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instead of designing contractual arrangements to minimize the ex ante
expected hold-up potential and, hence, the real resource costs incurred
during the hold-up process (as the transactor engaging in a hold-up
attempts to convince its transacting partner of the extent and magnitude
of the hold-up), these models focus on ex ante investment inefficiencies
as the economic motivation for contractual organization. Although the
reduced willingness to make specific investments (as well as the wasteful
expenditure of resources during the initial contracting process to protect
against future hold-ups) are costs of potential hold-ups in this framework,
the costless renegotiation formulation of the problem makes it difficult to
justify the post-contract flexibility advantages of vertical integration
discussed below.
6. Bernheim and Whinston (1998) present a model where increased
contractual specification may make things worse by creating asymmetric
non-performance gains for one party.
7. See Asanuma (1989). Similar descriptions of Japanese auto parts supply
contracts are provided in Cusumano and Takeishi (1991) and Sako and
Helper (1998).
8. A self-enforcement mechanism may work well for Japanese automobile
producers because of (until recently) the high level of expected future
demand growth and because of the increased social cohesiveness and
likely communication of non-performance to other participants in the
economy who may also impose a sanction by refusing to deal with the
non-performing transactor. Both of these factors imply a high level of the
parties' reputational capital.
9. See Klein and Murphy (1988) and Klein (1999).
10. See Klein (1995), pp. 22-3. In Kenney and Klein (1983), the ability of
DeBeers to commit to promise to pay siteholders a future profit premium
stream in return for not rejecting diamonds that have been only grossly
sorted analogously depends upon the cost savings of the DeBeers
marketing arrangement.
11. Klein (1996).
12. This is the basis of Oliver Williamson's definition of opportunism. He
states that "[b]y opportunism I mean self-interest seeking with guile. This
includes but is scarcely limited to more blatant forms, such as lying,
stealing and cheating. Opportunism more often involves subtle forms of
deceit More generally, opportunism refers to the incomplete or distorted
disclosure of information, especially to calculated efforts to mislead,
distort, obfuscate, or otherwise confuse" (Williamson 1985, p. 47).
13. In particular, Fisher refused to build an important body plant close to a
GM production facility in Flint, Michigan. Fisher would not be expected to
make the new, large specific investments required by General Motors
without a renegotiation (e.g. extension) of the contractual arrangement.
But as part of this renegotiation Fisher took advantage of its existing GM
contract to engage in a hold-up. See Klein (2000).
14. See Klein (1996).
15. This effect of increased uncertainty on vertical integration when
transactors are not risk averse is distinct from the effect increased
uncertainty may have on increased contractual incompleteness. If the
parties are risk neutral, increased incompleteness, in itself, has no effect
on vertical integration in the standard property-rights (Grossman and
Hart-type) approach to the theory of the firm. If the parties are risk neutral,
increased uncertainty and increased contractual incompleteness does
not affect organizational form (or which party owns which assets) in
these models because the models ignore self-enforcement.
16. Klein (1988, 2000).
17. A summary of the continuing literature in the Grossman and Hart tradition
can be found in Hart (1995).
18. Klein and Murphy (1997).
Entrepreneurship, Transaction-Cost
Chapter 5:

Economics, and The Design of Contracts
Eirik G. Furubotn
1 Introduction
As a result of Williamson's pioneering work in relating the theoretical concept of
transaction costs to real-world organizational and contractual activities, the field of
transaction-cost economics (TCE) emerged and became the central force driving the
development of the New Institutional Economics (NIE). Certainly, there can be no doubt
[1]
about the importance of TCE in influencing neoinstitutional thought. TCE took the
analysis of the capitalist firm well beyond the abstractions of neoclassical theory and
focused attention on actual institutional arrangements. In particular, it became possible
to throw light on how variations in certain characteristics of transactions can operate to
bring about differences in the specific contractual designs and organizational structures
adopted by business units. Moreover, since transaction-cost analysis is deliberately
oriented toward observable relationships, various hypotheses concerning such subjects
as the internal organization of firms, the properties of contractual agreements, the role of
vertical integration, etc. have become amenable to empirical testing. Thus, today, there
exists a large and growing body of factual studies that provides greater understanding of
many previously neglected aspects of enterprise behavior.

