de Marchi, Michael Meurer. and Sudhir Shetty for their guidance. All remaining errors are the sole responsibility of the author. 0167-268
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1989, Elsevier Science
Publishers
B.V. (North-Holland)
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1. Leir:el,
New instirufionni
economics
and a model of conrract
viewed as being governed by an implicit or explicit contract. While few consumers consider the purchase of a gaflon of milk to be governed by a contract, if the milk is sour they may quickly resort to an eiaboration of implicit contractual terms. What determines whether a ‘contract’ is of a mundane sort, as milk purchases generally are, or whether it is more problematic? Oliver Williamson, whose work’ wilt be taken as representative of the New Institutional Economics, suggests three conditions that are jointly necessary for the existence of non-standard contracting problems. They are (I) bounded rationality, (2) opportunism, and (3) asset specificity. Bounded rationality, which from some perspectives may be interpreted as the contention that information is costly,? means that complete contingent contracts of the Arrow-Debreu type are not feasible. ‘Opportunism’ centers around the notion that people take actions that are in their own best interest, regardless of the impact of those actions on others. Williamson (1985, pp. 30, 47) variously describes opportunism as ‘self-interest seeking with guile’ and as the ‘incomplete or distorted disclosure of information’. When some assets are more highly valued within a given contractual relationship than they are outside of the relationship, asset specificity is said to exist. Asset specificity, which may take the form of specific human capital, therefore generates a rationale for a current contractual relationship to continue in the future. Transaction costs economics is interested in situations where bounded rationality, opportunism, and asset specificity are all present. It should be noted, however, that these concepts are rarely well-specified. Other important aspects of transactions are uncertainty and the legal environment. Uncertainty is efficaciously handled in the Arrow-Debreu framework via complete contingent contracts. Bounded rationality makes this solution infeasible in the New Institutional world, creating a demand for alternative structures to deat with uncertainty. The legal background is undeveloped in most New Institutional analyses, though it is generalfy assumed that contracts can not be legally enforced. Williamson (1985, p. xii) states that ‘transactions cost economics maintains that the governance of contractual relations is primarily effected through the institutions of private ordering rather than through legal centralism’. Arbitration machinery is one example of private ordering. Williamson (1985, p. 168) goes on to suggest that, while the private ordering assumption is more instructive than court ordering for transactions cost analyses, a ‘more balanced view.. . will make shadow of the law provisions’. Section 2 provides a simple example of a strategic situation with uncertainty that illustrates the basic features of the contract model. The mathematical formalization of the contract model is presented in section 3. Section lSpeciticalty, 2 Williamson
Williamson (1985). ( t 985, p. 461).
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4 contains interpretations of various features of the contract model in terms of the New Institutional concepts of bounded rationality, opportunism, asset specificity, and transaction costs. The potential avenues through which contract law can increase the value of contractual relationships is also explored. Section 5 shows that contract law is not always dependable in raising the value of contractual relationships, by examining the influence of court enforcement of contracts on some notions associated with the New Institutional Economics. It is demonstrated that the joint presence of asset specificity, bounded rationality, and opportunism is neither a necessary nor a sufficient condition for non-standard contracting when court enforcement is available. The damage measure for breach of contract is shown to also play a role in determining whether efficiency can be achieved in contracting situations. Section 6 presents conclusions.
2. An example Consider a relationship between a supplier and a purchaser. The supplier can choose among 3 actions: provide a high quality product (H), provide a low quality product (L), or not provide any product (N). The purchaser can make a big payment (B), a small payment (S), or no payment (N). The parties can agree to a contract before they (simultaneously) choose their actions. The payoffs to various combinations of supplier and purchaser actions depend on the state of the world, which is unknown when the contract is agreed to but is known at the time the actions are chosen. States Oi and O2 are equally likely. In state Or, the high quality product is no more valuable to the purchaser than the low quality product, whereas in state 19i, the purchaser prefers high quality to low quality. The state-dependent payoffs are: State 0,:
Supplier
H L N
B 4.4 5,2 6. -3
Purchaser s 2.6 3.4 4, - 1
H L N
B 4.2 52 6, -3
Purchaser s 2.4 3,4 4, - 1
N -2.8 - 1,6
0.0
State 02:
Supplier
N -2,6 - I,6 0.0
In the absence of a contract, the unique (pure strategy) Nash equilibrium is (NJ) in both states.
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The degree of observability and verifiability of states and actions will determine what contracts are feasible. A complete contingent contract, for example, partitions the set of potential states (0,,0,~ into individual states, and specifies an unique action for each party in each state. If complete contingent contracts are available, and such contracts are specifically enforced (i.e., no breach is allowed), joint profit maximizing behavior by the parties will result in a contract that calls for a high quality product in state e1 and a low quality product in state 02.3 The payment in either state could be B or S, depending on the negotiating strength of the parties. Other contracts may employ coarser partitions of states or actions. If the state is prohibitively expensive to verify, for example, then state-contingent contracts are not feasible. One joint expected profit maximizing contract in this case would call for a high quality product in both states. If the quality of the product, as well as the state, cannot be verified, then the best contract will call for delivery of an unspecified quality product (H or 15,)in both states. The supplier will choose to supply a low quality product in both states under such a contract. While inferior to the complete contingent contract, such a contract is still preferred by both parties to the no contract outcome. One important element of contractual situations that has not been included in this example is the opportunity to make contract-specilic investments, known as reliance actions in legal terminology. By definition not included in the contract terms, reliance actions wifl be assumed to be made after the contract is agreed to, but before the state is revealed. The reliance actions wil1 thus depend on the agreed-upon contract. Assume that the supplier has available a reliance action that will raise the supplier’s payoffs to action H by one-half, will not change the supplier’s payoffs to action L, and will lower the supplier’s payoffs of not producing. Such an action will be taken if a complete contingent contract is availabIe, but the supplier will not risk the investment with the other contracts described above.
3. The model There are two risk neutraf contracting parties, party 1 and party 2. The timing of the contract problem is depicted in fig. 1: (a) the contract is agreed upon, (b) reliance actions are taken, (c) the uncertainty is revealed, (d) contract actions are chosen, and (e) the damage measure is applied in the event of breach. The timing is particularly important because prior events help to determine the feasible sets for later choices. Resources expended in drawing up the contract, for example, reduce the resources available for later use in retiance or contract actions. The set of the various alternatives that are 30ther specifications of the sanctions applied to a breaching party, i.e., varying the damage measure for breach of contract, may change the optimal contract.
J. L&t:rl.
I
choice of contract CEC
Xiew insriturional economics and a model of contract
I
reliance choices r,ER,
I
I
uncertainty revealed OEB
Fig.
