assessing contract

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Assessing ContractAuthor(s): Oliver E. WilliamsonSource: Journal of Law, Economics, & Organization, Vol. 1, No. 1 (Spring, 1985), pp. 177-208Published by: Oxford University PressStable URL: http://www.jstor.org/stable/764911

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Assessing ContractOLIVER E. WILLIAMSONYale University

A general framework for assessing contract is herein proposed and applied tocontractualpuzzles of two kinds. What factors are responsible for vertical re-strictions and related restraints on trade that are of concern to antitrust?When ought "impossibility" and related contract doctrines be grounds fordischarging a contract?What Ronald Coase (1972) characterized as the applied price theory ap-proach to industrialorganizationmaintained that restraints on trade had mo-nopoly origins. As discussed below, this was not a wholly unified perspec-tive; there were and are several monopoly variants within this tradition.Differences among them notwithstanding, all were informed by the thenprevailing (and still robust) firm-as-production-functionorientation. Tech-nology was thus held to be largely determinative of firm and marketorganization.Contract doctrines that permit excuse from strict performancewere origi-nally explained by reference to fairness. As KarlLlewellyn put it, "When weapproach constructive conditions bottomed on the unforeseen, not agree-ment, but fairness is the goal of the inquiry. This holds of impossibility, andof frustration; t holds of mistake"(746). More recently, however, impossibil-ity and related doctrines have been interpreted with reference to efficientrisk bearing.Dismay is sometimes registered over the readiness with which econo-mists have invoked monopoly to explain restrictive trade practices: "If an

The author is Gordon B. Tweedy Professor of Economics of Law and Organization, YaleUniversity. The paper was presented and benefited from the ensuing discussion at the Confer-ence of Law, Economics, and Organizationat Yale University in October 1984. Support fromthe Sloan Foundation is gratefully acknowledged.Journal of Law, Economics, and Organization vol. 1, no. 1 Fall 1985? 1985 by Yale University. All rights reserved. ISSN 8756-6222

177


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178 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985economist finds something-a business practice of one sort or another-thathe does not understand, he looks for a monopoly explanation"(Coase, 1972:67). Not only was this too easy-since any inventive economist could alwaysdiscover some monopoly purpose, however remote or insubstantial, lurkingsomewhere-but it discouraged efforts to investigate whether the businesspractice in question had other origins (as well or instead).The same is true of the readiness with which efficient risk bearing argu-ments are invoked. To be sure, importantfeatures of economic organizationare unarguablycrafted in response to differentialrisk aversion and capacitiesto bear risk. But if there is a good deal more to economic organizationthanthis, then when an economist finds something-a business or legal practiceof one sort or another-that he does not understand, he ought not to restcontent with an efficient risk bearing explanation.The possibility that nonstandardbusiness practices often arise in the serv-ice of efficiency-specifically, of economizing on transaction costs-was theneglected alternative to which Coase (1972) called attention. The inter-vening years have witnessed successive efforts to operationalize this ap-proach by ascertaining the factors that are responsible for the previouslyneglected "costs of running the economic system."' I submit, moreover,that this approachhas relevance not merely to restrictive trade practices butapplies to the study of economic organizationoverall. The possibility that ex-cuse from strict enforcement is warranted because of "contractualfailures"that have transaction cost origins thus warrantsscrutiny.This paper attempts to set out the rudiments of the transaction cost eco-nomics approach to contract; compare related approaches to contract inwhich some but not all of the key features of the transactioncost economicsapproach are preserved; display the main differences within and betweenalternative monopoly and efficiency approachesto restrictive trade practicesin a single contractual framework;and assess contractual doctrines relatingto excuse (for which the aforementioned efficient risk bearing treatmentshave already been advanced) from a transaction-cost economics point ofview.1. TRANSACTIONCOST ECONOMICSA variety of economic lenses can be and have been applied to the study ofcontract. The Chicago School has relied extensively on the lens of pricetheory (Posner, 1979). The lens of property rights affords another illu-minating perspective. I address issues of contract mainly through the lens oftransaction cost economics. Such an approach to the study of economic or-ganizationwas urged by RonaldCoase in his classic 1937 paper, "On the Na-ture of the Firm." Although Coase lamented, thirty-five years later, that this

1. The phrase originates with Kenneth Arrow (48).


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ASSESSING CONTRACT / 179

approach had not taken root (Coase, 1972), Vernon Smith was persuadedthat economic orthodoxy was spent and boldly predicted that a newmicrotheory would appear which "will, and should, deal with the founda-tions of organization and institution, and this will require us to have an eco-nomics of informationand a more sophisticated treatment of the technologyof transacting"(321).Implementing such a programcan take a variety of forms. What I refer tohere as transaction cost economics adopts John R. Commons's proposal thatthe transaction be made the basic unit of analysis. Attention is focused oneconomizing efforts that attend the organization of transactions-where atransaction occurs when a good or service is transferredacross a technologi-cally separable interface. One stage of activity terminates and another be-gins. With a well-working interface, as with a well-working machine, thesetransfersoccur smoothly. In mechanical systems we look for frictions:do thegears mesh, are the parts lubricated, is there needless slippage or other lossof energy? The economic counterpart of friction is transaction cost: do theparties to the exchange operate harmoniously, or are there frequent mis-understandings and conflicts that lead to delays, breakdowns, and othermalfunctions? Transaction cost analysis supplants the usual preoccupationwith technology and steady-state production (or distribution)expenses withan examination of the comparative costs of planning, adapting, and moni-toring task completion under alternative governance structures.As compared with other approaches to the study of economic organiza-tion, transaction cost economics: (1) is more microanalytic; (2) is more self-conscious about its behavioral assumptions; (3) introduces and develops theeconomic importance of asset specificity; (4) relies more on comparative in-stitutional analysis; (5) regards the business firm as a governance structurerather than a production function; and (6) places greater weight on the expost institutions of contract, with special emphasis on private ordering (ascompared with court ordering). The underlying viewpoint which informsthecomparative study of issues of economic organizationis this: transactioncostsare economized by assigning transactions (which differ in their attri-butes) to governance structures (the adaptive capacities and associated costsof which differ) in a discriminating way.1.1. BEHAVIORALASSUMPTIONSBehavioral assumptions are often regarded casually, almost as a matter ofconvenience. This is sometimes justified by the view that social scientistswho play hardball will emphasize what really counts-which, after all, arethe refutable implications (Friedman; Baiman). This orientation has beenvariously disputed, but none more effectively than Nicholas Georgescu-Roegen's prescription for serious science. He contends that "the purpose ofscience in general is not prediction, but knowledge for its own sake"(37). He


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180 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985nevertheless insists that prediction "is the touchstone of scientific knowl-edge" (37). Lest reasoningbecome speculative and undisciplined, predictionnecessarily plays a central role. But greater respect for behavioral assump-tions is introduced if knowledge rather than prediction drives scientificinquiry.Much of Frank Knight's work on economic organization is in this spirit.He argued that the study of organizationneeded to be informed by an appre-ciation for "humannature as we know it" (270), with special reference to thecondition of "moral hazard"(260). And Percy Bridgeman reminded socialscientists that "the principal problem in understanding the actions of men isto understand how they think-how their minds work" (450). Coase morerecently remarksthat "modern institutional economics should start with realinstitutions. Let us also start with man as he is" (1984: 231). Coase urges inthis connection that the view of man as a "rationalutility maximizer"shouldbe abandoned (1984: 231), but the salient attributes of"man as he is" other-wise remain undescribed.

