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Summary
This is a discussion of pitfalls and constraints to be aware
of when drawing up contracts. Economic literature has been
used to justify the arguments made, and more specifically,
literature on transaction costs, principal-agent theory and
contracts. Literature on strategic alliances and outsourcing
has also been used to some extent.
The main issues to consider when sub-contracting activities
are related to the lack of, quality, or allocation of information.
Consequently, human beings are not capable of drawing up perfect
contracts, and have to settle for very general agreements
that normally corresponds to the second preferred choice.
1 Introduction
Adam Smith argued in The Wealth of Nations in 1776,
that the market is controlled by an invisible hand, regulating
prices. Well functioning markets result in the best offer
being chosen by buyers. However, markets do not always succeed
in co-ordinating transactions, and hence hierarchies (firms)
are established. Oliver Williamson has several times, with
the help of transaction cost economics, described how hierarchies
will take over when costs of market transactions become too
high. Choosing
some form of co-operation, however, presents a possibility
of bringing the respective advantages of markets and hierarchies
together, which would explain why e.g. contracting frequently
occurs. 
If the nature of this relationship is continual there will
be a need for a contract. The situation is also complicated
by the fact that the choice is often irreversible. When abandoning
options like market transaction alternatives, switching-costs
will rise. The firm is then more or less stuck with its partners,
and the importance of a "perfect" relationship will
increase, which has to be managed with the help of an efficient
and well-functioning contract.
The constraints to be considered when drawing up contracts
are numerous. As if this is not enough, a complete contract
is somewhat of an oxymoron. Consequently, a thorough examination
of the potential pitfalls of sub-contracting is important
whenever considering this alternative.
2 Transaction Costs
Transaction costs emerge when alternative forms of managing,
planning, and monitoring inter-firm operations are chosen.
It is a question of analysing whether or not the parties act
harmonically, or if there are frequent conflicts causing delays
or mistakes. Williamsons very short way of describing this phenomenon is:
"Transaction costs are the economic equivalent of friction
in physical systems".
According to Coase,
there is friction on markets. Since these do not function perfectly,
different types and degrees of transaction costs arise, which
is why integrating or outsourcing sometimes is more profitable.
Transaction costs are all the disadvantages and sacrifices occurring
in connection to a transaction. The size of the costs depends
on different circumstances. In order to explain how factors
influence each other, Williamson developed the Organizational Failure Framework, where e.g. human
and environmental issues, are included.
2.1 Human factors
Transaction cost theory argues that individuals' actions are
shaped by bounded rationality and opportunism.
Bounded rationality means that an individual cannot always act
rationally. Actions are "intendedly rational but only limitedly
so", as individuals
do not have the capability to handle information without errors.
The bounded rationality leads to economic problems when limits
for what one can understand are breached. This is connected
to uncertainties and complexity linked to the transaction.
Opportunism means that individuals maximise their own utility,
even if this means that someone else will suffer. The occurrence
is common in small-number-situations.
This is when the transaction is of great strategic importance,
which occurs when the value of the intended use of the resource
differs significantly from an alternative use.Sometimes dependence occur after a contract is formulated. A
seemingly standardised relationship ex ante (before the contract
is formulated and signed) can often ex post (after the contract
is signed) develop so that one party becomes depending on e.g.
know-how. This development is called fundamental transformation,
and refers to the change in dependency from competitive bidding
to bilateral negotiating, or large number situations to small
number situations.
2.2 Environmental factors
Along with the strategic importance, the specificity of a transaction
determines the risk of opportunism. Common types of specificity
include:
" Site specificity. Investments in plants tied to
certain economically favourable locations.
" Physical
asset specificity. Investments in certain equipment or technology
tailored to a particular transaction.
" Human asset
specificity. Investments in the information, skills or know-how
of staff.
" Dedicated assets. Investments in equipment
or plant that are designed for a certain partner or buyer.
3 Principal-agent theory
If transaction cost theory discusses different general relations
in transactions, the principal-agent theory considers the relation
between the principal and the agent. In many situations, an
individual or organisation (the principal) delegates responsibility
to another (the agent). The core of the problem is based on
the assumption that the principal is depending on what the agent
does, and thus will be affected by the agent's output. Due to
information insufficiencies, the principal does not know whether
the agent fulfils his duties appropriately. The problem can
be summarised:
"Where people (principals), as
a result of lack of knowledge, cannot ensure that their best
interests are served by their agents".
The danger of an agent not fulfilling his duties (opportunism)
is often a result of asymmetric information. This is when one
party has information that the other cannot access.