19
contract action choices aiGA,
damage measure d applied
I
available before the contract is signed are termed potentially feasible, and are feasible denoted with a bar over them, e.g., A, is the set of potentially contract actions for party 1. The sets that are actually amiiable when the relevant choice is made are denoted without a bar. So, A, is the set of contract actions from which party 1 may choose when the occasion arises. The uncertainty in the contracting environment is represented by a finite set d of future states of the world. A realization 0~i? resolves all uncertainty to the contracting parties, excepting their own contract-related choices. The parties are assumed to share a probability distribution F over outcomes of 8. The finite set of potentially feasible contract-related actions for party i, i= 1,2, is denoted as Ai=(a/,af ,..., ali).4 A contract is a choice of a partition over the set of future states, with some subset of the potentially feasible action sets specified for each party, for each equivalence class of the state partition. Let the set of potentially feasible contracts be given by C. In general, the parties won’t have recourse to all contracts. The unobservability or unverifiability of some component of future states or actions will preclude contracts that make distinctions based on the unobservable component.’ The set of actually available contracts is denoted C, and consists of actually available state partitions r and actually available action subsets A,, for each party i. Denote a typical element of r by r, and denote the equivalence classes of the partition T as tj, j= 1,2,.. .,k. Each equivalence class ~j of r is termed a contingency, and k is the number of contingencies associated with partition y. The partition r will sometimes be referred to as the state informarion in the contract. For each contingency of the chosen state partition, a subset of the potentially feasible action sets must be specified for each party. These subsets 4The sets of states and actions may be considered to be payoff-relevant, in the sense that no 2 states (or actions) are distinguished solely by characteristics that do not affect either party’s payoif, regardless of the other aspects of the contracting environment. See, e.g., Marschak and Miyasawa (1968). 5The resulting contractual form is highly dependent on what components of states and actions are observable. The unobservability of actions, for example, implies that moral hazard must be reckoned with. Barzel (1982) demonstrates the relationships between the costly measurement of attributes and contractual forms.
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represent the actions that are in compliance with the contract under the given contingency. Denote the ‘compliance sets’ for party 1 and party 2 under contingency ~j as x{ E A, and rjz~ AZ, respectively. The ‘breach sets’ pi in every contingency consist of all the actions that are not in compliance with the contract, i.e., they are the complements (with respect to Ai) of the compliance sets, xi. A specification of compliance sets implicitly yields a specification of the breach sets. The action terms in a contract partition the sets of potentially feasible actions into 2 equivalence classes - the breach set and the compliance set - for each contingency. A contract CE C, then, is the choice of a state partition y =f$,.. . ,yk)~ r, and compliance sets xl =(rt,. . . ,a:) E 2: and a2 =(r$, . , . , a”,)E Al. The contract information on states is incomplete in that the contingencies can contain more than one state. The contract then treats two or more states identically, though they differ in ways that matter to the parties. The contract information on the parties’ actions is likewise incomplete. If the compliance sets contain two or more actions, then the contract treats these actions as the same, even though the differences between them are payoffreievant to the parties. Denote the set of potentially feasible reliance actions for party i as Ri, i== 1,2.6 Not all of these potentially feasible reliance actions may actually be available, however, since some resources may have already been devoted to the formation of the contract. Money spent in designing the contract will not be available for investment later .’ The sets of reliance actions actually available, then, depend on the agreed upon contract c, and are denoted as R,, a subset of Ri, for i = 1,2. The contract is enforced by the courts, employing the sanctions against breach of contract that have developed in contract law. These sanctions are encapsulated in the damage measure for breach of contract, denoted 6(q). A contracting party i who chooses an action from the breach set pi in contingency rj wifl be subject to the damage measure. Often the damage measure takes the form of the payment of monetary damages to the breached against party. More generaily, the damage measure affects the set of actually available actions in two ways. First, the damage measure may make it infeasible to take a breaching action without also paying damages. Second, the damage measure may be costly to administer, using up resources that might otherwise be available for contract actions.s The amount of damages determined by the legal damage measure may depend on the other features 6As with the set of states and actions, the reliance sets should be considered to be payoff:relevant. This example is taken from Radner (1970). sThe cost of damage measures affects the set of available actions only to the extent that the cost is boume by the contracting parties. In practice, some of the cost of administering damages is bourne by the state.
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of the contractual situation - e.g., contract and reliance actions, the state realization, and the contract c.~ After the uncertainty is revealed, the parties have to choose their contract actions, a,. Not all of the potentially feasible actions will be available at this stage. The set of available contract actions for party i is denoted Ai, a subset of Ai. Ai may depend, as argued above, on the contract c, party i’s reliance action ri, the damage measure 6, and the actual state of the world 8. The sets Ai are assumed to be non-empty, and to have monetary equivalents to the parties. The payoff from the contract to contracting party i depends on the contract actions of both parties, party i’s reliance action, the realized state of the world 0. and the damage measure, 6. Let Ui: 2, x A, x & x $x h+R’ be the von Neumann-Morgenstern utility of the contract to party i, where R’ represents the real numbers.rO Both parties are assumed to have complete knowledge of the utility functions and the other features of the contract problem. Uncertainty in the contracting environment takes the form of the distribution F over states 0. The contract actions that the parties choose after 8 is revealed will therefore be the Nash equilibrium solution to the game of complete information with payoff to party i of Ui(. j, and strategy sets A~. Pareto efficient contracts are found by maximizing one party’s utility while assuring the other party a given level of utility. If (non-contingent) lump-sum transfers are available, the risk neutrality of the parties implies that this procedure is equivalent to maximizing the sum of the parties’ payoffs. Definifion 1. The contract problem is to choose state partition 7= (y’,. . . ,;tk) E f, compliance sets xl E i: and x2 E A;, reliance actions rig Ri, and contract actions aie Ai, to max EU I + EU2, subject to: ( 1) ri E argmax EU,( r;, 6(r _ i); . ), where ri E Ri; and (2) a,~argmax Ui(a{, a-,; .), where a;~ Ai, for i= 1,2. The notations u__~ and r-i represent the other party’s action and reliance choices, respectively. The reliance choices must be a Nash equilibrium, as indicated in Definition 1, since the damage measure 6( .) may depend on the reliance actions of both parties. ‘The assumption that d is given exogenously may appear to rule out the use of liquidated damage clauses, where the parties specify within the contract the damages for breach. These clauses. however, can be viewed as contract action clauses. though now contingent on the other ‘normal‘ action choices. Liquidated damage clauses may themselves be breached, whereupon contract law provides the remedy. Thus, while contractual clauses contingent on contract actions are not provided for in this model, the dependence of the damage measure 6 on the contract c maintains a mechanism for their inclusion. to Party i has preferences over all actions in his potentially feasible action set A,, but his actual choice of action must be made from the smaller set of ex post feasible actions, Ai. No third parties are affected by the contract-related choices of parties 1 and 2.
a2
J. Leirzel, New insritutional economics
and a model of confract
While the question of the existence of a solution to the contract problem given in Definition 1 is beyond the scope of this paper, it should be noted that the probiem of existence may not be as severe as it is in other contexts. This is because the parties are choosing the terms of the contract themselves, rather than being at the mercy of some pre-specified game. In choosing contractual terms, the parties will attempt to circumvent the difliculties caused by non-existence, as well as the difliculties that arise from multiple, or mixed-strategy solutions.” 4, Interpretation The model presented in section 2 may be used as a framework for the analysis of contractual situations that involve bounded rationality, opportunism, and asset specificity. The existence of bounded rationality enters this model as a constraint on the information that can enter contracts. Specifically, bounded rationality is responsible for the difference between the set of potentially feasible contracts, c, and the set of actually feasible contracts, f. This approach permits the use of a maximizing model, as opposed to the use of a ‘satisficing’ model. Note that this interpretation equates bounded rationality with costly information.‘? ‘Opportunism’ is accounted for by modelling party i’s action choice, ai, as the argmax of Ui. This implies that each party will choose an action without regard to the consequences of that action on the other party. When there are no damages for breach of contract, for example, each party will choose his best action independentIy of the contract terms. Reliance actions account for the existence of asset specificity. Specific assets, like reliance, are expected to pay off only if the contract is properly executed, that is, if compliance actions are taken. Actions that result in specific assets, of course, may be written into the terms of the contract, breaking the necessary link between reliance and specific assets. The difliculties that arise solely because of asset specificity, however, only occur if reliance actions result in the specific assets. The problems that arise from specific assets in the contractual terms (namely, incompleteness and enforcement) are no different from the problems that occur with ait contractual terms. Section 5 will further address this issue. Transactions costs implicitly enter this contract model through the restrictions placed on the actual reliance sets R, and the actual action sets rl, by the contract c and the costs of the damage measure 6. The differences between potentially feasible reliance sets Wi and the actual reliance sets Ri are I’ A similar point is made in Green and Stokey (1983, p. 35%). l*While this approach to bounded rationality seems to capture the notion that Williamson expresses, Simon argues for a broader definition, encompassing the costs of the decision rules, as well as other aspects of decision making. See, e.g., Simon (1979).