I have previously argued that contracting man is distinguished from theorthodox conception of maximizing man in two respects. First, his ability toreceive, store, retrieve, and process informationis strictly limited. Second,contracting man is given to self-interest seeking of a deeper and more trou-blesome kind than his economic man predecessor.Although it is sometimes believed that Herbert Simon's notion ofbounded rationality is alien to the rationalitytradition in economics, Simonactually enlarges rather than reduces the scope for rationality analysis. Thusthe economic actorswith whom Simon is concerned are "intendedlyrational,but only limitedly so" (1961: xxiv). Both parts of the definition warrant re-spect. An economizing orientation is elicited by the intended rationalitypartof the definition, while the study of institutions is encouraged by acknow-ledging that cognitive competence is limited: "It is only because individualhuman beings are limited in knowledge, foresight, skill, and time that organ-izations are useful investments for the achievement of human purpose" (Si-mon, 1957: 199).It is sometimes argued that bounded rationality is merely a convolutedway of stating that informationis costly. Once this has been acknowledged,maximizing modes of analysis can deal with all of the issues with whichbounded rationality is concerned. There is something to be said for this: asSimon observes, a large "plotof common ground is shared by optimizing andsatisficinganalysis"(1978:8, n. 6). Although one might, on grounds of parsi-mony, recommend that "we prefer the postulate that men are reasonable tothe postulate that they are supremely rationalwhen either one of these as-sumptions will do" (Simon, 1978: 8), it is easy to understand how others candecide differently. Working within an extended neoclassical framework isnot a benefit that will be sacrificed lightly.


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As Richard Nelson and Sidney Winter argue, however, fundamental ten-sions remain:There is . . . a fundamental ifferencebetweena situation n whicha decisionmaker s uncertain bout he stateX anda situationn whichthe decisionmakerhasnot givenanythoughtto whetherX mattersor not, betweena situationn whichaprethought ventjudgedof lowprobabilityccursanda situationnwhichsomethingoccurs hatneverhas been thoughtabout.... Mostcomplexmodelsof maximizingchoice do not cometogripswiththeproblemof boundedrationality.Onlymetaphor-icallycana limited nformationmodelbe regarded samodelofdecisionwith imitedcognitiveabilities.(66-67)

Maximizing analysis can deal with much, but not with the entire landscapewith which bounded rationality is concerned.2Transaction cost economics pairs the assumption of bounded rationalitywith a self-interest seeking assumption that makes allowance for self-interestseeking with guile. This allows economic agents to disclose informationin aselective and distorted manner. Calculated efforts to mislead, disguise, ob-fuscate, and confuse are thus admitted. This self-interest seeking attribute isvariously described as opportunism, moralhazard, and agency. As discussedbelow, problems of contract and, more generally, of economic organizationare vastly complicated by this condition.1.2. DIMENSIONSHaving adopted the transactionas the basic unit of analysis, the question is,what are the principal dimensions with respect to which transactionsdiffer?If some transactionsare organized in one way and other transactionsare or-ganized in another, underlying differences in the attributes of transactionsare presumably contributing factors.The principal dimensions on which transactioncost economics presentlyrelies for purposes of describing transactions are (1) the frequency withwhich they recur; (2) the degree of uncertainty to which they are subject;and (3) the condition of asset specificity (Williamson, 1979; 1985). The lattertwo are of special importance for the purposes of this paper.As discussed elsewhere (Williamson, 1985), different kinds of uncertaintyneed to be distinguished. Suffice it to say here that all long-term contractsare necessarily incomplete (fail to make express provision for all future con-tingencies) if human agents are subject to bounded rationality and if con-

2. A furtherpoint which deserves mention is the temptation-to which maximizinganalysissometimes yields-of dealing with toy problems. This is not a necessary consequence. It is nev-ertheless common, upon acknowledging that information is costly, to press ahead with theformalanalysisrather than examine the factorsthat are responsible for this condition. Especiallyfor an understandingof contract, the underlying costliness conditions are often the key features.


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182 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985tracts are executed under conditions of uncertainty. The central problemwith which transaction cost economics is concerned is thus posed: how, inthe face of ex ante contractual incompleteness, are effective adaptations tochanging circumstances to be implemented?The condition of asset specificity has reference to what, in the legal litera-ture, is often referred to as reliance investments. These are investments inwhich the full productive values are realized only in the context of an on-going relation between the original parties to a transaction. Put differently,such assets cannot be transferredto alternative uses or users without loss ofproductive value (Klein et al., 1978). Partieswho are engaged in a trade thatis supported by nontrivial investments in transaction-specificassets are ef-fectively operating in a bilateral trading relation with one another.Harmonizing the contractual interface that joins the parties, thereby ef-fecting adaptability and promoting continuity, becomes the source of realeconomic value.2. CONTRACTUAL SCHEMATICSMy examination of contract in this section proceeds in two parts. The firstcontrasts alternative conceptions of the process of contract and relates theseto the two behavioral attributes and to the condition of asset specificity dis-cussed above. The second describes a general schema for examining contractin which interactions between technology, prices, and governance are alljoined.2.1. CONTRACTAS PROCESSThe world of contract is variously described as one of planning, promise,competition, and governance (or private ordering). Which of these descrip-tions is most applicable depends on the behavioral assumptions which per-tain to an exchange and on the economic attributes of the good or service inquestion.Thus assume that uncertainty is present in nontrivialdegree and considerthe ramifications for contract of differences in bounded rationality, oppor-tunism, and asset specificity. Assume, in particular,that each of these condi-tions can take on either of two values: either it is present in significant de-gree (denoted +) or it is presumed to be absent (denoted 0). Consider thethree cases in which only one of these factors is presumed to be absent andthen that in which all three are joined. Table 1 shows the four conditions tobe compared and the contracting model that is associated with each.The case where parties are opportunisticand assets are specific but eco-nomic agents have unrestricted cognitive competence essentially describes


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Table1. ContractingModelsImplied

Asset ContractingBehavioral Assumption Specificity ProcessBounded

Rationality Opportunism0 + + Planning+ 0 + Promise+ + 0 Competition+ + + Governance+ Present n significant egree0 Presumed o be absent

the mechanism design literature (Hurwicz, 1972, 1973; Myerson, 1979;Harris and Townsend, 1981). Although the condition of opportunism re-quires that contracts be written in such a way as to respect private informa-tion, whence complex incentive alignment issues are posed, all of the rele-vant issues of contract are settled at the ex ante bargaining stage. Givenunbounded rationality, a comprehensive bargain is struck at the outset, ac-cording to which appropriate adaptations to subsequent (publicly observa-ble) contingent events are fully described. Contract execution problems thusnever arise-or defection from such agreements is deterred because courtadjudication of all disputes is assumed to be efficacious (Baiman:168). Con-tract, in the context of unbounded rationality, is therefore described as aworld of planning.Consider alternatively the situation where agents are subject to boundedrationality and transactions are supported by specific assets, but the condi-tion of opportunism is assumed to be absent. This last implies that the wordof an agent is as good as his bond. Thus although gaps will appear in thesecontracts, because of bounded rationality, these do not pose execution haz-ards if the parties take recourse to a self-enforcinggeneral clause. Each partyto the contract simply pledges at the outset to execute the contractefficiently (in a joint profit-maximizingmanner)and to seek only fairreturnsat contract renewal intervals. Strategic behavior is thereby denied. Partiesto a contract thus extract all such advantages as their endowments entitlethem when the initial bargain is struck. Thereafter, contract execution goesefficiently to completion because promises of the kind described above are,in the absence of opportunism, self-enforcing. Contract, in this context, re-duces to a world of promise.