Despite the valuable insights that TCE has made possible, questions can be raised
about the adequacy of the approach as a means for addressing the full range of issues
that have relevance for contracting and the theory of the firm. In the standard
presentation, TCE offers a somewhat specialized view of the capitalist firm's motivations
and adaptive behavior. As Masten has put it: "The central tenet of transaction-cost
economics is that the efficiency of alternative organizational arrangements turns on a
comparison of the costs of transacting under each" (Masten 1996, 4). It is arguable,
though, that more attention should be paid to what would seem to be the firm's
fundamental objective - the need to maintain viability by earning an acceptable level of
profit. We know, of course, that profit is always in the background of TCE analysis
because it is impossible to say whether a particular action (and contractual arrangement)
undertaken by the firm is desirable or not purely on the basis of the cost of transacting.
The TCE approach recognizes that production costs as well as transaction costs play a
role in determining appropriate enterprise behavior. Nevertheless, it is the alignment of
governance structures with transactions that is stressed and, because of this, the
impression can be conveyed that adequate profits will appear if only the firm is able to
keep transaction costs down in reaching and enforcing agreements. There is reason,
then, to give greater consideration to the question of how profits are generated. Quite
simply, once attention is shifted in this direction, the way is open to examine various
factors other than transaction costs that affect profits and hence the firm's organization
and survival capability.

The total organizational structure of a firm has many dimensions and is based on
decisions made about a variety of particular issues. Transaction-cost economizing can
certainly be important, but the firm's complete organizational configuration and economic
behavior depend as well on policies adopted with respect to such matters as the
procedures the firm employs to reach decisions, the allocation of property rights within
the firm, the way in which economic efficiency is perceived and sought within a
"neoinstitutional" environment, etc. Relative to the last point, it should be emphasized
that the economic environment in which decisions are made has a significant effect on
the way the firm is able to perform. The so-called "neoinstitutional environment" is
distinctive because it is one in which individuals operate subject to bounded rationality
and face significant transaction costs in undertaking transactions. Research in the NIE
has demonstrated that such "frictions," and the uncertainties to which they lead, exist in
all real-world systems, and place severe restrictions on the ability of decision-makers to
reach "idealized" solutions. Consequently, in practice, we must expect to encounter not
only incomplete contracts but diverse and imperfect organizational arrangements.
When the firm's problem is viewed in the manner just suggested, there is reason to move
beyond the usual strict interpretation of TCE and consider how the idea of transaction-
cost economizing fits into a broader framework of analysis. Thus, the general objective of
the chapter is to examine the forces that influence the firm's decision-making and
contracting activities when its operations are conducted in a pure neoinstitutional
environment and its goal is to achieve at least a minimally acceptable level of profit.
In developing the argument that contract theory should place greater emphasis on the
way in which contractual arrangements affect enterprise profit, it will be useful to begin
with a discussion of how the firm conducts itself when its operations are undertaken in a
neoinstitutional environment. Thus, section 2 considers an economic system whose
characteristics are different from those assumed in the neoclassical model and closer to
real-world conditions. Specifically, individuals seeking profits are taken to be constrained
by limited cognitive capacity and to face unavoidable deliberation and transaction costs
in obtaining information about the economy, and in deciding on the policies to follow.
Since decision-makers functioning in this milieu must contend with substantial
uncertainty, they act as entrepreneurs rather than as mere managers who routinely
implement clear-cut marginal rules. Against this background, section 3 indicates that
optimization is a costly economic process in itself and that efforts have to be made to
economize on the outlays made in this connection. The situation is such that firms are
free to choose among different kinds of decision rules or procedures for optimization.
And, in general, firms can be expected to differ in the rules they adopt and in the
economic success they achieve. Under these circumstances, it appears that a firm's
contractual activities are influenced by important factors in addition to those stressed by
TCE. Section 4 pursues this theme further by explaining how the property-rights
structure chosen by the firm affects both its decision-making processes and its ability to
compete effectively in the drive for profits. In addition, the section indicates how
ambiguities can arise in the interpretation of transaction-cost economization. Next, in
section 5, the objective is to show that when the assumptions of neoclassical theory are
abandoned, it is no longer possible to speak of economic efficiency in precise terms.
Insofar as positive transaction costs and bounded rationality condition behavior, complex
choice problems cannot be solved to determine "ideal" solutions. Rather, the firm can be
understood to conduct a more or less continuing search for contractual and other
arrangements that promise adequate profits and survival. Finally, section 6 offers some
general observations concerning the manner in which the theory of the firm can be
addressed by the new institutional economics.