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due solely to the transaction costs involved in agreeing to the contract. The differences between Ai and the actual action sets A, involve more elements. For a given potentially feasible action set A,, the actual action set Ai depends on the contract c, the reliance action ri, the damage measure 6, and the realized state of the world, 8. The restrictions placed on feasible actions by 6 take 2 forms - those restrictions on actions caused by the working of the damage measure itself, and those restrictions arising from the costs to the parties of administering the damage measure. Let 6’ be the ‘costless’ version of damage measure 6. The restrictions placed on action sets by 8, then, are simply those that are associated with the operation of the (costless) damage measure. Denote the set of actions for party i restricted only by ri, S’, and 8 as A:. The difference between A: and Ai is then attributable to the transaction costs of writing and enforcing the contract. The total transaction costs attributable to a contract c =(t; zr, rz) can be defined as the payment that would make the parties indifferent between the use of the potentially feasible reliance sets Ri and action sets A; and the use of the actually feasible reliance and action sets. More formally, let W(c) =max ELI I + EU2, given contract c and damage measure 6, and subject to constraints (1) and (2). The transaction costs associated with contract c=(r; r,,aW,) are then given by the real number TC(c)= w’(c)- W(c), where W’(c)=max EC’, + EU2, given contract c and to constraints (1’) rig argmax EUi(ri; damage measure 8, and subject cS(~_~),.), where r:sRi; and (2’) n,~argmax Ui(a:,a_i; .), where u~EAI, for i= 1,2. Constraints (1’) and (2’) differ from (1) and (2) in that the sets from which reliance and contract actions may be chosen are no longer limited by the costs of the contract or the damage measure. This definition of transaction costs includes both ex ante (negotiation) and ex post (maladaption) forms. The ex ante transaction costs enter via the restrictions that the contract c places on the feasible reliance and contract actions. The cost of administering the damage measure (arising through the difference between 6 and 6’) is an ex post transaction cost. Note that transactions costs are not the difference in value between the actual contract and a ‘Pareto efficient complete contingent contract’,” but rather the difference in value between the actual contract, and the best contract that could be achieved with costless contract specification. Informational and incentive problems may still prevent such a contract from achieving first best Pareto efficiency. Consider the potential avenues through which the legal background can make W(S) as large as possible. Raising W, for a fixed actually feasible contract c and fixed actually available reliance and contract action sets Ri and Ai, can be accomplished by providing incentives for the choice of 13This terminology
is due to Shave11 (1980).
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efficient reliance and contract actions. Damage measures that require compensation for breach and protect reasonable reliance are one way that contract law provides such incentives. A second method of raising W involves the expansion of the feasible contract and reliance action sets. This expansion results from lowering the (ex ante transaction) costs of achieving a given contract c. Contract law doctrines achieve this through the provision of a set of standard contract terms. The third method of raising the value W of contract problems is to expand the set of feasible contracts C, by lowering the costs of information (or equivalently, by reducing bounded rationality). The record of previously decided cases in contract law lowers information costs by providing information concerning contingencies, as well as the law’s treatment of them.
5. The New Institutional
Economics with court ordering
When contracting parties do not have access to the courts, efficiency is still achievable. Williamson (1985, p. 32) notes that only when asset specificity, bounded rationality, and opportunism are jointly present is it necessary to devise complex governance arrangements. Without asset specificity, competition assures efficiency; without bounded rationality, planning suffices; and without opportunism, promises are kept and efficiency results. This section reexamines these ideas in the case when the parties have access to a courtenforced damage measure.‘” Consider a special case of the model presented in section 2. Let each party have two potential actions, ,&=(a!,~?). There is no uncertainty, i.e., 8= ((!I,], and the probability of t?=fI, is 1. There are no transaction costs, i.e., 6 =6’ and Ai= A:. There is no opportunity for reliance, so Ri= 4. The payoffs to the parties are: L'i(U:,Ui)= -5; ui(U:,u:)= - 1; II,(u:,a~)=Q U,(U:,U~)= - 10; U,(a:,u:) = - 10; UJu:,u$) =O. If actions a! are associated with ‘confess’, and actions a: are associated with ‘don’t confess’, the payoffs form a prisoner’s dilemma. (a) The absence of asset specificity (i) Assume that bounded rationality is such that the parties can not distinguish between the 2 actions in a contract: Ai= {{ar’,af>;. Let the (costless) damage measure be specific performance, so that compliance actions must be taken, though the restrictions on Ai make this assumption superfluous. Regardless of the state of ex ante competition, the parties will each choose ui=uf, though this is not the efficient solution. This may create a demand for private governance, such as arbitration machinery, even lJRoumasset (1979) takes an alternative approach to the question efficiency. focusing on the number of potential contracting agents.
of when contracts
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though the courts costlessly enforce contracts via the damage measure of specific performance. (ii) Now, allow the parties to contract on individual actions, so that Ai= {{a/,~:}, ({a,! 1, {uf])J. If the damage measure for breach remains specific performance, the parties will agree to a contract calling for ai=af, and the efficient outcome results. If, however, the parties no longer have recourse to the courts, or that 6=‘no damages’, then the complete contract is to no avail; the parties will breach with Ui=u!, an inefficient outcome. The example in part a(i) demonstrates that without complete contracts, court enforcement of contracts does not guarantee efficiency, even in the absence of asset specificity. The example in part a(ii) shows that with complete contracts, and in the absence of asset specificity, the damage measure provided by contract law still plays a role in providing incentives for efficient outcomes. (b) The absence of bounded rationality Part a(ii) presents a case of unbounded rationality where efliciency is not achieved. The enforcement mechanism may affect the contractual outcome, even with unbounded rationality. If contracts can be perfectly and costlessly enforced, and there is no bounded rationality, then the efficient outcome is achieved via complete contingent contracts. With other damage measures (such as ‘no damages’), however, inefficient outcomes may still arise. (c) The absence of opportunism The outcome in this case is critically dependent on the definition of the ‘absence of opportunism’. If the absence of opportunism means that no party will ever take any action other than the joint profit maximizing action, then efficiency is achieved by definition. A less tautological view of the absence of opportunism in this contract model might be that no party will ever breach a contract.‘s Contracts may still always achieve Pareto efficiency in this context, if a ‘general clause’ is available.16 A general clause consisting of wording such as ‘both parties agree to take only joint profit maximizing actions’ would be adhered to in the absence of opportunism, and efficiency is assured. If a general clause is not available (perhaps because it is not common knowledge that the parties are not opportunistic), then problems could arise. In this case, contracts that have compliance sets consisting of multiple actions, or contracts that do not involve perfect state information, may not achieve Pareto efficiency. For example, amend the previous problem to ISThis interpretation accords well with Williamson’s description of opportunism as ‘selfinterest seeking with guile’. iMany breaches occur because adverse realization of the state of the world make compliance actions infeasible or extremely costly. ‘Opportunistic behavior’ may not be an accurate description of such breaches. 16See Williamson (1985, p. 3l), for a discussion of the ‘general clause’.