Consider then the situation where agents are subject to bounded rational-ity and are given to opportunism, but asset specificity is presumed to be ab-sent. Parties to such contracts have no continuing interests in the identity ofone another. This describes the world where discrete market contracting is


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184 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985

efficacious, where markets are fully contestable,3 where franchise biddingfor natural monopoly goes through. Inasmuch as fraud and egregious con-tract deceits are deterred by court ordering,4contract, in this context, is de-scribed by a world of competition.Each of these conceptions fails when bounded rationality, opportunism,and asset specificity arejoined. Planninghere is necessarily incomplete (be-cause of bounded rationality), unguarded promise predictably breaks down(because of opportunism), and the pair-wise identity of the parties now mat-ters (because of asset specificity). This is the world of governance. Since theefficacy of court ordering is problematic, contract execution falls heavily onthe institutions of private ordering (Kronman, 1985). This is the world withwhich transaction cost economics is concerned. The organizationalimpera-tive that emerges in the circumstances is this: organize transactions so as toeconomize on bounded rationalitywhile simultaneously safeguarding themagainst the hazards of opportunism. Such a statement supports a differentand larger conception of the economic problem than does the imperative"maximize profits!"2.2. A SIMPLE CONTRACTING SCHEMA

I take as given that the parties to a contract are subject both to bounded ra-tionality and to opportunism. Accordingly, concepts of contract as eitherplanning or promise are disallowed. The condition of asset specificity, how-ever, is regarded as variable. It will be useful for this purpose to expand theconcept of governance to include competition as one of the possible alter-natives. In particular, competition is the appropriate governance structurefor the case where assets are fully redeployable (k = 0).The object of the exercise in this subsection is to display the systematicrelations that obtain between technology, governance, and the price underwhich product is supplied. Albeit rudimentary, failure to acknowledge theinteractive nature of these three features has been responsible for repeatedconfusion in earlier treatments of contract where these are treated in apiecemeal way.5

3. Differences between transaction cost economics and "contestability theory" (Baumol,Panzer, and Willig) in asset specificity respects are noteworthy. Both approachesto the study ofeconomic organizationacknowledge the importance of asset specificity, but they view it fromopposite ends of the telescope. Thus contestability theory reduces asset specificity to insignifi-cance, whence hit-and-runentry is easy. Transactioncost economics, by contrast, magnifies thecondition of asset specificity. It maintains that durable, firm-specificassets are widespread, inwhich case hit-and-run entry is often not feasible. For recent assessments of contestabilitytheory, see Michael Spence (1983) and W. G. Shepherd.4. The assumption that court ordering is effiacious in a regime of bounded rationalityandopportunism is plainly gratuitous, but it is the maintained assumption nonetheless.5. See my discussion of the confusions that arise upon failure to assess contracts in theirentirety (Williamson, 1983).


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Assume that a good or service can be supplied by either of two alterna-tive technologies. One is a general purpose technology; the other is a specialpurpose technology. The special purpose technology requires greater invest-ment in transaction-specific durable assets and is more efficient for servingsteady-state demands.Using k as a measure of transaction-specificassets, transactions that usethe general purpose technology are ones for which k = 0. When trarnactionsuse the special purpose technology, by contrast, a k > 0 condition obtains.Assets here are specialized to the particularneeds of the parties. Productivevalues would therefore be sacrificed if transactions of this kind were to beprematurely terminated. The bilateral monopoly condition described aboveand elaborated elsewhere applies to these.Whereas classical market contracting-the discrete contracting ideal-suffices for transactions of the k = 0 kind, unassisted market governanceposes hazards whenever nontrivial transaction-specificassets are placed atrisk. Parties have an incentive to devise safeguardsto protect investments intransactions of the latter kind. Let s denote the magnitude of any such safe-guards. An s = 0 condition is one in which no safeguardsare provided; a de-cision to provide safeguards is reflected by an s > 0 result.

Figure 1 displays the three contracting outcomes corresponding to thisdescription. Associated with each node is a price. To facilitate comparisonbetween nodes, assume that suppliers are risk neutral, are prepared to sup-ply under either technology, and will accept any safeguardcondition whatso-ever so long as an expected breakeven result can be projected. Thus node A

A Pi

k =

B pk>O

P< ~ P>P

C p

Figure 1. A Simple Contracting Schema


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186 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985is the general purpose technology (k = 0) supply relation for which abreakeven price of pi is projected. The node B contract is supported bytransaction-specificassets (k > 0) for which no safeguardis offered (s = 0).The expected breakeven price here is p. The node C contract also employsthe special purpose technology. But a safeguardis employed in this instance(s > 0), whence the breakeven price, p, at node C is less than p.The protective safeguardsto which I refer normally take on one or moreof three forms. The first is to realign incentives, which commonly involvessome type of severance payment or penalty for premature termination. Asecond is to create and employ a specialized governance structure forreferringand resolving disputes. The use of arbitration,rather than litigationin the courts, is thus characteristicof node C governance. A third is to intro-duce trading regularitieswhich supportand signal continuity intentions. Ex-panding a tradingrelation fromunilateralto bilateralexchange-through theconcerted use, for example, of reciprocity-thereby to effect an equilibra-tion of trading hazards is an example of this last. If, despite best efforts,nonstandard contracting still experiences great governance strains, marketcontracting may eventually be supplanted by unified ownership (vertical in-tegration). Transaction cost economics thus maintains the premise that "inthe beginning there were markets"and that internal organizationis adoptednot immediately but only when contracts (comparatively)fail.6This simple contracting schema applies to a wide variety of contractingissues. It facilitates comparative institutional analysis by emphasizing thattechnology (k), contractualgovernance/safeguards(s), and price (p) are fullyinteractive and are determined simultaneously. Vertical integration,7labormarket organization,8regulation,9 corporate governance,'? reciprocity andvertical restraints on trade," and even family organization12 turn out to be

6. This market-favoring presumption is a device by which to set comparative analysis inmotion. Since transactionsneed to be located somewhere, why not startin marketsand, if prob-lems develop, see what can be done to mitigate the difficultiesand keep them there. To be sure,one could startinstead with internal organizationandaskwhat disabilities it experiences. Trans-actions could then be moved into markets because of the (comparative)failures of internal or-ganization. Originating transactionsin markets comes more naturallyto economists and is fa-vored by the differential development of the market failure in relation to the bureaucraticfailure literature. For efforts to treat the latter, see Williamson (1975: chap. 7; 1985: chap 6).

7. My first efforts to address these matters were in the context of vertical integration(Williamson, 1971). For a related discussion, see Klein, et al. (1978). John Stuckey's examina-tion ofjoint ventures and vertical integrationin the aluminumindustrydemonstrates the meritsof the microanalytic approach. Also see studies by Monteverde and Teece and by Masten. Al-though many students of economic organizationhave only limited interest in vertical integra-tion, it turns out to be a paradigmproblem.8. See Williamson, Wachter, and Harris; Wachter and Williamson; and Williamson(1984a).9. See Williamson (1976); Goldberg (1976); Joskow and Schmalensee (1983);and Palay.10. See Fama and Jensen; Williamson (1984b);and FitzRoy and Mueller.11. See Williamson (1979); Goldberg (1980); Klein and Leffler (1981); Williamson (1983);and Kenney and Klein.12. See YoramBen-Porath; Robert Pollak.


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variations on a theme. As Friedrich Hayek observed, "Whenever the capac-ity of recognizing an abstract rule which the arrangement of these attributesfollows has been acquired in one field, the same master mould will applywhen the signs for those abstract attributes are evoked by altogether differ-ent elements" (50).

By the way of summary, the nodes A, B, and C in the contractualschemaset out in figure 1 have the following properties:1. Transactions that are efficiently supported by general purpose assets(k = 0) are located at node A and do not need protective governance struc-tures. Discrete market contracting suffices. The world of competitionobtains.2. Transactions that involve significant investments of a transaction-specific kind (k > 0) are ones for which the parties are effectively engaged inbilateral trade.3. Transactions located at node B enjoy no safeguards(s = 0), on whichaccount the projected breakeven supply price is great (p > p). Such transac-tions are apt to be unstable contractually. They may revert to node A (inwhich event the special purpose technology would be replaced by the gen-eral purpose [k = 0] technology) or be relocated to node C (by introducingcontractual safeguards that would encourage the continued use of the k > 0

technology).4. Transactions located at node C incorporate safeguards (s > 0) andthus are protected against expropriation hazards.5. Inasmuch as price and governance are linked, parties to a contractshould not expect to have their cake (low price) and eat it too (no safeguard).More generally, it is important to study contracting in its entirety. Both theex ante terms and the manner in which contracts are thereafter executedvary with the investment characteristics and the associated governancestructures within which transactions are embedded.3. RESTRICTIVE TRADE PRACTICES: MONOPOLY ANDEFFICIENCY APPROACHES TO CONTRACTThe field of specialization with which transaction cost economics is mostclosely associated is that of industrial organization. A number of the leadingapproaches to the study of industrialorganizationand the relation that trans-action cost economics bears to them are examined here.Industrial organization examines contract in terms of the purposesserved. What are the parties trying to accomplish? Nonstandard forms ofcontracting-customer and territorial restrictions, tie-ins, block booking,franchise restrictions, resale price maintenance, exclusive dealing, and thelike-are of special interest. Here as elsewhere in industrial organization,monopoly and efficiency purposes are usefully distinguished. The parti-tioning shown in figure 2 begins with this distinction.


