Simple Contracting Schema

"It's a weird subculture, Al."
--Frank Horrigan (In the Line of Fire)

Simple model of contracting from Williamson (2008):

Let k be a measure of asset specificity. For transactions that use general purpose technology, k = 0. In these cases, no specific assets are involved and the parties involved in exchange are essentially faceless. Node A corresponds to the ideal transaction in law and economics. Governance is accomplished through competition and disputes are resolved by the courts.

Transactions that use special purpose technology are those for which k > 0. Such transactions give rise to bilateral dependencies, and parties have incentives to build continuities that safeguard specific investments. Let s represent that size of such safeguards which might include penalties, information disclosure and verification procedures, specialized dispute resolution (e.g., arbitration), and, in the extreme, integration under unified ownership.

Node B corresponds to unrelieved contractual hazards in that specialized investments (k > 0) are exposed and no safeguards (s = 0) have been provided. Such hazards will be recognized by farsighted players who will price out the risks.

Added contractual supports (s > 0) are provided by Nodes C and D. At Node C, these take the form of inter-firm contractual safeguards. If costly breakdowns continue in the face of foresight to craft effective contractual safeguards, then the transaction may be taken off the market and organized under unified ownership (a.k.a. vertical integration) instead as reflected by Node D.

Because added bureaucratic costs accrue upon taking the transaction out of the market, Node D can be thought of as an organization form of last resort that becomes attractive when higher degrees of asset specificity and added uncertainty pose greater needs for integrative adaptation.

Reference

Williamson, O.E. 2008. Outsourcing: Transaction cost economics and supply chain management. Journal of Supply Chain Management, 44(2): 5-16.