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include a second state of the world, Bt. Let the payoffs in e2 be the same as in t?,, except that U,(ai,a:)= 10, and let the probability of 0,=0.1, with the probability of 0i therefore being 0.9. If bounded rationality precludes contracts distinguishing between the two states, the solution to the contract problem involves a: as the compliance actions. If the absence of opportunism implies that the parties will not breach (or if the terms are strictly enforced) when t3=8,, the contract will not achieve ex post efficiency, since joint profit maximizing implies that party 1 should choose ai in this state. Examples (a), (b), and (c) above illustrate that bounded rationality, asset specificity, and opportunism are not jointly necessary for interesting contract problems to develop when the parties have access to court ordering. The damage measure for contract breach is shown to play an equally important role in creating non-standard contract problems. Now, let bounded rationality, opportunism, and specific assets all be present, and examine the ‘flip side’ of this argument - that this joint presence is not sufficient for creating interesting contracting problems when court ordering is feasible. Some damage measures might still allow ex post efficiency to be achieved.” Consider a damage measure that perfectly enforces contract terms. Then contracts written with a general clause, as in part c, could be enforced, and ex post efficiency would result, even with opportunistic parties. Finally, the large role played by asset specificity in the New Institutional Economics18 is reduced in the presence of court ordering. Reconsider the prisoner’s dilemma example of part a(ii), where the parties can specify compliance sets that consist only of the actions a:, i.e., don’t confess. Give the parties the opportunity to take a reliance action, which will raise the value of the (a:,~:) outcome to both of them, but will lower the value of all the other outcomes. The reliance actions therefore only pay off in the event that the contract is complied with by both parties. If the contract is perfectly enforced by the courts, the parties will engage in the reliance, and the contract will not be breached. Alternatively, if the damage measure assures that reliance expenditures will be returned in damages, the parties will engage in reliance. If, however, there are no damages for breach, and reliance expenditures are not insured via contract law, the parties will not engage in reliance, nor comply with the contract. The damage measure thus plays a role in determining if asset specificity results in contracting difficulties. This point can be further illustrated by considering specific investments that can be written into the contract. Such investments are contract actions, not reliance actions, in this contract model. Suitably specified and enforced, they produce no difficulties. It is only when they are incompletely specified or not efficaciously enforced that such specific investments prevent Pareto “This has been demonstrated in some cases for the expectations damage measure. See Shavell (1980) and Leitzel (1986). 18See Williamson (1985, p. 56).
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efficiency. This is no different, however, than the situation for other contractual terms. Thus it is the non-contractability of specific investments, together with the law’s approach to the protection of specific investments, and not the specificity itself, which is responsible for the large role that asset specificity often plays in contract problems.i9 The theme of this section has been that damage measures for breach of contract often influence the degree of difficulty faced by potential contracting parties in designing efficacious contracts. While contract law has the potential for raising the value of contractual relationships, not all damage measures are equally effective in all situations. This conclusion is not without policy relevance. The New Institutional Economics has demonstrated how non-standard contracting, including vertical integration, may be an efficient response to situations characterized by bounded rationality, opportunism, and asset specificity, as opposed to arising from the exercise of monopoly power. Since the damage measures provided by contract law may differ based on the nature of the contractual relationship, differential enforcement mechanisms may represent an alternative route to non-standard contracting. Consider a situation where a firm desires to purchase an input from an individual. (Imagine that the input is such that a long-term agreement is necessary.) If the quality of the input is observable by the parties but not verifiable by the courts, the firm will be unable to collect damages for a breach, which would typically be given by its contract expectations. Furthermore, if after a short time the firm discovers that the quality is unacceptable, it may not be able to breach the contract without paying extensive damages. If the firm hires the individual as an (at-will) employee, however, the firm will simply tire the individual if he supplies low quality, and incur no damages for breach. If the ‘individual’ is viewed as a firm, vertical integration may be the result. This vertical integration occurs, even in the absence of asset speciticity, because of the unverifiability of contract actions and the differential damage measures, and not from any extension of monopoly power.
6. Conclusions The New Institutional Economics has made substantial headway towards an understanding of non-standard contracting. This progress has been restricted, however, by the lack of a formal structure and the use of concepts, such as ‘transaction costs’ and ‘bounded rationality’, that often are not well-defined. This paper has developed a contract model appropriate to the examination of issues featured in the New Institutional Economics. Bounded rationality, I9 Williamson (1985, p. 32) makes note of this. His analysis exists except in the presence of asset specificity.
assumes
eflicacious
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opportunism, asset specificity, and transaction costs within the framework of the model. Some ideas from Economics have been extended to the case where court This extension suggests that a consideration of the when formulating policies concerned necessary contracting.
can all be addressed the New Institutional ordering is available. legal background is with non-standard
Appendix Guide to notation $
e
- the set of states of the world.
- a realization from 8.
Ft.1 - probability distribution over 8. Ai
- the set of potentially feasible contract actions for party i. - the set of actually available contract actions for party i. c - the set of potentially feasible contracts. c - the set of actually available contracts. I- the set of partitions of 8 available for use in the contract. i’ - a state partition; an element of f. class of y; a contingency. '/j, - an equivalence Ai - the set of subsets of Ai available for use in the contract. $ ; the compliance set for party i in contingency j; an element of Ai. the breach set for party i in contingency j; /?(= &--CC;. ii - the set of potentially feasible reliance actions for party i. Ri - the set of actually available reliance actions for party i. at.1 - the damage measure for breach of contract. ui - party i’s von Neumann-Morgenstern utility function. R’ - the real numbers. ri - a reliance action for party i. a, - a contract action for party i. Ai
References Barzel, Yoram, 1982, Measurement cost and the organization of markets, Journal of Law and Economics 25, 2748. Green, Jerry R. and Nancy L. Stokey, 1983, A comparison of tournaments and contracts, Journal of Political Economy 91, 349-364. Leitzel, Jim, 1986, An information-theoretic model of incomplete contracts, Unpublished Ph.D. dissertation, Duke University. Marschak, Jacob and Koichi ‘Miyasawa. 1968, Economic comparability of information systems, International Economic Review 9. 137-174. Radner, Roy, 1970. Normative theory of individual decision: an introduction, in: C.B. McGuire and Roy Radner, eds., Decision and Organization (North-Holland, Amsterdam) 1-18.
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Roumasset. James, 1979, Sharecropping, production externalities, and the theory of contracts, American Journsl of Agricultural Economics 61, 64G674. Shavell. Steven. 1980. Damage measures for breach of contract. Bell Journal of Economics 11, 466-490. Simon. Herbert, 1979. Rational decision making in business organizations, American Economic Review 69,493-5 13. Williamson, Oliver. 1985, The Economic Institutions of Capitalism (The Free Press, New York).
of Economic
Behavior
and Organization
11 (1989) 75-89.
THE NEW INSTITUTIONAL ECONOMICS CONTRACT
North-Holland
AND A MODEL OF
Jim LEITZEL* Vanderbilr
Received
Unirersify,
December
Nashrille,
1986. final version
TX 37235, USA
received
March
1988
This paper presents a model of contract that incorporates many of the features identified in the New Institutional Economics. Concepts such as ‘transaction costs’, ‘bounded rationality’, ‘opportunism*, and ‘asset specificity’ have natural interpretations in the framework of the model. The model makes explicit provision for damage measures for breach of contract, permitting a reexamination of some New Institutional ideas when court ordering is possible. It is demonstrated that an explicit provision for the legal background has a profound effect on New Institutional reasoning, and should be taken into consideration in developing policy towards non-standard contracting.