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t 6

Leverage

Price discriminationEntry barriers

StrategicbehaviorProperty rights

Efficiency Incentives

AgencyTransactioncost \ Governance

MeasurementFigure 2. Cognitive Map of Contract

3.1. THE MONOPOLY BRANCH

All of the approaches to contract shown in figure 2, monopoly and efficiencyalike, are concerned with the same puzzle: what purposes are served by sup-planting classical market exchange-whereby product is sold at a uniformprice to all comers without restriction-by more complex forms of con-tracting (including nonmarket modes of economic organization)?The mo-nopoly approaches ascribe departures from the classical norm to monopolypurpose. The efficiency approaches hold that these departures serveeconomizing purposes instead.The four monopoly approaches to contract are grouped under two head-ings. The first examines the uses of contractualrestraints in relation to buy-ers. The second is concerned with the impact of such practices on rivals.The leverage theory of contract and the price discrimination interpreta-tion of nonstandardcontractingboth focus on buyers. Richard Posner (1979)associates leverage theory with the (earlier) Harvard School and price dis-


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crimination with the Chicago School approaches to antitrust economics.Leverage theory maintains that original monopoly power can be extendedand that nonstandardcontracting practices accomplish this. Although lever-age theory is largely discredited among economists, it maintains an appeal tomany lawyers'3and continues to find its way into legal briefs'4and courtopinions. 5The price discrimination approach to nonstandardcontracting maintainsthat original monopoly power is unchanged. Price discrimination is merely ameans by which latent monopoly power is actualized. This interpretation ofnonstandard contracting has been advanced by Aaron Director and EdwardLevi in conjunction with tie-in sales and by George Stigler (1963) in relationto block booking. Tie-in sales and block booking are purportedly devices bywhich sellers are able to discover underlying product valuation differencesamong consumers and monetize consumers' surplus.The other two monopoly approaches examine nonstandard contractingpractices in relation to rivals. These are expressly concerned with the en-largement of monopoly power by large established firms in relation tosmaller actual or potential rivals. The barriers to entry literature, which isprominently associated with the work of Joe Bain (1956), is in this tradition.The early work in this area has come under considerable criticism, much of itoriginating with the Chicago School. The main problems with the early workare that it was static and did not carefully identify the essential preconditionsfor entry barrier arguments to go through. The more recent literature onstrategic behavior relieves many of the objections.'6 Investment and infor-mation asymmetries are expressly introduced. Intertemporal attributes arerecognized and reputation effect features are developed. The use of non-standard contracting as a means of "raising rivals' costs" (Salop andScheffman) is an especially intriguing possibility.The recent strategic behavior literature excepted, all of the monopoly ap-proaches to contract work within the neoclassical framework, in which thefirm is regarded as a production function. Inasmuch as the natural bounda-ries of the firm are therein defined by technology, any effort by the firm toextend its reach by recourse to nonstandard contracting was presumed to

13. Louis Kaplow'srecent effort to resuscitate it locates leverage theory in an intertemporalcontext. This is more promising, but it is not the applied price theory context in which it wasoriginally presented. Kaplow's leverage argumentsare more usefully regarded as partof the de-veloping literature on strategic behavior-on which I have little to say here but regardas muchmore instructive than the earlier monopoly traditions. For a discussion, see Williamson (1982).14. See, for example, the Amicus brief prepared by Lawrence A. Sullivan in support of therespondent in Monsanto Company v. Spray-Rite Service Corporation.15. Although the majorityopinion in Jefferson Parish Hosp. Dist. No. 2 v. Hyde (44CCHS. Ct. Bull., P.) reaches the correct result, it also muddies the opinion by passing reference toleverage theory.16. These matters are surveyed in Williamson (1982).


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190 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985have monopoly purpose and effect.'7This "applied price theory" approachto industrial oganization was the prevailing postwar orientation. As Coaseobserved (1972: 61), it informed both of the leading industrial organizationtexts-the one by Joe Bain (1958) and the other by George Stigler (1968).Public policy toward business was massively influenced by this approach.Examples here are legion. None, however, displays the pervasive influenceof production function thinking better than the government's confusion overthe merits of vertical restraints as compared with vertical integration, as ex-pressed in Schwinn:'8Even if the threatto integratewere not wholly lackingcredibility n the circum-stancesofthiscase,we wouldurgethat t was not aproperdefenseto the restraint ftradecharge. .. A rule thattreatsmanufacturers hoassume hedistributionunc-tion themselvesmore eniently han hosewhoimposerestraints nindependentdis-tributorsmerelyreflects he fact hat,althoughntegrationndistributionmaysome-times ead tocostsavings,agreement o maintain esalepricesor toimpose erritorialrestrictions f unlimitedduration r outlet imitations f thetypeinvolvedhere haveneverbeen shownto producecomparableconomies.Evidently those who briefed the government's case'9were persuaded thateconomies of a production function kind (economies of scale, economies ofscope) were real but that to exercise control over distributors through con-tractual restraints could only have pernicious monopoly purpose and effect.The predisposition to favormonopoly explanations, which Coase had attrib-uted to economists, was thus shared by antitrust enforcement officials aswell. The production function conception of the firm, which held that thenatural boundaries between firms and markets were a parameter (definedmainly by technology)-hence did not need to be assessed or derived-wasvirtually determinative of this result.Much of the strategic behavior literature, by contrast, is more closely as-sociated with the governance structure conception of the enterprise. Tohighlight this important monopoly distinction, the dashed curve (denotedPF) in figure 2 separates the earlier production function approachesfrom themore recent strategic conception of contract.3.2. THE EFFICIENCY BRANCHMost of what may be referredto as the new institutionaleconomics is locatedon the efficiency branch of contract. The efficiency branch of contract distin-

17. To be sure, it can be argued thatprice discriminationis efficient, which it ordinarilyis ifit can be effected at zero transactioncost and if income distribution effects wash out. The zerotransactioncost assumption is rarelywarranted,however. Private and social valuationsof pricediscrimination can yield contradictoryresults for this reason (Williamson, 1975: 11-13).18. Brieffor the United Statesat 50, United States v. Arnold, Schwinn & Co., 388 U.S. 365(1967).19. The principal architects of the government's brief were highly sophisticated antitrustspecialists, Richard Posner and Donald Turner. Each has since changed his position.


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guishes between those approaches in which incentive alignments are em-phasized and those which feature economies of transactioncosts. The incen-tive alignment literature focused on the ex ante side of contract. New formsof property rights and complex contracting are thus interpreted as efforts toovercome the incentive deficiencies of simpler property rights and con-tracting traditions. Ronald Coase (1960), Armen Alchian (1961, 1965), andHarold Demsetz (1966, 1969) are prominently associated with the propertyrights literature.2' Leo Hurwicz (1972; 1973); Michael Spence and RichardZeckhauser (1971); Stephen Ross; Michael Jensen and William Meckling(1976); and James Mirrlees opened up the agency approach.21The property rights literature emphasized that ownership matters, wherethe rights of ownership of an asset take three parts:the right to use the asset;the right to appropriate returns from the asset; and the right to change theform and/or substance of an asset (Furubotn and Pejovich: 4). Upon gettingthe property rights straight, it is commonly assumed (often implicitly; some-times explicitly) that asset utilization will thereafter track the purposes of itsowners. This will obtain if (1) the legally sanctioned structure of propertyrights is respected, and (2) human agents discharge their jobs in accordancewith instructions.22

Thus, whereas the monopoly branch of contract interprets nonstandardforms of exchange as having monopoly purpose and effect, the propertyrights literature would inquire whether mistaken property rights assign-ments were responsible for resource misallocations. Redescribing propertyrights, possibly in complex (nonstandard)ways, is what explains contractualirregularities. In other words, discrete market contracting is supplanted bymore complex forms of contracting because this is the way residual rights tocontrol can be placed in the hands of those who can use these rights mostproductively.The agency literature, particularly the early agency literature, empha-sizes that principals contract in full awareness of the hazardthat contract ex-ecution by agents poses. Although the separationof ownership from controlattenuates profit incentives, this is anticipated at the time that separationoc-curs and is fully reflected in the price of new shares (Jensen and Meckling,1976). The future therefore holds no surprises;all of the relevant contractingaction is packed into ex ante incentive alignments.