If information were cost-less, the principal-agent problem would
never arise. Parties would then ex ante take actions against
opportunism, since they would know how others would act. Optimal
contracts would then be possible to write, with details for
every contingency included, but without wasting too many resources
on negotiations. This is would be the first-best-alternative.
In reality however, the agent tries to generate advantages from
the asymmetric information. The principal, in turn, seeks to
avoid this by the use of control and supervision. Consequently,
costs for control will erase some of the advantages gained from
subcontracting.
Only a second-best alternative is hence feasible. The discrepancy
between the first-best alternative and the second-best alternative
is the agency-costs.
A trade-off is the only way to minimise the agency-costs; i.e.
finding the second-best alternative that is closest to the first-best
alternative.
The theory is based on the same assumptions about human action
and the environment as transaction cost theory, albeit with
some additions. Principal-agent theory views the decision-making
situation from the principal's perspective. As the principal
does not have the same information as the agent, three types
of asymmetric information problems can arise.
" Hidden characteristics
" Hidden action
and hidden information
" Hidden intention
When the principal cannot see all the agent's true characteristics,
they are hidden characteristics. As a result of the hidden characteristics,
an unwanted partner may be chosen. This is called adverse selection.
Hidden action is when the principal ex post cannot assess what
the agent is doing and if this is necessary. Consequently, the
principal becomes depending on the agent and his judgement.
Hidden information on the other hand occurs when the principal
can see what the agent does, but is not able to understand it
due to lack of knowledge. Problems arising in these cases may
appear because of moral hazard. These are opportunities for
shirking that cannot be prevented by contracts.
Hidden intention is when the principal can see what the agent
is doing, but cannot prevent it. The agent's intentions ex ante
are not known, but appear ex post. The co-operation may then
be linked to large investments and the principal may not be
able to dismiss the agent. The principal cannot withdraw, as
the input is of great importance. This is known as a hold-up
situation.
4 Contracts
In the particular case of subcontracting, costs
have been estimated to be lower if the organisation buys the
input instead of producing in-house. A need for contracts
will then arise, which as touched on above, raises further
issues. Contracts are as a result of the problems raised,
often incomplete.
The simplest form of contracts is plainly a
transaction between a seller and a buyer. All necessary information
must then be available at the time of transaction. If this
is not the case, such as for instance when using external
contractors, some other form of contract needs to be established.
As the duration of the co-operation increases, the need for
such a contract will also increase.
Administrative adjustments will take place and there will
be a development from the simple contractual form towards
a relation.Instead of agreements taking place and being modified on markets,
political processes will take place. These are expressed in
contractual norms between players. The complexity resulting
in these processes can to some extent be said to be an outcome
of asymmetric information. We are forced to handle this problem
by adjusting to others in order to minimise the risks involved
with not knowing.
Apart from the already discussed problems of bounded rationality
and asymmetric information, one further issue arises in the
particular concept of formulating contracts. This is the problem
of difficulties in specifying or measuring performance. Subtleties
of performance and ambiguities of its interpretation often
result in such vague and open-ended language in the contract,
that it may not be clear what constitutes fulfilment.
Hence, high negotiating costs are likely to be worsened by
the fact that parties may seek to avoid ending up in a situation
where the other party obtains supremacy. Naturally, this will
complicate contract formulations. Furthermore, a contract
cannot be all-embracing. Nobody can formulate an agreement
that comprehensively specifies every possible outcome.
This phenomenon is what e.g. Hartcalls incomplete contracts. Such a contract incorporates gaps
in the sense that it stipulates what should happen if developments
the environment takes a certain direction, but not another.
As a result of these shortcomings, events will take place
that will make the parties want to act in un-efficient manners,
and parties will want to re-negotiate contracts. Further costs
will arise because parties sometimes will not agree on what
the contract actually means. Disputes may arise, and a third
party may be needed to solve the conflict.
5 Conclusions
Even if all-embracing contracts covering every
possible contingency are desirable, a number of factors that
prevent this. These include deficiencies in information and
its distribution. The paradox lies in the fact that information
insufficiency often increases the need for formalities. Usually
friction is unavoidable.
There will always be a question of striking
a balance between choices, and how to handle this balance.
Different choices often excludes others, and the trade-offs
that have to be made means that no complete contracts can
be formulated and that the firm will have to settle for the
second-best alternative.
"The costs of using the market for anything
other than spot contracts are far from trivial. They stem
from problems of co-ordination, co-operation and trust. There
are also costs of searching, of writing contracts, of negotiating
(ex ante and ex post), of monitoring and control and a host
of other factors. The crucial question is not whether the
costs are significantly higher when exchange of goods and
services occurs between separate organisations than when it
takes place within them. It is rather whether contracts can
be designed and implemented in such a way that the benefits
do exceed the costs."
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