Interfirm Contracting:Key Concepts and Lessons for Economic Organization

It will come as little or no surprise that I examine complex contracting and economic organization from the transaction cost economizing perspective. This perspective is to be contrasted with the older-style price theoretic or neoclassical perspective(wherein monopoly was invoked to explain nonstandard and unfamiliar forms of contracting and economic organization) and can be thought of as one way of implementing contemporary ideas on the importance of “mutual cooperation”. Since the limitations of the former are now widely conceded, my discussion relates more to emerging views on mutual cooperation. Mainly I am supportive of the idea that mutual cooperation is a constructive way to think about contract and economic organization. I am nonetheless concerned that the concept of mutual cooperation is often used in an encompassing way, when instead it should be used in a selective or discriminating way, and that its meaning remains obscure for lack of operationalization. One of the benefits of introducing terms such as mutual cooperation and trust is to encourage practitioners of the “dismal science” of economics to re-think their project in more constructive(less adversarial) terms. We must, however, move beyond celebrating the merits of cooperation in a missionary way. If cooperation is more important in some circumstances than in others, we need to know what factors are responsible for these differences and why. If cooperation sometimes occurs spontaneously but at other times requires supports of a conscious, deliberate, purposeful kind, we need to know when to introduce added supports, how they work, and why. The pressing need is to breathe operational content into the “new paradigm” by moving beyond good ideas to develop a theory from which we can derive refutable implications that are thereafter submitted to empirical testing. To be sure, as Nicholas Georgescu-Roegen reminds us, “the purpose of science in general is not prediction, but knowledge for its own sake,” yet prediction is “the touchstone of scientific knowledge”(1971). There being many promising new ideas out there from which to choose, we need to sort the sheep(good ideas that withstand scientific scrutiny) from the goats(plausible but vague ideas that invite ex post rationalization). The ramifications of new concepts of all kinds need to be worked up in a hard-headed way. This is a central and recurring theme. As developed herein, there are no contractual elixirs; there is no all-purpose best mode of contracting. Those who would engage the study of contract must take the turn in the road that reads “hard work ahead.” Some might regard that as bad news, but it has been my experience that the study of complex contract and economic organization-from the transaction cost economics perspective and more generally-is endlessly interesting and that there are rewards at the end of the rainbow. Note that my remarks are qualified in the following respect : throughout this presentation I take the institutional environment as given, thereby to focus entirely on the governance of contractual relations, as these are worked out between the immediate parties to a transaction-commonly referred to as “private ordering”. The efficacy of governance nevertheless varies with differences in the institutional environment–of both informal(customs, traditions, norms, religion, etc.) and formal(the polity; property rights and contract laws and their enforcement) rules of the game-among regions and nation states. Thus although the theory of interfirm contracting as herein described has broad application to economics of all kinds, differences in the institutional environment among nation states(say as between the Republic of Korea and the United States) matter-to which the literatures on International Business and Positive Political Economy attest. I begin with three quotations that provide background for the study of contract and organization and help to set the stage for later remarks. I then discuss the three principal modes of governance that anchor the study of outsourcing : simple market exchange, hybrid contracting, and hierarchy. The use of credible commitments to support hybrid contracting is then developed and logic of efficient contracting is interpreted with the benefit of a simple contractual schema. The main lessons of interfirm contracting and economic organization are then summarized.