20. For a recent survey, see Louis De Alessi. For an earlier survey, see Eirik Furubotn andSvetozar Pejovich.21. For a recent survey, see Stanley Baiman.22. The recent treatment of vertical integration by Sanford Grossman and Oliver Hartillustrates both of these propositions. Thus they view asset ownership as control over residualrights: "Each asset will have a single owner and that owner has the right to control the asset inthe case of a missing [contractual]provision"(7). They further contend that the owner of phys-ical assets "canorder plant employees" to utilize these assets in accordancewith his directions(17). Differences between market organizationand vertical integration are thus entirely attrib-uted to the asset ownership differences which distinguish them.


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192 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985Actually, as Michael Jensen's influential survey points out (1983), this lit-erature has actually developed in two parts. He refers to the one branch as

the positive theory of agency. Here, "capital intensity, degree of specializa-tion of assets, informationcosts, capital markets, and internal and externallabor marketsare examples of factorsin the contractingenvironment that in-teract with the costs of various monitoring and bonding practices to deter-mine the contractualforms"(Jensen, 1983:334-35). Thus described, numer-ous commonalities appear between this branch of the agency literature andthe governance branchof transactioncosts described below. Jensen refers tothe second type of agency literature as that of "principal-agent" 1983: 334).This relatively mathematicalliterature features ex ante incentive alignmentsin superlative degree. It has come to be known more recently as the mecha-nism design approach. This line of research is akin to the earlier contingentclaims contracting literature23 ut moves beyond it by admitting contractingcomplications in the form of private information. Complex problems of in-centive alignment are posed (which the contingent claims contracting litera-ture had ignored) if full and candid disclosure of private information cannotbe assumed. In other respects, however, the mechanism design and contin-gent claims contracting literature are very similar: both resolve all of the rel-evant contracting issues in a comprehensive ex ante bargain,24 nd both as-sume that court ordering is efficacious.2 Again, efficiency rather thanmonopoly purposes drive the argument.The transactioncost literature also maintainsthe rebuttable presumptionthat nonstandardforms of contracting have efficiency purposes. Greater at-tention is shifted, however, to the contract execution stage. As shown infigure 2, the transactioncost approachis split into a governance branch and ameasurement branch. Both are important and, in fact, are interdependent.

23. Mervyn King characterizes the Arrow-Debreu model as follows:Commodities are distinguished not only by physical and spatial characteristics, andby the date at which the commodity is made available, but also by the "state of theworld" in which it is delivered. A "state of the world"is defined by assigningvalues to allthe uncertain variableswhich are relevant to the economy . .. and comprises a completelist of all these variables. These states of the world are mutually exclusive, and togetherform an exhaustive set . . . Commodities are now defined as contingent on the occur-rence of certain events, and the marketsystem comprises marketsin all these contingentcommodities. (128)

24. The mechanism design literature assumes that the parties to a contract have the cogni-tive competence to craftcontractsof unrestricted complexity. In effect, the parties to a contracthave unbounded rationality. (See Bengt Holmstrom). By contrastwith the property rights liter-ature, the mechanism design approachholds that "since each party'sobligation to the other iscompletely specified for every state of nature, there are no residual rights of control over assetsto be allocated" (Grossmanand Hart: 7). Complex contracts are not concerned therefore withresidual rights but with getting the obligations defined at the outset-due provision for privateinformationhaving been acknowledged.25. See Baiman (168).


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In common with the property rights literature, transactioncost economicsagrees that ownership matters. It furthermore acknowledges that ex ante in-centive alignments matter. But whereas the property rights and mechanismdesign approaches operate within the tradition of legal centralism, transac-tion cost economics disputes that court ordering is efficacious. Attention isshifted instead to private ordering. What institutions are created with whatadaptive, sequential decisionmaking and dispute settlement properties? Toownership and incentive alignment, therefore, transaction cost economicsadds the proposition that the ex post support institutions of contract matter.James Buchanan has argued that "economics comes closer to being a 'sci-ence of contract' than a 'science of choice' . . . [on which account] themaximizer must be replaced by the arbitrator,the outsider who tries to workout compromises among conflicting claims"(229). The governance approachadopts the science of contract orientaion but joins the arbitratorwith an in-stitutional design specialist. The object is not merely to resolve conflict inprogress but also to recognize potential conflict in advance and devise gov-ernance structures which forestall or attenuate it.Transaction cost economics maintains that it is impossible to concentrateall of the relevant bargainingaction at the ex ante contracting stage. Instead,bargaining is pervasive-in which case the institutions of private orderingand the study of contracting in its entirety take on critical economicsignificance. The behavioral attributes of human agents, whereby conditionsof bounded rationality and opportunism are joined, and the complex attri-butes of transaction (with special reference to the condition of assetspecificity) are responsible for this condition.The measurement branch of transaction cost economics is concerned withperformance or attribute ambiguities that are associated with the supply of agood or service. The Alchian-Demsetz (1972) treatment of technologicalnonseparabilities (team organization) is an example. The issues have sincebeen addressed by William Ouchi, with respect to the organizationof mar-kets. A recent interesting application is the study of Roy Kenney and Benja-min Klein of what they refer to as "oversearching."They take exception toStigler's view that block booking has monopoly (price discrimination) pur-poses and argue instead that it serves to economize on measurement costs.Breakingout of the production function frameworkas it does, the transac-tion cost approach leads to a very different interpretation of the contractualrestrictions to which the government objected in Schwinn. Indeed, sincethe strategic hazards in Schwinn were negligible (market shares were toosmall to effect foreclosure; there was no collective action), and since the re-strictions arguably contributed to the integrity of the franchise mode ofdistribution (an s > 0 result), the government's arguments were wholly in-apposite.2Attributing monopoly purpose where there could be none and

26. For an elaboration, see Williamson (1979).


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194 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985disregarding possible transactioncost benefits were to be expected of anti-trust contract analysis, however, so long as the monopoly predispositionruled.More recent assessments of restraints on trade acknowledge that bothmonopoly and efficiency are sometimes served. The easy cases, of course,are those where one of these purposes predominates. Identifying the pre-conditions that most favormonopoly in relation to efficiency (or the reverse)is now feasible and will permit the polarcases to be distinguished. Consider-ing the primitive state of our knowledge, however, mixed cases will some-times arise for which an unambiguous net assessment will sometimes be im-possible. Candid ambiguity is nonetheless to be preferred to the mistakenclarity of the monopoly era.4. COMMERCIAL IMPOSSIBILITY27Contract doctrines of commercial impossibility have been interpreted fromboth fairness and efficiency points of view. Llewellyn's views on fairnesswere cited at the outset. Richard Posner and Andrew Rosenfield appeal notto fairness but to efficient risk bearing in their examination of this doctrine.They observe that whereas the law could treat each failure to perform "byreason of an unforeseen or at least unprovided-forevent" as a breach of con-tract, thereby assigning the risk to the promisor, it could also excuse the fail-ure and "discharge the contract, thereby in effect assigning the risk to thepromisee" (1977: 83). Efficient discharge, they contend, "should be allowedwhere the promisee is the superior risk bearer; if the promisor is the supe-rior risk bearer, nonperformance should be treated as a breach of contract"(84).The analysis here also adopts an efficiency orientation. The emphasis,however, is not on a firm-to-firmcomparisonof riskbearing but on the trans-action cost ramificationsof contract doctrines which permit discharge. Also,whereas the examples discussed by Posner and Rosenfield mainly have ref-erence to one-time events, those with which I am concerned involvesignificant investments in durable transaction-specificassets. Continuity ofthe relation is valued for this class of transactions.These are the same trans-actions that are of concern to Richard Speidel in his recent examination ofcourt-ordered contract adjustment.The mine-mouth coal contracts to which Joskow(1985)refers, which havea typical duration of twenty-five to fifty years, are plainly of this kind. Thelong-term contractbetween Alcoa and Essex Wire, whereby Alcoaagreed tosupply molten aluminum ingot to a plant that Essex Wire located near anAlcoa facility, is another illustration (Speidel). The Westinghouse agree-

27. The discussion of commercial impossibility in this section is related to and relies uponearlier treatments of these matters by Paul Joskow (1977) and Richard Speidel.