1. Introduction The New Institutional Economics, with its focus on transaction cost analysis, has furthered our understanding of exchanges that do not take place in perfectly competitive markets. These gains, however, are tempered by the absence of a formal structure within which new propositions can be analyzed systematically. This paper presents a model of contract that attempts to provide such a formal structure. The contract model serves as a framework for interpreting common notions of the New Institutional Economics. Damage measures for breach of contract are explicitly considered, allowing for a reexamination of New Institutional propositions when contracting parties have recourse to the courts. This analysis suggests that in looking for potential efficiency sources for non-standard contracting, the damage measure for breach of contract should not be ignored. A contracting approach is general, in that virtually any transaction can be ‘I would like to thank Neil de Marchi and anonymous referees for thoughtful comments. Some of the ideas in this paper have grown out of my Ph.D. dissertation, ‘An InformationTheoretic Model of Incomplete Contracts’. I would like to thank my committee members, Daniel A. Graham, Chair, Robert F. Conrad, Neil de Marchi, Michael Meurer. and Sudhir Shetty for their guidance. All remaining errors are the sole responsibility of the author. 0167-268
10X9/93.50 0
1989, Elsevier Science
Publishers
B.V. (North-Holland)
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1. Leir:el,
New instirufionni
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viewed as being governed by an implicit or explicit contract. While few consumers consider the purchase of a gaflon of milk to be governed by a contract, if the milk is sour they may quickly resort to an eiaboration of implicit contractual terms. What determines whether a ‘contract’ is of a mundane sort, as milk purchases generally are, or whether it is more problematic? Oliver Williamson, whose work’ wilt be taken as representative of the New Institutional Economics, suggests three conditions that are jointly necessary for the existence of non-standard contracting problems. They are (I) bounded rationality, (2) opportunism, and (3) asset specificity. Bounded rationality, which from some perspectives may be interpreted as the contention that information is costly,? means that complete contingent contracts of the Arrow-Debreu type are not feasible. ‘Opportunism’ centers around the notion that people take actions that are in their own best interest, regardless of the impact of those actions on others. Williamson (1985, pp. 30, 47) variously describes opportunism as ‘self-interest seeking with guile’ and as the ‘incomplete or distorted disclosure of information’. When some assets are more highly valued within a given contractual relationship than they are outside of the relationship, asset specificity is said to exist. Asset specificity, which may take the form of specific human capital, therefore generates a rationale for a current contractual relationship to continue in the future. Transaction costs economics is interested in situations where bounded rationality, opportunism, and asset specificity are all present. It should be noted, however, that these concepts are rarely well-specified. Other important aspects of transactions are uncertainty and the legal environment. Uncertainty is efficaciously handled in the Arrow-Debreu framework via complete contingent contracts. Bounded rationality makes this solution infeasible in the New Institutional world, creating a demand for alternative structures to deat with uncertainty. The legal background is undeveloped in most New Institutional analyses, though it is generalfy assumed that contracts can not be legally enforced. Williamson (1985, p. xii) states that ‘transactions cost economics maintains that the governance of contractual relations is primarily effected through the institutions of private ordering rather than through legal centralism’. Arbitration machinery is one example of private ordering. Williamson (1985, p. 168) goes on to suggest that, while the private ordering assumption is more instructive than court ordering for transactions cost analyses, a ‘more balanced view.. . will make shadow of the law provisions’. Section 2 provides a simple example of a strategic situation with uncertainty that illustrates the basic features of the contract model. The mathematical formalization of the contract model is presented in section 3. Section lSpeciticalty, 2 Williamson
Williamson (1985). ( t 985, p. 461).
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4 contains interpretations of various features of the contract model in terms of the New Institutional concepts of bounded rationality, opportunism, asset specificity, and transaction costs. The potential avenues through which contract law can increase the value of contractual relationships is also explored. Section 5 shows that contract law is not always dependable in raising the value of contractual relationships, by examining the influence of court enforcement of contracts on some notions associated with the New Institutional Economics. It is demonstrated that the joint presence of asset specificity, bounded rationality, and opportunism is neither a necessary nor a sufficient condition for non-standard contracting when court enforcement is available. The damage measure for breach of contract is shown to also play a role in determining whether efficiency can be achieved in contracting situations. Section 6 presents conclusions.
2. An example Consider a relationship between a supplier and a purchaser. The supplier can choose among 3 actions: provide a high quality product (H), provide a low quality product (L), or not provide any product (N). The purchaser can make a big payment (B), a small payment (S), or no payment (N). The parties can agree to a contract before they (simultaneously) choose their actions. The payoffs to various combinations of supplier and purchaser actions depend on the state of the world, which is unknown when the contract is agreed to but is known at the time the actions are chosen. States Oi and O2 are equally likely. In state Or, the high quality product is no more valuable to the purchaser than the low quality product, whereas in state 19i, the purchaser prefers high quality to low quality. The state-dependent payoffs are: State 0,:
Supplier
H L N
B 4.4 5,2 6. -3
Purchaser s 2.6 3.4 4, - 1
H L N
B 4.2 52 6, -3
Purchaser s 2.4 3,4 4, - 1
N -2.8 - 1,6
0.0
State 02:
Supplier
N -2,6 - I,6 0.0
In the absence of a contract, the unique (pure strategy) Nash equilibrium is (NJ) in both states.
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The degree of observability and verifiability of states and actions will determine what contracts are feasible. A complete contingent contract, for example, partitions the set of potential states (0,,0,~ into individual states, and specifies an unique action for each party in each state. If complete contingent contracts are available, and such contracts are specifically enforced (i.e., no breach is allowed), joint profit maximizing behavior by the parties will result in a contract that calls for a high quality product in state e1 and a low quality product in state 02.3 The payment in either state could be B or S, depending on the negotiating strength of the parties. Other contracts may employ coarser partitions of states or actions. If the state is prohibitively expensive to verify, for example, then state-contingent contracts are not feasible. One joint expected profit maximizing contract in this case would call for a high quality product in both states. If the quality of the product, as well as the state, cannot be verified, then the best contract will call for delivery of an unspecified quality product (H or 15,)in both states. The supplier will choose to supply a low quality product in both states under such a contract. While inferior to the complete contingent contract, such a contract is still preferred by both parties to the no contract outcome. One important element of contractual situations that has not been included in this example is the opportunity to make contract-specilic investments, known as reliance actions in legal terminology. By definition not included in the contract terms, reliance actions wifl be assumed to be made after the contract is agreed to, but before the state is revealed. The reliance actions wil1 thus depend on the agreed-upon contract. Assume that the supplier has available a reliance action that will raise the supplier’s payoffs to action H by one-half, will not change the supplier’s payoffs to action L, and will lower the supplier’s payoffs of not producing. Such an action will be taken if a complete contingent contract is availabIe, but the supplier will not risk the investment with the other contracts described above.
3. The model There are two risk neutraf contracting parties, party 1 and party 2. The timing of the contract problem is depicted in fig. 1: (a) the contract is agreed upon, (b) reliance actions are taken, (c) the uncertainty is revealed, (d) contract actions are chosen, and (e) the damage measure is applied in the event of breach. The timing is particularly important because prior events help to determine the feasible sets for later choices. Resources expended in drawing up the contract, for example, reduce the resources available for later use in retiance or contract actions. The set of the various alternatives that are 30ther specifications of the sanctions applied to a breaching party, i.e., varying the damage measure for breach of contract, may change the optimal contract.