[1]
It was, after all, Williamson who coined the term "New Institutional Economics" (1975, p. 1).
2 Profit-seeking in a neoinstitutional environment
To understand economic behavior as it occurs in real-life economic systems, it is
essential to come to terms with the fact that individuals have limited ability to acquire and
process information, and recognize that, in practice, a large proportion of an economy's
resources has to be devoted to the continuing task of facilitating exchange. Of course,
the introduction of new assumptions concerning positive transaction costs and bounded
rationality has far-reaching consequences. Indeed, all of the elements traditionally
accepted as data in the neoclassical model undergo a change of status simultaneously.
That is, given the constraints affecting the availability of information and human cognitive
capacity, each decision-maker has only partial understanding of the options extant in
society, and it is no longer possible to assume that each person knows everything about
current technological alternatives, the nature and availability of all productive resources,
the existence and true properties of every commodity in the system, etc. What takes
place, in short, is a fundamental shift to a distinctive new economic environment “ the
"neoinstitutional" environment. And, as TCE has also noted, this new, more restrictive
environment is a quite special one characterized by widespread uncertainty,
asymmetrical information, opportunistic behavior, and many other "frictional" features not
found in the orthodox neoclassical system.
It follows that insofar as a firm functions in the changed conditions of a neoinstitutional
environment, it faces significant difficulties in determining a suitable operating
configuration. The behavior of such a "neoinstitutional" firm, which must contend with this
environment, differs from that of a standard neoclassical firm in respect to both the
nature of the solution it reaches at any time and the process by which it achieves a
solution (Furubotn 2001). Since the firm's decision-maker can be aware of only some of
the myriad technological/organizational options extant and has modest powers of
assessment and prediction, neoclassical-type "ideal" arrangements are beyond
discovery and are not to be expected. Moreover, adjustments are not easily
accomplished. Information is costly to obtain and, therefore, only limited additional
knowledge of the system can be acquired and evaluated at any period. The result is that
the individual guiding the neoinstitutional firm's policies has to make hard decisions and
act as an entrepreneur rather than as a fully informed manager routinely implementing
clear-cut marginal rules. In principle, the entrepreneur of a neoinstitutional firm would like
its operations to yield very large profits, but she also appreciates that the realities of the
firm's situation are such that straightforward profit maximization in the neoclassical sense
is not possible “ or necessary. More concretely, she understands that in an economy in
which all firms proceed subject to highly incomplete information and uncertainty, the
pertinent requirement is positive profits attained through relative efficiency (Alchian 1950,
p. 20). What is critical is the position of the entrepreneur's firm relative to its actual
competitors.
Granting the importance of relative efficiency, the entrepreneur must be concerned with
controlling costs, including the costs incurred in reaching decisions (Göttinger 1982, pp.
223“4). This means, inter alia, that she must shape a production plan with the aid of
decision rules designed to economize on search and deliberation costs. For example,
rules of thumb, or some comparable devices, may be employed even though they do not
lead the firm to a classic "optimal" equilibrium position. Such an outcome (which may
depart greatly from a hypothetical ideal solution) presents no problem, however. This is
so because, in the uncertain world in which she operates, the entrepreneur is content to
achieve an "acceptable" solution (i.e. one that promises some positive level of profit).
Subsequently, she may resume activity and search for a relatively superior
technological/organizational configuration using trial and error methods. Nevertheless,
under the circumstances of the neoinstitutional environment, no entrepreneur can have
knowledge of all of the existing production options, or of what the theoretical "ideal" is[2]
and, thus, there is never a possibility of comparing the "actual" with the "ideal" in order to
range in on a hypothetical optimizing position. Moreover, there can be no assurance that
trial and error processes in the system as a whole will force all firms to become elements
of an ideal order (De Vany 1996). In general, firms in any given industry can be expected
to show differences in organization and the profits they achieve.
Understandably, the special characteristics of the neoinstitutional firm have a direct
bearing on the contractual process. Behavior is changed sharply from the neoclassical
pattern. The decision procedures used in acquiring inputs are different, and even the
types and quantities of inputs selected tend to be different. This development, however,
is not given much attention by TCE which does not discuss how the firm's overall
technological problem is solved. Rather, TCE focuses on governance, and argues that
transactions, which differ in their attributes, should be aligned with appropriate
governance structures. The latter, of course, differ in their cost and effectiveness so that
the goal is to ensure that the value of hazard reduction to the firm is consistent with the
cost of the safeguarding procedures. It is true, that, ceteris paribus, the firm has an
interest in economizing on transaction costs. But, as noted earlier, this approach, placing
emphasis mainly on the cost of transacting, can lead to some confusion, and it would
seem that a better plan would be to consider how any given contract affects firm
profitability.
Each input employed by a firm is associated with at least two economically significant
effects. That is: (1) the act of contracting for and managing an input over time involves
transaction costs, and (2) each input makes some contribution to the productivity of the
firm. It is understood, of course, that TCE analysis must account for both the transaction-
cost effect and the productivity effect. Obviously, a profit-seeking firm will not select an
input, say K1, solely because it promises lower transaction costs than another input K2.
The respective productivity effects of K1 and K2 must figure in the assessment of which
option is preferable. For example, if K1 and K2 happen to have the same acquisition
prices and productivity effects but are linked to different governance structures, the
standard transaction-cost logic would prevail. The option having the lower costs of
transacting would be chosen. When the firm's situation is viewed from this perspective,
though, the TCE model seems to lose its distinctiveness. It really appears to be
indicating that, ultimately, profit-seeking behavior rather than transaction-cost
economizing is central to the firm's decision-making actions. But, if this is so, a question
arises as to why a special (TCE) theory is needed. Indeed, if the firm's very survival
depends on its ability to earn a positive economic profit, why should contracting activity
not be associated directly with its consequences for enterprise profitability?