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ments to supply uraniumfuel to a large number of electric utilities is a thirdexample (Joskow, 1977).28How does transaction cost economics have abearing on the choice between strict enforcement and court-ordered adjust-ment when unanticipated circumstances intrude that place one of the parties(usually the seller) to such contracts under severe stress-in the Westing-house case amounting to billions of dollars?My treatment of these issues is comparative and does not pretend to bedispositive. As discussed earlier, the transactioncost approach to economicorganization always proceeds in comparative terms. Choices are madeamong alternatives, all of which are "defective" if judged with reference to africtionless ideal. My purpose here is merely to ascertainwhether previouslyneglected transaction cost features should be taken into account in shapingpublic policy in this area.The argument is in five parts. I begin with a precontract analysis of alter-native modes of economic oganization. I then examine the ramifications oflong-term contracting in a regime of strict enforcement whereby parties arerelieved under claims of impracticability only if they have made contractualprovision for it. The use of contract doctrine to permit excuse is then consid-ered. Enforcement problems of effecting adjustment under both strict andexcuse regimes are addressed next. An overview of the argument is thenattempted.4.1. PRECONTRACT ANALYSIS OF ALTERNATIVE MODES

OF ECONOMIC ORGANIZATIONThe comparative institutional approach to economic organization regardsboth the mode of organizationand the choice of technology as decision varia-bles. By contrast, noncomparative analysis typically takes both as given. If,however, one mode/technology pair for accomplishing a taskexperiences se-vere difficulties, a superior result can often be realized by makingchanges inone or both.Thus suppose that long-term contracts for a good or service that are sup-ported by significant investments in transaction-specificassets are thoughtto pose severe hazards. What are the main alternatives for getting the jobdone?One possibility is to preserve the technology and shift to a governancestructure that is believed to be less hazardous. Vertical integration is oftenadopted for this reason. An electric generating plant, for example, could in-tegrate backward nto mine-mouth coal supply. Such backward ntegration is

28. The asset specificity in the mine-mouth and aluminum supply contracts involved sitespecificity. The investments for uraniumsupply are of the dedicated-asset kind. For discussionof asset specificity in its various forms, see Williamson (1983: 526; 1985, chap. 4).


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not always feasible, however.29Even where feasible, moreover, the adap-tive benefits of vertical integration must be weighed against its incentivedisabilities.30Another alternative is to sacrificethe transaction-specifictechnology in fa-vor of a more general purpose technology. This corresponds to a shift fromthe k > 0 to the k = 0 branch on the contractual schema in figure 1. For ex-ample, rather than use mine-mouth coal, which poses the aforementionedcontracting costs (or is subject to the incentive limits of vertical integration),the electric utility could use petroleum fuel as its thermal source. Inasmuchas little transaction-specific investment is required to supply refined petro-leum, a bilateral dependency between buyer and supplier would not de-velop. Large numbers of suppliers being available both at the outset and atthe contract renewal interval (which interval can now be short), adaptive, se-quential decisions can be made here under the aegises of competition.The firstlesson of transactioncost economics for the study of contract doc-trine, therefore, is that it does not suffice to show that one doctrine is supe-rior to another in a context where technology and governance structures areregarded as parametric. Doctrines that encourage parties to employ inferior(but less hazardous) technologies or to abandon markets in favor of hierar-chies come at a high cost.

A comprehensive assessment of these matters is enormously ambitious,however. Except for brief remarks later, it will simplify matters to assumethat technology is given and that market organizationwill be employed andto focus on previously unremarked transaction cost consequences of the con-tract doctrines relating to commercial impossibility.4.2. STRICT ENFORCEMENTThe main tradeoff with which economic organization is beset is that incen-tives for cost economizing or demand enhancement can often be intensifiedonly at the sacrifice of adaptability features of the relation. Cost plus con-tracting, which is highly adaptable but has weak incentive properties, is anexample. To be sure, inferior modes of organization can sometimes beidentified for which improvements in both respects can be realized. Themove from the functional to the multidivisional form of organization wasarguably of this kind (Chandler; Williamson, 1975: chap. 8). Limits, how-ever, are eventually reached. The use of high-powered incentives (such asstrict transfer pricing rules) in the multidivisional enterprise, for example,can limit adaptability.

29. Backward ntegration by electric utilities into the supply of uranium fuel would not beeconomical unless first the electric utilities were reorganized, possibly through a gigantic hori-zontal merger-which poses problems of its own.30. The issues here are rather involved. I have addressed them elsewhere (Williamson,1985: chap. 6).


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Suppose, for the purposes of this subsection, that contracts will be strictlyenforced at the insistence of either party. Since long-term contracts are un-avoidably incomplete, how will the parties deal with unanticipated contin-gencies? One possibility is to make no adaptationwhatsoever. Despite mis-alignment, business is continued as usual. A second is to accommodate tothe needs of one another in an informal, uncontested reciprocal manner. Butwhat if the shock to the system is really great?If one partyasksto be relievedfrom "business as usual"and the other party refuses to accommodate, whatthen?The obvious way to deal with such an impasse is to recognize the potentialin advance and create a machinery to deal with it. An agreement to submitsuch disputes to an arbitrator s an illustration. Certainly this weakens incen-tives. But presumably the parties regard the adaptability gains as more thanoffsetting.Suppose, however, that the parties consciously refuse to create an arbitra-tion machinery. Evidently the contingencies which would warrantsuch re-lief are thought to be too remote, or the costs of arbitrationtoo great, or theincentive impairments too severe. Strict enforcement, despite its adaptivelimitations, may nevertheless survive a comparative institutional test. Forcontract doctrine to declare otherwise and permit adjustment in these cir-cumstances undermines both the integrity of contract and the purposes ofthe parties.This is plainly a reasonable view of contract. It suffers, however, fromthree unremarked disabilities: gambling incentives, possible informationdisparities, and unintended cost escalation. Enforcement ramificationsalsowarrant remark. Consider these seriatim.The gambling incentives of a regime of strict enforcement can be ad-dressed in two parts. The first is that a decision not to attenuate outliers bycontract may sometimes reflect a preference for gambling. The issue here iswhether the game of commerce should be available to play for such pur-poses. The second and more troublesome part is that those who make thedecision to gamble may be gambling with other peoples' resources. Sup-pose, for example, that firm-specific skills of workers are placed in jeopardybecause the management has agreed to a contract that does not permit ad-justment when severe adversity eventuates. If these workers are not ap-praised of this risk and do not have the opportunity to realign their own con-tractual relation to the firm to reflect this condition, the presumption thatthe labor agreement reflects responsible risk bearing breaks down.