J. L&t:rl.
I
choice of contract CEC
Xiew insriturional economics and a model of contract
I
reliance choices r,ER,
I
I
uncertainty revealed OEB
Fig.
19
contract action choices aiGA,
damage measure d applied
I
available before the contract is signed are termed potentially feasible, and are feasible denoted with a bar over them, e.g., A, is the set of potentially contract actions for party 1. The sets that are actually amiiable when the relevant choice is made are denoted without a bar. So, A, is the set of contract actions from which party 1 may choose when the occasion arises. The uncertainty in the contracting environment is represented by a finite set d of future states of the world. A realization 0~i? resolves all uncertainty to the contracting parties, excepting their own contract-related choices. The parties are assumed to share a probability distribution F over outcomes of 8. The finite set of potentially feasible contract-related actions for party i, i= 1,2, is denoted as Ai=(a/,af ,..., ali).4 A contract is a choice of a partition over the set of future states, with some subset of the potentially feasible action sets specified for each party, for each equivalence class of the state partition. Let the set of potentially feasible contracts be given by C. In general, the parties won’t have recourse to all contracts. The unobservability or unverifiability of some component of future states or actions will preclude contracts that make distinctions based on the unobservable component.’ The set of actually available contracts is denoted C, and consists of actually available state partitions r and actually available action subsets A,, for each party i. Denote a typical element of r by r, and denote the equivalence classes of the partition T as tj, j= 1,2,.. .,k. Each equivalence class ~j of r is termed a contingency, and k is the number of contingencies associated with partition y. The partition r will sometimes be referred to as the state informarion in the contract. For each contingency of the chosen state partition, a subset of the potentially feasible action sets must be specified for each party. These subsets 4The sets of states and actions may be considered to be payoff-relevant, in the sense that no 2 states (or actions) are distinguished solely by characteristics that do not affect either party’s payoif, regardless of the other aspects of the contracting environment. See, e.g., Marschak and Miyasawa (1968). 5The resulting contractual form is highly dependent on what components of states and actions are observable. The unobservability of actions, for example, implies that moral hazard must be reckoned with. Barzel (1982) demonstrates the relationships between the costly measurement of attributes and contractual forms.
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represent the actions that are in compliance with the contract under the given contingency. Denote the ‘compliance sets’ for party 1 and party 2 under contingency ~j as x{ E A, and rjz~ AZ, respectively. The ‘breach sets’ pi in every contingency consist of all the actions that are not in compliance with the contract, i.e., they are the complements (with respect to Ai) of the compliance sets, xi. A specification of compliance sets implicitly yields a specification of the breach sets. The action terms in a contract partition the sets of potentially feasible actions into 2 equivalence classes - the breach set and the compliance set - for each contingency. A contract CE C, then, is the choice of a state partition y =f$,.. . ,yk)~ r, and compliance sets xl =(rt,. . . ,a:) E 2: and a2 =(r$, . , . , a”,)E Al. The contract information on states is incomplete in that the contingencies can contain more than one state. The contract then treats two or more states identically, though they differ in ways that matter to the parties. The contract information on the parties’ actions is likewise incomplete. If the compliance sets contain two or more actions, then the contract treats these actions as the same, even though the differences between them are payoffreievant to the parties. Denote the set of potentially feasible reliance actions for party i as Ri, i== 1,2.6 Not all of these potentially feasible reliance actions may actually be available, however, since some resources may have already been devoted to the formation of the contract. Money spent in designing the contract will not be available for investment later .’ The sets of reliance actions actually available, then, depend on the agreed upon contract c, and are denoted as R,, a subset of Ri, for i = 1,2. The contract is enforced by the courts, employing the sanctions against breach of contract that have developed in contract law. These sanctions are encapsulated in the damage measure for breach of contract, denoted 6(q). A contracting party i who chooses an action from the breach set pi in contingency rj wifl be subject to the damage measure. Often the damage measure takes the form of the payment of monetary damages to the breached against party. More generaily, the damage measure affects the set of actually available actions in two ways. First, the damage measure may make it infeasible to take a breaching action without also paying damages. Second, the damage measure may be costly to administer, using up resources that might otherwise be available for contract actions.s The amount of damages determined by the legal damage measure may depend on the other features 6As with the set of states and actions, the reliance sets should be considered to be payoff:relevant. This example is taken from Radner (1970). sThe cost of damage measures affects the set of available actions only to the extent that the cost is boume by the contracting parties. In practice, some of the cost of administering damages is bourne by the state.
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of the contractual situation - e.g., contract and reliance actions, the state realization, and the contract c.~ After the uncertainty is revealed, the parties have to choose their contract actions, a,. Not all of the potentially feasible actions will be available at this stage. The set of available contract actions for party i is denoted Ai, a subset of Ai. Ai may depend, as argued above, on the contract c, party i’s reliance action ri, the damage measure 6, and the actual state of the world 8. The sets Ai are assumed to be non-empty, and to have monetary equivalents to the parties. The payoff from the contract to contracting party i depends on the contract actions of both parties, party i’s reliance action, the realized state of the world 0. and the damage measure, 6. Let Ui: 2, x A, x & x $x h+R’ be the von Neumann-Morgenstern utility of the contract to party i, where R’ represents the real numbers.rO Both parties are assumed to have complete knowledge of the utility functions and the other features of the contract problem. Uncertainty in the contracting environment takes the form of the distribution F over states 0. The contract actions that the parties choose after 8 is revealed will therefore be the Nash equilibrium solution to the game of complete information with payoff to party i of Ui(. j, and strategy sets A~. Pareto efficient contracts are found by maximizing one party’s utility while assuring the other party a given level of utility. If (non-contingent) lump-sum transfers are available, the risk neutrality of the parties implies that this procedure is equivalent to maximizing the sum of the parties’ payoffs. Definifion 1. The contract problem is to choose state partition 7= (y’,. . . ,;tk) E f, compliance sets xl E i: and x2 E A;, reliance actions rig Ri, and contract actions aie Ai, to max EU I + EU2, subject to: ( 1) ri E argmax EU,( r;, 6(r _ i); . ), where ri E Ri; and (2) a,~argmax Ui(a{, a-,; .), where a;~ Ai, for i= 1,2. The notations u__~ and r-i represent the other party’s action and reliance choices, respectively. The reliance choices must be a Nash equilibrium, as indicated in Definition 1, since the damage measure 6( .) may depend on the reliance actions of both parties. ‘The assumption that d is given exogenously may appear to rule out the use of liquidated damage clauses, where the parties specify within the contract the damages for breach. These clauses. however, can be viewed as contract action clauses. though now contingent on the other ‘normal‘ action choices. Liquidated damage clauses may themselves be breached, whereupon contract law provides the remedy. Thus, while contractual clauses contingent on contract actions are not provided for in this model, the dependence of the damage measure 6 on the contract c maintains a mechanism for their inclusion. to Party i has preferences over all actions in his potentially feasible action set A,, but his actual choice of action must be made from the smaller set of ex post feasible actions, Ai. No third parties are affected by the contract-related choices of parties 1 and 2.