The issue concerning the firm's objective is especially important because, in a
neoinstitutional environment, factors other than transaction-costs alone affect profit “ and,
hence, transaction-cost minimization does not imply (constrained) profit maximization. It
is arguable that a more general theory of the contractual process should be formulated.
In particular, it appears that closer study ought to be undertaken of: (1) the constraints
imposed on enterprise behavior by the unique conditions of the neoinstitutional
environment, and (2) the relationships that exist between contract design and the firm's
ongoing search for profits.
Since the literature reveals that the analysis of contracts tends to be conducted with the
aid of several different types of models, table 5.1 may be of some use in clarifying the
arguments of the present study.


Table 5.1: A comparison of models
Transaction Deliberation Total cost of Solution
cost cost optimization



Model Information Cognitive Economization Timing
available capability procedure

Neoclassical Zero Zero Zero Ideal position
Complete Unlimited No action reached
information calculating needed Instantaneous
on all capability
options
known to
society
Table 5.1: A comparison of models
Transaction Deliberation Total cost of Solution
cost cost optimization



Model Information Cognitive Economization Timing
available capability procedure

TCE Positive Some, but Total cost of Efficient
Information not all, costs optimization is sorting of
on all are under-estimated arrangements
feasible considered Seek to Variable
options Substantial minimize costs
power to of transactions
assessal
ternatives
Neoinstitutional Positive Positive Positive Accept any
Budget Significant Seek low-cost solution that
allocation limitations on methods yields returns
limits the the ability to (subjective above
collection of solve decision) minimum
information problems profit
constraint
Optimization
process on-
going in order
to sustain or
improve profit
position

Table 5.1 gives a general indication of the differences that exist among the various
models by showing the key assumptions underlying each. For example, in the first cell
pictured in the upper left-hand side, it is apparent, from the headings at the top of the
table, that the neoclassical case presupposes costless transactions. At the same time, it
is also clear, from the second line of headings, that the neoclassical decision-maker
possesses complete information on all options extant. Other cells are interpreted in
similar fashion. Since the TCE model has not been formalized, it is somewhat harder to
clarify with precision. Nevertheless, we understood from the literature that the model is a
hybrid construct, drawing on elements of both neoclassical and neoinstitutional theory.

[2]
Only the "observing economist" of theoretical treatises is fully informed and capable of
determining a Pareto-efficient solution.
3 The process of decision-making
Neoclassical theory views economic choice as a straightforward and costless activity.
Thus, it is asserted that the firm, although subject to certain constraints, is always able to
select the best alternative from among the feasible options in a vast set of
technological/organizational arrangements.[3] Detailed knowledge of technical processes
and prices is available in the system because transaction costs are zero and individuals
are taken to be "completely rational." Supposedly, a decision-maker compares each
option in the choice set with every other, in an exhaustive fashion, so that the true
optimum can be found. This procedure suggests that optimization is automatic and
errorless, and that a stable equilibrium end state is reached instantly. By contrast, the
TCE model is aware of the various frictions present in a real-world environment, and
recognizes the difficulties these forces represent for contracting and optimization. But,
despite this recognition, TCE still shares some ideas in common with neoclassicism. In
particular, TCE assumes that "efficient sorting" between transactions and governance
structures will take place, and that something close to transaction-cost minimization will
be achieved - in the long run if not immediately (Klein 1999, pp. 470-1).
The assumption made with respect to "efficient sorting" has importance because it points
up certain deficiencies in the TCE approach. That is, TCE appears to give too little
attention to the specific manner in which decision-making is actually conducted within a
firm when information is costly and decision-makers are boundedly rational, and to
suggest that the process a firm employs to discover usable organizational arrangements
leads inexorably to ideal, or near-ideal, results.[4] What can be argued in opposition,
however, is that: (1) different decision procedures will tend to be adopted by different
firms to economize on search and deliberation costs, and (2) decision-making is always
a costly and uncertain undertaking that does not promise optimal results. Moreover,
since the firm's total technological/organizational structure has many dimensions and
[5]
emerges as a consequence of decisions taken about various specific issues, it is
essential to distinguish among the numbers of separate policies the firm pursues as it
seeks to achieve overall profitability. Judgments on many of these diverse policy matters
need not involve narrow transaction-cost considerations, and it can be expected that
decisions on some of the issues will be more costly to reach than decisions on others.