Consider next the possibility that the contractingparties have differentialknowledge or sophistication. If the more knowledgeable party, recognizingthat outliers are skewed to the disadvantage of the other, is silent or craftsterms that afford it but not the other with ample protection, the presump-tion that the agreement reflects intended and intelligent riskbearing is againproblematic. Successive generations of commercially able but contractually


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198 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION I:1, 1985unsophisticated small firms may find that business risks are needlessly greatin such a milieu.3'

The possibility that contracting costs are unavoidably increased whenmore legalistic approaches to contract are adopted is suggested by the fol-lowing observation by Stewart Macaulay:"Detailed negotiated contracts canget in the way .... If one side insists on a detailed plan there will be a delaywhile letters are exchanged as the parties try to agree on what should hap-pen if a remote and unlikely contingency occurs" (64). Some agreementsmay not be reached at all, while in others "one gets performanceonly to theletter of the contract"(64).More generally, highly legalistic approaches toward contracting (hardbargains, strictly enforced) operate to the advantage of those whose calcula-tive instincts are greater. Possibly that is a desirable outcome, but differentsocieties may assess the benefits of intensifying calculativeness differently.Those that wish to attenuate calculativeness will be more apt to adopt con-tract doctrines which permit contract adjustment when outliers occur.Consider finallythe enforcement of general clauses that have been craftedby the parties to permit adjustment should unanticipatedevents place one ofthe parties at an extreme disadvantage. Whether private ordering efforts todeal with surprise have enforcement advantages over court ordering turnson the following comparative issues: (1) the ease of determining whether thepreconditions for surpriseare satisfied;(2)the efficacyof the adjustment;and(3) the costs of reaching an accommodation. As discussed in section 4.4 be-low, there are reasons to believe that court ordering is at a disadvantage inall three of these enforcement respects.4.3. DOCTRINAL EXCUSEThe use of contract doctrine which permits excuse for commercial impracti-cability does not, of course, preclude private efforts to address these mattersin the context of the contract:"Ifprospective contracting parties do not likethe terms supplied by contract law, normallythey are free to supplant themwith their own express terms" (Kronmanand Posner:6). What it does is pro-vide blanket language to deal with surprise in the event that the contract issilent on these matters: "Many substantive rules of contract law are simplyspecifications of the consequences of some contingency for which the con-tract makes no provision"(4). But contract doctrines that relate to commer-cial impossibility should also be evaluated in relation to the aforementioneddisabilities of strict enforcement. Thus consider whether doctrinal provisionfor discharge in the event of surpriserelieves the gambling features, the haz-

31. The implicit assumption here is that new entrants are unable to craft contracting lan-guage that puts them on a parity with more established firms.


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ards of informationasymmetry, and the cost escalation conditions discussedin section 4.2.It plainly relieves the first of these. In particular, it limits the degree towhich managers are able to expose suppliers of firm-specific inputs to un-wanted and unbargained-forhazards. It is useful for this purpose to think ofthe firm as a "nexus of contracts"(Jensen and Meckling), but a nexus that issubject to possible distortion by reason of the strategic relation of the man-agement to the contracting process.Thus whereas each constituent part of the enterprise strikes a bilateraldeal with the firm (alongthe lines set out in Williamson [1984]), the manage-ment has knowledge of and is implicated in all of the contracts. Consider, for

example, the contracts that are struck between the firm and each of the fol-lowing: labor, management, and the firm's customers.Assume, arguendo, that labor is asked to make firm-specific investmentsin human capital. Assume further that, expressed with reference to the con-tractual schema in figure 1, a node C bargain(with wage wo nd safeguardss)is struck between firm and labor. This bargainis reached on the assumptionthat the commercial hazards to which the firmis subject can be inferred froma simple extrapolation of the recent past. An employment agreement be-tween the firm and the management also needs to be reached. Assume thatthis agreement provides for extensive profitsharing. Finally, a contract be-tween the firm and its customers needs to be negotiated. Suppose, with re-spect to this last, that the buyer is prepared to pay a price of p if the contractdoes not permit adjustment in the event of unanticipated cost increases andp if adjustment is permitted (where p > p). If a contractof the p kind is struckand if the unanticipated does not eventuate, the seller will show a largeprofit when the contract is completed. If, however, a p agreement is reachedand the unanticipated does occur, then the seller will bear the full costs ofadversity. If the management of the selling firmappropriatesthe benefits inthe first instance and, because of lock-in effects, is able to shift the burdensof adversity to the suppliers of specific inputs in the second (forexample, byasking for give-backs), then a remediable failure in the private ordering con-tractingprocess (one for which contract doctrine that permits ex post adjust-ment in the event of adversity affordspartial relief) may be said to exist.32Suppose these matters are set aside. Consider whether contract doctrinethat permits discharge helps to mitigate ex ante informationasymmetries be-tween a supplier and a buyer. The concern here is that one of the parties ismore knowledgeable or sophisticated than the other and that asymmetric32. I do not mean to suggest that the contract thatjoins the firm-specificinputs to the firm isdefective except in this one respect. To the contrary, I assume that the labor contractaccuratelyreflects the main governance needs of the firm-to-labor nterface. But it does not provide for re-view by labor of other contractsmade by the firm which potentially place firm-specific labor in-puts at hazard.


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provision for contractual hazards is the result. Two cases are usefully distin-guished: the contract is silent with respect to all such contingencies; and thecontract makes selective provision for some but not all of the hazards.Contract doctrine that permits discharge is easier to justify in the firstcase than the second. The difference is that the disadvantaged party isalerted to the possibility of unforeseen (and possibly unforeseeable) hazardsas soon as the more knowledgeable partymakes selective provision for any ofthem. If, being alerted, it makes no effort to broaden the protection, it ismore reasonable to infer that the incentive-adapatability tradeoff was ex-pressly faced and resolved in favor of maintaining high-powered (unatten-uated) incentives.

Consider finally whether a contract doctrine that admits to surprise andex post contract adjustment has a bearing on the cost escalation conse-quences that Macaulayascribes to more legalistic styles of contracting. Con-ceivably it does, but this depends on the way in which the parties attempt todeal with remote contingencies. One way is to identify and stipulate appro-priate adaptations to such contingencies very carefully in advance. The sec-ond is to provide for such contingencies through a general arbitrationclause.33Contract doctrine that admits to surprise may be a real benefit inthe first instance, in that it relieves the parties of the need to deal with re-mote contingencies and permits them to focus on the main contingenciesand central tendencies. This more affirmativeorientation not only saves con-tractingcosts but carries over to the manner in which contracts are executedas well. Getting the job done, rather than preoccupation with legal rules is

33. Consider the following "general clause" that appears in the thirty-two-yearcoal supplyagreement between the Nevada Power Company and the Northwest Trading Company:It is the intent of the Parties hereto that this Agreement, as a whole and in all of itsparts, shall be equitable to both Parties throughout its term. The Parties recognize that

omissions or defects in the Agreement beyond control of the Parties or not apparent atthe time of its execution maycreate inequities or hardships during the term of the Agree-ment, and further, that supervening conditions, circumstancesor events beyond the rea-sonable and practicablecontrol of the Parties, may from time to time give rise to inequi-ties which impose economic or other hardships upon one or both of the Parties. In theevent an inequitable condition occurs which adversely affects one Party, it shall be thejoint and equal responsibility of both Parties to act promptly and in good faith to deter-mine the action required to cure or adjust for the inequity and effectively to implementsuch action. Upon written claim of inequity served by one Party upon the other, the Par-ties shall act jointly to reach an agreement concerning the claimed inequity within sixty(60) days of the date of such written claim. An adjusted base coal price that differs frommarket price by more than ten percent (10%)shall constitute a hardship. The Partyclaiming inequity shall include in its claim such information and data as may be reasona-bly necessary to substantiate the claim and shall freely and without delay furnish suchother informationand data as the other Party reasonably may deem relevant and neces-sary. If the Parties cannot reach agreement within sixty (60) days the matter shall besubmitted to arbitration. (1980: 11-12)


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more apt to be the prevailing orientation.34The same benefits cannot, how-ever, be claimed in the case where the parties eschew comprehensive con-tracting in favor of a general purpose arbitrationclause.The upshot is that between the three transaction cost benefits that mightbe ascribed to the contract doctrine of commercial impossibility-attenu-ating gambling hazards, compensating for information asymmetries, re-ducing contracting costs-the benefits are most evident for the first of theseand obtain only with qualifications for the latter two. The transaction costcase for the doctrine of commercial impossibility is thus real but limited. It iseven weaker when enforcement considerations are taken into account.