a2
J. Leirzel, New insritutional economics
and a model of confract
While the question of the existence of a solution to the contract problem given in Definition 1 is beyond the scope of this paper, it should be noted that the probiem of existence may not be as severe as it is in other contexts. This is because the parties are choosing the terms of the contract themselves, rather than being at the mercy of some pre-specified game. In choosing contractual terms, the parties will attempt to circumvent the difliculties caused by non-existence, as well as the difliculties that arise from multiple, or mixed-strategy solutions.” 4, Interpretation The model presented in section 2 may be used as a framework for the analysis of contractual situations that involve bounded rationality, opportunism, and asset specificity. The existence of bounded rationality enters this model as a constraint on the information that can enter contracts. Specifically, bounded rationality is responsible for the difference between the set of potentially feasible contracts, c, and the set of actually feasible contracts, f. This approach permits the use of a maximizing model, as opposed to the use of a ‘satisficing’ model. Note that this interpretation equates bounded rationality with costly information.‘? ‘Opportunism’ is accounted for by modelling party i’s action choice, ai, as the argmax of Ui. This implies that each party will choose an action without regard to the consequences of that action on the other party. When there are no damages for breach of contract, for example, each party will choose his best action independentIy of the contract terms. Reliance actions account for the existence of asset specificity. Specific assets, like reliance, are expected to pay off only if the contract is properly executed, that is, if compliance actions are taken. Actions that result in specific assets, of course, may be written into the terms of the contract, breaking the necessary link between reliance and specific assets. The difliculties that arise solely because of asset specificity, however, only occur if reliance actions result in the specific assets. The problems that arise from specific assets in the contractual terms (namely, incompleteness and enforcement) are no different from the problems that occur with ait contractual terms. Section 5 will further address this issue. Transactions costs implicitly enter this contract model through the restrictions placed on the actual reliance sets R, and the actual action sets rl, by the contract c and the costs of the damage measure 6. The differences between potentially feasible reliance sets Wi and the actual reliance sets Ri are I’ A similar point is made in Green and Stokey (1983, p. 35%). l*While this approach to bounded rationality seems to capture the notion that Williamson expresses, Simon argues for a broader definition, encompassing the costs of the decision rules, as well as other aspects of decision making. See, e.g., Simon (1979).
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due solely to the transaction costs involved in agreeing to the contract. The differences between Ai and the actual action sets A, involve more elements. For a given potentially feasible action set A,, the actual action set Ai depends on the contract c, the reliance action ri, the damage measure 6, and the realized state of the world, 8. The restrictions placed on feasible actions by 6 take 2 forms - those restrictions on actions caused by the working of the damage measure itself, and those restrictions arising from the costs to the parties of administering the damage measure. Let 6’ be the ‘costless’ version of damage measure 6. The restrictions placed on action sets by 8, then, are simply those that are associated with the operation of the (costless) damage measure. Denote the set of actions for party i restricted only by ri, S’, and 8 as A:. The difference between A: and Ai is then attributable to the transaction costs of writing and enforcing the contract. The total transaction costs attributable to a contract c =(t; zr, rz) can be defined as the payment that would make the parties indifferent between the use of the potentially feasible reliance sets Ri and action sets A; and the use of the actually feasible reliance and action sets. More formally, let W(c) =max ELI I + EU2, given contract c and damage measure 6, and subject to constraints (1) and (2). The transaction costs associated with contract c=(r; r,,aW,) are then given by the real number TC(c)= w’(c)- W(c), where W’(c)=max EC’, + EU2, given contract c and to constraints (1’) rig argmax EUi(ri; damage measure 8, and subject cS(~_~),.), where r:sRi; and (2’) n,~argmax Ui(a:,a_i; .), where u~EAI, for i= 1,2. Constraints (1’) and (2’) differ from (1) and (2) in that the sets from which reliance and contract actions may be chosen are no longer limited by the costs of the contract or the damage measure. This definition of transaction costs includes both ex ante (negotiation) and ex post (maladaption) forms. The ex ante transaction costs enter via the restrictions that the contract c places on the feasible reliance and contract actions. The cost of administering the damage measure (arising through the difference between 6 and 6’) is an ex post transaction cost. Note that transactions costs are not the difference in value between the actual contract and a ‘Pareto efficient complete contingent contract’,” but rather the difference in value between the actual contract, and the best contract that could be achieved with costless contract specification. Informational and incentive problems may still prevent such a contract from achieving first best Pareto efficiency. Consider the potential avenues through which the legal background can make W(S) as large as possible. Raising W, for a fixed actually feasible contract c and fixed actually available reliance and contract action sets Ri and Ai, can be accomplished by providing incentives for the choice of 13This terminology
is due to Shave11 (1980).
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efficient reliance and contract actions. Damage measures that require compensation for breach and protect reasonable reliance are one way that contract law provides such incentives. A second method of raising W involves the expansion of the feasible contract and reliance action sets. This expansion results from lowering the (ex ante transaction) costs of achieving a given contract c. Contract law doctrines achieve this through the provision of a set of standard contract terms. The third method of raising the value W of contract problems is to expand the set of feasible contracts C, by lowering the costs of information (or equivalently, by reducing bounded rationality). The record of previously decided cases in contract law lowers information costs by providing information concerning contingencies, as well as the law’s treatment of them.
5. The New Institutional
Economics with court ordering
When contracting parties do not have access to the courts, efficiency is still achievable. Williamson (1985, p. 32) notes that only when asset specificity, bounded rationality, and opportunism are jointly present is it necessary to devise complex governance arrangements. Without asset specificity, competition assures efficiency; without bounded rationality, planning suffices; and without opportunism, promises are kept and efficiency results. This section reexamines these ideas in the case when the parties have access to a courtenforced damage measure.‘” Consider a special case of the model presented in section 2. Let each party have two potential actions, ,&=(a!,~?). There is no uncertainty, i.e., 8= ((!I,], and the probability of t?=fI, is 1. There are no transaction costs, i.e., 6 =6’ and Ai= A:. There is no opportunity for reliance, so Ri= 4. The payoffs to the parties are: L'i(U:,Ui)= -5; ui(U:,u:)= - 1; II,(u:,a~)=Q U,(U:,U~)= - 10; U,(a:,u:) = - 10; UJu:,u$) =O. If actions a! are associated with ‘confess’, and actions a: are associated with ‘don’t confess’, the payoffs form a prisoner’s dilemma. (a) The absence of asset specificity (i) Assume that bounded rationality is such that the parties can not distinguish between the 2 actions in a contract: Ai= {{ar’,af>;. Let the (costless) damage measure be specific performance, so that compliance actions must be taken, though the restrictions on Ai make this assumption superfluous. Regardless of the state of ex ante competition, the parties will each choose ui=uf, though this is not the efficient solution. This may create a demand for private governance, such as arbitration machinery, even lJRoumasset (1979) takes an alternative approach to the question efficiency. focusing on the number of potential contracting agents.