When a firm is about to enter an industry, an individual investor or group of investors
must decide on how the "design" of the firm is to be established. In the classic case, a
single owner-manager will take on the task of "designing" the production unit, but, in
general, hired agents, responsible to the equity holders, will be used. Although all of the
people involved are characterized by limited cognitive capabilities, critical decisions have
to be made concerning such basics as the structure of authority in the firm, the specific
choice methods to be employed, as well as the extent and allocation of resources
earmarked for the acquisition and assessment of information on relevant economic
matters. At this initial planning stage, the decisions arrived at have not been
implemented.
These are entrepreneurial projections and are independent of actual transactions and
contracting. Of course, the decision-making process is ongoing, not a once-and-for-all
exercise. As experience is gained, as data is updated, and as conditions change, the
original policies of the firm will tend to be modified. It is true, nevertheless, that
entrepreneurial decisions, both at the outset and subsequently, play a key role in
determining the institutional and technical arrangements of the neoinstitutional firm, and
will decide the firm's success. Contrary to TCE, the overall organization and performance
[6]
of the firm is not dictated exclusively by the properties of transactions.
In order to put the decision-makers' plans into actual operation, contracts normally have
to be negotiated with other individuals or organizations. While certain decisions made by
the firm's authorities require no further action (as, for example, a decision by the firm's
owners not to partition their property rights in the organization), most entrepreneurial
decisions have to be embodied in contracts involving outside people and institutions, and
lead to transactions of one sort or another. As TCE suggests, these transactions often
require further decisions to be reached by the firm's authorities (using the firm's
established decision procedures), and demand a greater or lesser expenditure of scarce
resources. Even when a firm reaches the transacting stage, however, its unique
decision-making characteristics must condition the contracting process and the particular
types of contracts concluded. Understandably, in a neoinstitutional environment, choice
among alternatives always constitutes a form of economic activity in its own right.
Decision-making, as such, requires time and other resources. In effect, a "technology of
choice-making" is involved, and constraints exist in the shape of the scarce inputs that
have been allocated to the general task of choice making (Nelson and Winter 1982).
Depending on the (subjective) judgment of the firm's entrepreneur, the total resources
devoted to decisions and contracting, and the allocation of these total resources among
different policy lines, will show one pattern or another. Yet, whatever the magnitudes of
deliberation and optimization outlays in any given case, it is clear that the outlays,
together with the decision rules adopted, will shape the characteristics of the firm.[7]

The amount and quality of the information possessed by a firm will influence its success.
But the question of precisely how much information to acquire about alternatives, and
how much effort to put into the evaluation of the alternatives, is not easily answered. This
is so because there is a trade-off between the value of a more extensive and exacting
optimization process, on the one hand, and the cost of such a process, on the other. Any
decision made will be subjective and imperfect. This must be the case because of
uncertainty, and because any attempt to discover a rule to aid the determination of
"optimal optimization" will require its own rule (i.e. the rule to choose the rule). But,
logically, still higher-order rules will then be needed to guide choice and, hence, the
problem of infinite regress cannot be avoided. Ultimately, the rules structure chosen is
decided in arbitrary fashion.
A firm's survival in a capitalistic economy depends critically on its ability to realize at
least some profits. The firm, however, does not have to achieve ideal efficiency or
maximize profits in the sense presumed by orthodox price theory. It follows, inter alia,
that contracts need not be ideally formulated, and, in general, will not be. How intensively
(and expensively) the optimization process will be carried out depends on a variety of
factors - including the firm's existing profit situation, the severity of competition in the
industry, the boldness and ambition of the decision-maker, etc. It is true, however, that,
given the complexity of the firm's choice problem (and the difficulty of deciding on the
total array of the contractual options from which a choice is to be made), an over-riding
condition constraining behavior is the need to rely on some form of cost-saving decision
procedure such as rules of thumb, imitation, random choice, convention, obeying an
authority, etc. (Leibenstein 1985, pp. 5-8); Pingle 1992, p. 8). Thus, as Nelson and
Winter have noted: "the decision rules employed by a firm ought to be regarded as an
important part of its overall capabilities, in the same sense as the production activities in
its production set" (1982, p. 68).
When attention is centered on the modern corporation, there can be considerable
difficulty in trying to understand the various conditions that shape its actual decision-
making procedure (Miller 1992). A corporation, however, can be recognized as having
certain capabilities that are firm-specific. Thus, some writers argue that it is not contracts
but the firm's "core competence" that is crucial: "firms exist because they are superior
institutional arrangements for accumulating specialized productive knowledge, quite
independently of considerations of opportunism, incentive alignment and the like" (Foss
1996 as quoted by Klein 1999, p. 469). However this may be, there can be little doubt
that special problems are faced in the case of the corporation. Since a corporation is
composed of many semi-autonomous parts, and since decision-makers exist at various
levels, the decision process is not likely to be straightforward. Moreover, there may well
be a different decision procedure for each kind of policy question that the corporation
must address when solving its total organizational problem. At best, then, corporate
decision-making faces a series of complicating factors: information is dispersed
throughout the organization, different goals and points of view have to be reconciled,
committees do not reach decisions in the same way as individuals, prevailing corporate
culture tends to constrain behavior, group utility functions cannot be employed
convincingly, etc. Under these conditions, different firms in the same industry can be
expected to reach different solutions, and it seems too facile to say that the essential
structure of the firm and its behavior is determined by the relative costs of organizing
transactions under alternative governance arrangements.
A more fundamental objection to TCE has been raised by Hellwig, who finds difficulty
with the very concept of transaction costs. He argues that insofar as the concept often
refers as much to a social as to a technical phenomenon, its usefulness is compromised.
Specifically:

when there is incomplete information, Coasian transaction costs depend on the precise
nature of the strategic interactions and cannot be assessed prior to a full analysis of the
system. After such an analysis, when one understands the system anyway, it is not clear
what additional purpose the concept can serve. (Hellwig 1988: 200)
In other words, if transaction costs represent simply the technically given costs of
negotiating and transacting that must be incurred to establish a contract, they are said to
be meaningful. In general, though, given uncertainty, and assuming that strategic
behavior comes into play, the actual course of contractual negotiations cannot be
predetermined or predicted accurately. Against this pessimistic view, of course, one
might suggest that the parties seeking a contract are frequently willing to moderate
strategic contentiousness because they are anxious to reach accommodation for long-
term association and mutual gain.
While TCE may not be able to provide a truly comprehensive explanation of the firm's
contractual activities and overall organization, this does not mean that the existing
empirical studies on TCE topics are necessarily misleading. Rather, they shed light on
how decision-makers can proceed when one particular dimension of the firm's
operations is being considered and the associated choice problem is not too complex.
Relative to this situation, it seems plausible to say that the extent to which scarce
resources are used by decision-makers to find desirable arrangements is likely to be
determined by perceived costs and benefits. Thus, a decision procedure similar to the
orthodox neoclassical approach can be adopted to deal with certain policy problems that
arise within the general framework of the firm. When the extent of the information that
must be collected and assessed for a project is modest, the costs of optimization for this
organizational feature will be acceptable. Then, the problem in question can be dealt with
via exhaustive search and careful assessment. This understanding helps to explain why
certain cases involving relationship-specific investments tend to justify the TCE logic. For
example, Joskow's (1985) investigation of the duration of contracts between coal mines
and electrical generating companies shows that a relatively small number of key factors
(such as regional differences in the characteristics of coal, transportation distances,
alternative markets, etc.) affect the length of coal contracts by firms located in different
sections of the United States. Transaction-cost economizing in this limited sense can
certainly be illuminating. Nevertheless, it remains true that the complete organizational
structure (and success) of a firm is affected by other elements than those emphasized by
TCE.

[3]
Even with a simplified model of technology, it is easy to show that the number of alternative
production arrangements capable of generating a given commodity can run in the millions.
(See Furubotn 2001.)

[4]
See section 6 for a discussion of Williamson's remediableness criterion for efficiency.

[5]
Examples of some of these policies include: the flexibility built into the firm's technical
facilities that enable it to adapt readily to different types of raw materials or to new lines of
production, the tautness of managerial control over workers maintained to ensure high
productivity, the measures taken to promote the safety of the firm's production workers, etc.

[6]
In the usual interpretation, TCE asserts that organizational form is a function of such
variables as asset specificity, uncertainty, complexity, and frequency.