4.4. CONTRACTENFORCEMENTIn consideration of the advantages of having contract doctrine that admits tosurprise and permits adjustments to be made in such instances, are thereany disabilities? As discussed above, private ordering and court orderingneed to be compared in the following enforcement respects: (1) ascertainingwhether a state of the world realization qualifies as an exception; (2) theefficacy of the resulting adjustment; and (3) the cost of reaching agreementon the adjustment.Court ordering is arguably inferior to private ordering on all three cri-teria. To be sure, both methods will experience difficulty in ascertainingwhether a contingency qualifies as an outlier. Many remote contingencieswill be so idiosyncratic as to defy ex ante description. To list "wars, embar-goes, changes in government rules and regulations, destruction of key sup-ply facilities, hyperinflation, etc." (Joskow, 1977: 154), to which "acts ofGod" and other open-ended categories can be added, does not delimit mat-ters in any very useful way. Judgment based on detailed ex post knowledgeof the particulars, including an examination of the magnitude of the profit-ability consequences that accrue, will often be the only way to ascertainwhether an adjustment is warranted. If both private and public orderingmust go through substantially the same exercise, the advantage accrues tothe mechanism which is more knowledgeable, or can be more easily ap-prised, of the particulars.Arbitration has an advantage over the courts in this respect. For onething, arbitrators can be presumed to have superior ex ante knowledge ofthe industry and even of the firms. For another, there are important proce-dural differences between arbitrationand litigation:Thereare open to the arbitrator . . quickmethodsof educationnot open to thecourts.Anarbitrator illfrequently nterrupthe examinationfwitnesseswith a re-

34. KarlLlewellyn's distinctions between contract as legal rules and contract as frameworkare apposite (737).


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quest that the partieseducatehim to the pointwherehe can understandhe testi-mony being received.The educationcan proceedinformally,with frequent nter-ruptionsby the arbitrators,ndby informedpersonson either side, when a pointneeds clarification. ometimes herewillbe arguments cross he table,occasionallyeven withineachof the separate amps.The end resultwillusuallybe a clarificationthatwill enableeveryone oproceedmore ntelligentlywiththe case.(Fuller:11-12)

Not only are the costs of litigation relatively great for these reasons, butthey are furthermore partly socialized-in that the parties do not bear thefull costs of court ordering. Arbitration thus offers the prospect of superioradjustments, often at a lesser social cost.35

4.5. RECAPITULATIONA transaction cost approach to commercial impracticability discloses thathitherto neglected benefits can be attributed to such a doctrine under thespecial circumstances where parties to a contract are operating in a long-term bilateral relation to each other. Speidel has already made this argu-ment in general terms. I address the issues at a somewhat more micro-analytic level and attempt to identify the particular form these benefitsmight take. An even more narrowly circumscribed case for such a doctrinethan Speidel advances is the result.To be sure, there is more to the study of contract than transaction costeconomizing. The other two leading candidates upon which to justify ex postadjustment of contractare to effect a more efficient assignment of risks and topromote fairness. The conditions that would warrantadjustment for the firstof these reasons are very special (Posner and Rosenfield). If, therefore, abroader case for commercial impossibility is to be made, either an additionaljustification needs to be advanced or fairness must bear the burden.The problem with the fairness doctrine, as it stands now, is that it lacks acutting edge. It does not clearly distinguish between those cases which qual-ify for ex post adjustment and those which do not. Although one can agreethat "allpromises [are not] enforceable [because] the people and the courtshave too much sense" (Llewellyn: 738), the intuitive appeal of this remarkmust be given operationalcontent, lest the doctrine be invoked uncritically.Absent an effort to delimit the applications, changes away from or aroundcontract, of the comparative institutional kinds discussed in section 4.1, willbe provoked.36

35. Note, however, that the courts have displayed considerable ingenuity in dealing withcases in which court ordered adjustment is requested. Speidel's description of the role of thecourt in Westinghouse is especially instructive (413-14).36. Joskowobserves that courts have been unwilling to allow excuse merely because a con-tracthas become unprofitable:"Itappears ... that moderate increases in cost of up to 100 per-cent do not satisfy the requirement, while extreme increases of 1000 percent or more do. This


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5. CONCLUDING REMARKSThe study of economic organizationis an enormously complex undertaking.Such a complex subject matter is usefully viewed from several perspectives.The most seasoned and leading perspective is that of neoclassical economics.But several other approaches have recently been proposed in which the pro-duction function theory of the firm has been supplanted by a more micro-analytic, contract-based orientation. The concept of the firm as governancestructure and/or nexus of contracts informs these alternative perspectives.Transaction cost economics is one of these alternatives and is the one thatis emphasized here. Upon setting out the rudiments of the transaction costeconomics approach, I thereafter contrast this with other approaches tocontract-with special emphasis on differences between the transaction costand neoclassical orientation.

Neoclassical treatments of contract deal with contract proscriptions (re-straints on trade) and facilitative practices (contract doctrine) rather dif-ferently. Monopoly purposes are said to be mainly responsible for thoserestraints on trade with which antitrust has been traditionallyconcerned-customer and territorial restrictions, tie-ins, block booking, exclusivedealing, vertical integration, and the like. By contrast, efficient risk bearingis invoked to ascertain when impossibility and related contract doctrineswhich permit discharge from contract should be permitted.Transaction cost economics acknowledges merit in both monopoly andefficient risk bearing approaches to contract. It insists, however, that effi-ciency purposes are sometimes served by restraintson trade. Furthermore,if the requisite preconditions are satisfied, excuse may sometimes be war-ranted for reasons that are unrelated to differential risk aversion.

Examinationof the underlying attributes of transactions discloses that re-straints on trade can help to safeguard the integrity of transactions whenfirm-specific investments are at hazard. A presumption of monopoly (in anyof its forms-leverage, price discrimination, barriers to entry, and combina-tions thereof) is thus unwarrantedwhere restraints on trade are observed tooccur in conjunction with, and possibly in support of, a condition of assetspecificity. A more even-handed assessment in which both monopoly andefficiency purposes are admitted is needed.Fewer applications of transaction cost reasoning to contract doctrine havebeen attempted. It is nevertheless noteworthy that the behavioral assump-leaves a considerable area for controversy"in judging whether a conltracthas become impracti-calle (Joskow, 1977: 360). The 100 to 1,000 percent range applicable to court ordered adjust-ment is usefully contrasted with the 10 percent range referred to in the arbitrationagreement in33 above.


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tions that inform contract doctrine and transaction cost economics are sub-stantially identical. What, if not the conjunction of opportunism andbounded rationality, are manipulative interpretation, capacity, fraud-toname a few-all about?37But the more fruitful use of transaction cost eco-nomics to contract doctrine will involve applications of more microanalytickinds.The effort to assess the doctrine of commercial impracticabilityin transac-tion cost terms discloses that such a doctrine should be invoked (fortransac-tion cost reasons) only in carefully delimited circumstances. The threshholdquestion is whether the transactionsin question are supported by nontrivialinvestments in transaction-specificassets. Absent this condition, continuityof the exchange relation is not greatly valued-whence a case for ex post ad-justment for transactioncost reasons is not evident. Even, moreover, if thisthreshhold test is satisfied, the reason why the contract did not provide foradjustment through arbitration, or some other informal dispute resolutionmechanism, must be asked (Speidel: 422). If a contractualfailure occurred,wherein does it originate? Of the various possibilities, the strongest trans-action cost rationale for ex post adjustment obtains if the management hasstruck a deal that exposes the specific assets of workers (or other suppliers)to risk of contractual catastrophe without having received their express(bargained-for)consent.REFERENCESAlchian, Armen. 1961. Some Economicsof Property. Santa Monica: RANDCorporation.. 1965."TheBasisof Some RecentAdvancesn theTheoryof Managementfthe Firm,"14Journalof IndustrialEconomics 0-41., andHaroldDemsetz. 1972."Production,nformation osts,andEconomicOrganization,"2 AmericanEconomicReview777-95.Arrow,Kenneth.1969. "TheOrganizationf EconomicActivity,"n TheAnalysis

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ASSESSINGCONTRACT 207

Palay, Thomas. 1985. "AvoidingRe

assessing contract

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