of when contracts
achieve
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though the courts costlessly enforce contracts via the damage measure of specific performance. (ii) Now, allow the parties to contract on individual actions, so that Ai= {{a/,~:}, ({a,! 1, {uf])J. If the damage measure for breach remains specific performance, the parties will agree to a contract calling for ai=af, and the efficient outcome results. If, however, the parties no longer have recourse to the courts, or that 6=‘no damages’, then the complete contract is to no avail; the parties will breach with Ui=u!, an inefficient outcome. The example in part a(i) demonstrates that without complete contracts, court enforcement of contracts does not guarantee efficiency, even in the absence of asset specificity. The example in part a(ii) shows that with complete contracts, and in the absence of asset specificity, the damage measure provided by contract law still plays a role in providing incentives for efficient outcomes. (b) The absence of bounded rationality Part a(ii) presents a case of unbounded rationality where efliciency is not achieved. The enforcement mechanism may affect the contractual outcome, even with unbounded rationality. If contracts can be perfectly and costlessly enforced, and there is no bounded rationality, then the efficient outcome is achieved via complete contingent contracts. With other damage measures (such as ‘no damages’), however, inefficient outcomes may still arise. (c) The absence of opportunism The outcome in this case is critically dependent on the definition of the ‘absence of opportunism’. If the absence of opportunism means that no party will ever take any action other than the joint profit maximizing action, then efficiency is achieved by definition. A less tautological view of the absence of opportunism in this contract model might be that no party will ever breach a contract.‘s Contracts may still always achieve Pareto efficiency in this context, if a ‘general clause’ is available.16 A general clause consisting of wording such as ‘both parties agree to take only joint profit maximizing actions’ would be adhered to in the absence of opportunism, and efficiency is assured. If a general clause is not available (perhaps because it is not common knowledge that the parties are not opportunistic), then problems could arise. In this case, contracts that have compliance sets consisting of multiple actions, or contracts that do not involve perfect state information, may not achieve Pareto efficiency. For example, amend the previous problem to ISThis interpretation accords well with Williamson’s description of opportunism as ‘selfinterest seeking with guile’. iMany breaches occur because adverse realization of the state of the world make compliance actions infeasible or extremely costly. ‘Opportunistic behavior’ may not be an accurate description of such breaches. 16See Williamson (1985, p. 3l), for a discussion of the ‘general clause’.
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include a second state of the world, Bt. Let the payoffs in e2 be the same as in t?,, except that U,(ai,a:)= 10, and let the probability of 0,=0.1, with the probability of 0i therefore being 0.9. If bounded rationality precludes contracts distinguishing between the two states, the solution to the contract problem involves a: as the compliance actions. If the absence of opportunism implies that the parties will not breach (or if the terms are strictly enforced) when t3=8,, the contract will not achieve ex post efficiency, since joint profit maximizing implies that party 1 should choose ai in this state. Examples (a), (b), and (c) above illustrate that bounded rationality, asset specificity, and opportunism are not jointly necessary for interesting contract problems to develop when the parties have access to court ordering. The damage measure for contract breach is shown to play an equally important role in creating non-standard contract problems. Now, let bounded rationality, opportunism, and specific assets all be present, and examine the ‘flip side’ of this argument - that this joint presence is not sufficient for creating interesting contracting problems when court ordering is feasible. Some damage measures might still allow ex post efficiency to be achieved.” Consider a damage measure that perfectly enforces contract terms. Then contracts written with a general clause, as in part c, could be enforced, and ex post efficiency would result, even with opportunistic parties. Finally, the large role played by asset specificity in the New Institutional Economics18 is reduced in the presence of court ordering. Reconsider the prisoner’s dilemma example of part a(ii), where the parties can specify compliance sets that consist only of the actions a:, i.e., don’t confess. Give the parties the opportunity to take a reliance action, which will raise the value of the (a:,~:) outcome to both of them, but will lower the value of all the other outcomes. The reliance actions therefore only pay off in the event that the contract is complied with by both parties. If the contract is perfectly enforced by the courts, the parties will engage in the reliance, and the contract will not be breached. Alternatively, if the damage measure assures that reliance expenditures will be returned in damages, the parties will engage in reliance. If, however, there are no damages for breach, and reliance expenditures are not insured via contract law, the parties will not engage in reliance, nor comply with the contract. The damage measure thus plays a role in determining if asset specificity results in contracting difficulties. This point can be further illustrated by considering specific investments that can be written into the contract. Such investments are contract actions, not reliance actions, in this contract model. Suitably specified and enforced, they produce no difficulties. It is only when they are incompletely specified or not efficaciously enforced that such specific investments prevent Pareto “This has been demonstrated in some cases for the expectations damage measure. See Shavell (1980) and Leitzel (1986). 18See Williamson (1985, p. 56).
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and a model of contract
efficiency. This is no different, however, than the situation for other contractual terms. Thus it is the non-contractability of specific investments, together with the law’s approach to the protection of specific investments, and not the specificity itself, which is responsible for the large role that asset specificity often plays in contract problems.i9 The theme of this section has been that damage measures for breach of contract often influence the degree of difficulty faced by potential contracting parties in designing efficacious contracts. While contract law has the potential for raising the value of contractual relationships, not all damage measures are equally effective in all situations. This conclusion is not without policy relevance. The New Institutional Economics has demonstrated how non-standard contracting, including vertical integration, may be an efficient response to situations characterized by bounded rationality, opportunism, and asset specificity, as opposed to arising from the exercise of monopoly power. Since the damage measures provided by contract law may differ based on the nature of the contractual relationship, differential enforcement mechanisms may represent an alternative route to non-standard contracting. Consider a situation where a firm desires to purchase an input from an individual. (Imagine that the input is such that a long-term agreement is necessary.) If the quality of the input is observable by the parties but not verifiable by the courts, the firm will be unable to collect damages for a breach, which would typically be given by its contract expectations. Furthermore, if after a short time the firm discovers that the quality is unacceptable, it may not be able to breach the contract without paying extensive damages. If the firm hires the individual as an (at-will) employee, however, the firm will simply tire the individual if he supplies low quality, and incur no damages for breach. If the ‘individual’ is viewed as a firm, vertical integration may be the result. This vertical integration occurs, even in the absence of asset speciticity, because of the unverifiability of contract actions and the differential damage measures, and not from any extension of monopoly power.
6. Conclusions The New Institutional Economics has made substantial headway towards an understanding of non-standard contracting. This progress has been restricted, however, by the lack of a formal structure and the use of concepts, such as ‘transaction costs’ and ‘bounded rationality’, that often are not well-defined. This paper has developed a contract model appropriate to the examination of issues featured in the New Institutional Economics. Bounded rationality, I9 Williamson (1985, p. 32) makes note of this. His analysis exists except in the presence of asset specificity.
assumes
eflicacious
court
ordering
J. Leirzel, New insriturional economics and a model of contract
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opportunism, asset specificity, and transaction costs within the framework of the model. Some ideas from Economics have been extended to the case where court This extension suggests that a consideration of the when formulating policies concerned necessary contracting.
can all be addressed the New Institutional ordering is available. legal background is with non-standard
Appendix Guide to notation $
e
- the set of states of the world.
- a realization from 8.
Ft.1 - probability distribution over 8. Ai
- the set of potentially feasible contract actions for party i. - the set of actually available contract actions for party i. c - the set of potentially feasible contracts. c - the set of actually available contracts. I- the set of partitions of 8 available for use in the contract. i’ - a state partition; an element of f. class of y; a contingency. '/j, - an equivalence Ai - the set of subsets of Ai available for use in the contract. $ ; the compliance set for party i in contingency j; an element of Ai. the breach set for party i in contingency j; /?(= &--CC;. ii - the set of potentially feasible reliance actions for party i. Ri - the set of actually available reliance actions for party i. at.1 - the damage measure for breach of contract. ui - party i’s von Neumann-Morgenstern utility function. R’ - the real numbers. ri - a reliance action for party i. a, - a contract action for party i. Ai
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Roumasset. James, 1979, Sharecropping, production externalities, and the theory of contracts, American Journsl of Agricultural Economics 61, 64G674. Shavell. Steven. 1980. Damage measures for breach of contract. Bell Journal of Economics 11, 466-490. Simon. Herbert, 1979. Rational decision making in business organizations, American Economic Review 69,493-5 13. Williamson, Oliver. 1985, The Economic Institutions of Capitalism (The Free Press, New York).