[7]
Since each firm tends to have its own decision-making procedure and to possess different
stocks of information, it is reasonable to assume that firms will show quite different
organizational configurations, have different boundaries between themselves and markets,
and negotiate different kinds of contractual arrangements.
4 The firm's property-rights structure
The TCE literature asserts that property-rights analysis is misleading because it
assumes that court ordering of contracts is costless and efficacious and that, in
consequence, the full contracting process is given inadequate consideration. More
concretely, it is argued that property-rights analysis, by placing virtually all emphasis on
ex ante incentive alignment, suggests that bargaining action occurs only in the initial
contracting stage. Supposedly, what is lacking is the anticipation of potential future
conflicts, and, given this condition, it is said that the approach fails to provide for private
ordering which may be able to establish adaptive mechanisms designed to settle
disputes that occur over time (Williamson 1985, pp. 28-9). When this interpretation is
made, and it is assumed that the main contractual action takes place in the context of
private ordering, the essential problem of organization becomes one of "getting the
governance structure right." A key proposition here is that, in developed market
economies, where property rights are reasonably well defined and secure against
expropriation by the state, the system moves from (L2) or first-order economizing ("get
the institutional environment right") to second-order economizing (L3) - i.e. to the
alignment of transactions with governance structures in an effort to enhance economic
performance (Williamson 2000, p. 597).
It is true that firms cannot rely exclusively on court ordering to settle all disputes.
Moreover, the fact that contracting becomes more important in developed economies is
not in dispute (Scott 1996). Nevertheless, it is not clear that most of the analytical action
moves from property to contract as development progresses. The significance of
property rights for economic behavior does not end once a society has achieved an
institutional environment in which basic rights are well defined and secure. The property
rights held by the various participants in an enterprise influence incentives and hence
behavior and enterprise productivity. If, as we assume, the firm's ultimate objective must
be profitability, incentive effects can be more powerful in shaping the firm's organization
and boundaries than transaction costs. TCE argues that the efficiency of alternative
organizational arrangements (say, G1 and G2) turns on a comparison of the costs of
transacting under each arrangement. But the firm, in comparing two possible situations
based on different property-rights assignments to input owners, will not necessarily
contract for the arrangement with the lower transaction costs. The reason is that the
arrangement (or governance structure) G2, although requiring higher negotiation and
safeguarding costs than G1, may also offer high-powered incentives to certain inputs,
and thus promises the firm productivity results that offset, or more than offset, the higher
transaction costs that will be incurred. A simple example suggesting the forces at work
here is found in the case in which land, collectively owned by a group of cattle raisers, is
subsequently distributed among individuals as private property. Under the new
arrangement, transaction costs will normally be higher since each owner must now take
action to enforce his property rights, but the more efficient incentive scheme that obtains
with private ownership can bring about productivity (and profit) gains that will justify the
choice of the governance structure having higher transaction costs.
What makes property-rights analysis significant for organizational questions is the
possibility of devising different ways to partition the basic property rights associated with
the classical capitalist firm (Alchian and Demsetz 1972). In the classical case, the owner
has: full control rights (i.e. final authority over all of the policies pursued by the firm), full
income rights (i.e. the unattenuated right to the firm's residual), and full transfer rights (i.e.
complete freedom to assign his rights, in whole or in part, to others). Thus, for example,
if the equity holders of a firm assign some of their rights to hired workers, a change in
worker incentives and behavior can be anticipated. Depending on what specific rights
assignments are made, and how the cost-benefit evaluations are established, the
partitioning process may, or may not, promise advantage for the firm's profit position. If
partitioning is agreed upon by the firm's owners, contracts have to be negotiated, and
these contracts will imply, inter alia, certain transaction costs (for the initial period and
into the future). But the crucial element driving analysis in this area is the property-rights
structure being enforced (and the productivity results the structure implies), not simply
the costs linked to the writing and monitoring of contracts and to the efforts required to
treat contractual hazards. Indeed, as noted above, the incentive effects resulting from
property-rights allocations may dominate transaction-cost considerations.
It is no exaggeration to say that the property-rights allocations within a firm affect its
internal organization, the boundary between the firm and markets, and the specifics of
the contractual arrangements formed between the buyers and sellers of commodities
and services. As an example of how property-rights-induced changes can reconfigure
enterprise behavior, consider a case in which the firm's original equity holders give up
their exclusive right to the residual by offering hired labor certain stock options.
Transaction costs arising in the labor market may be relatively high for the firm because
it must search more intensively for capable workers who are willing to take a lower than
normal money wage in early periods in the hope of securing large capital gains when
they exercise their stock options in the future. Of course, for their part, the firm's original
equity holders expect to gain the advantage of lower monitoring costs and higher
productivity because they anticipate that workers will have a strong incentive to work
hard and effectively to make the enterprise profitable. The firm may also expect to
benefit from the fact that the lower wage bill for employees has the effect of increasing its
apparent profit level in the near term and, thus, of making it somewhat easier to raise
capital funds for expansion. Obviously, risk is involved for both the firm and the workers
but firms in high-tech industries that seem to have opportunities for securing expanding
markets and high future profits have used the device in practice.
Note, however, that with respect to the firm of our example, it is not necessarily clear
whether it has violated the logic of TCE or not. Presumably, if most firms in the industry
believe that the high transaction costs incurred in the search for special workers (relative
to the transaction costs associated with the recruitment of workers who receive the
standard higher wage and no stock options) are not justified, a problem exists. That is,
the option-offering firm is making a mistake and is not economizing on transaction costs
because the general view is that the potential gains in worker effort (and more easily
available finance) are not large enough to outweigh the high transaction costs of
searching through the labor market for the option-interested workers, plus any losses
occasioned by the dilution of the stock held by the firm's original owners. On the other
hand, if it is generally agreed by firms that the likely gains are greater than the higher
transaction costs, TCE might say that the requirement of transaction-cost economizing is
being met. The trouble with this approach, of course, is that the estimate of whether
transaction costs are too high or acceptable rests on anticipations and subjective
calculations. Different decision-makers operating in a neoinstitutional environment
inevitably face difficulties because they have cognitive limitations and must work with
imperfect information. Thus, they will often reach different conclusions about what is, and
what is not, transaction-cost economizing. The situation here is very much like the well-
known problem faced when individuals decide whether certain policies of the firm lead to
the maximization of the present value of the stream of profits anticipated over time.
Virtually any choice can be rationalized as being consistent with the assumed objective.
Moreover, the issue is untestable ex ante.
Although the TCE literature suggests that property-rights analysis is concerned with
incentive alignment and contract adjustment only at the outset of the firms' operations,
this judgment is not correct. One way in which specific property-rights arrangements can
be used in an attempt to forestall conflict and maintain worker-management cooperation
over time is well illustrated in the case of codetermination - a policy of great importance
in Europe. Equity holders may give up some of their control rights in the firm to labor
either voluntarily or, in other cases, through legal requirement. Then, direct worker
participation in the firm's decision-making process (via representation on the firm's
Management Board) is supposed to moderate labor alienation, improve communication
within the firm, reduce absenteeism and labor turnover, anticipate potential areas of
conflict so that solutions can be worked out in advance, etc. In principle, by sharing
policy-making power with the firm's stock holders, labor representatives on the Board are
in a position to aid in the design of new modes of cooperation as they become necessary
because of the changing circumstances of the firm. Whether significant efficiency
advantages inhere in mandatory codetermination is a disputed question (Furubotn 1985,
1989). One difficulty, however, would seem to arise as a result of the "horizon effect"
(Furubotn 1976). Insofar as a significant portion of the firm's work force looks toward a
particular future date, say t*, for retirement or exit from the firm, an incentive problem
must exist. That is, workers may opt for policies that yield short-term, or medium-term,
benefits to t*, and oppose other policies (however desirable they may be for promoting
enterprise wealth) that yield major rewards in periods after t*. In brief, if workers have
relatively short planning horizons, decisions may be taken with respect to investments,
the work environment, job rights, etc. that do not contribute to the efficiency of the firm. It
is also true that in the case of the legally mandated codetermined firm (in which workers
have certain control rights but no claim on the firm's residual), the interests of the firm's
capital owners and workers diverge substantially. By granting workers major control
rights without regard to their actual investment position in the firm, state programs violate
an important rule for ensuring rational allocation. Specifically, what the scheme fails to
obey is the rule that those making decisions should bear the full consequences of the
decisions they make. It follows, then, that codetermination can affect the terms of
contracts, and possibly over-ride transaction-cost considerations.
The voluntary form of the codetermined firm (Furubotn 1988) has interest because it
reveals another reason why minimization of transaction costs need not take place. Under
voluntary codetermination, the firm's equity holders assign both control rights and
income rights to workers in proportion to their investment in firm-specific human capital.
The rationale for this action is that when workers finance their firm-specific investments,
they supply one part of the total capital stock required by the firm for production. Thus, it
is arguable that worker-investors should be regarded as equity holders like any others,
and be granted control and income rights in the enterprise accordingly. From a
motivational standpoint, there is good reason for the firm's participants to believe that
this type of property-rights arrangement has the effect of enhancing enterprise
productivity, and that it leads to lower transaction costs and a more rational allocation of
risk. Despite these presumed advantages, though, experience has shown that this form
of business organization has not been widely adopted in practice (Furubotn and Richter
1997, pp. 399-404). The preferred organizational scheme seems to be the traditional one
which views labor inputs merely as hired workers who should have no direct control or
income rights in the firm. Reward is then determined by union-management negotiations.
But when workers secure all of their pecuniary reward and job rights through a
multiperiod employment agreement, there are, inevitably, recurrent costs attached to
renewing, adjusting, monitoring, and enforcing the agreement (plus third-party costs
when strikes occur). While these costs of contracting are almost certain to be higher than
the transaction costs under voluntary codetermination, the latter approach is resisted.
Workers appear to believe that their best chance for gain lies more with reliance on
strong labor unions and political influence (or with mandatory codetermination) than with
worker-investor status. In other words, the (formal) institutional environment
(Williamson's L2) together with informal institutions and social attitudes (Williamson's L1)
can act to guide the choice of contractual design and, in some cases, may prevent the
economization of transaction costs. Path dependence is, therefore, a force to be
considered (Williamson 2000, pp. 596-9).
Given the different ways in which property-rights structures can affect the behavior of the
firm and shape contractual arrangements, it does not seem appropriate that TCE should
take Level Two institutions (L2) as no more than given constraints and assert that the
study of economic organization involves, almost exclusively, Level Three (L3) operations
(Williamson, 2000, pp. 597-9). We are told that, in the TCE interpretation, organization is
determined largely by the process of aligning governance structures with the attributes of
transactions and ensuring that transaction costs are as low as possible. But, as indicated
above, property-rights arrangements are not confined solely to the formal legal rules
extant, and the adjustment of contracts can be aided significantly by certain types of
informally attained property-rights structures. Thus, these arrangements need not
depend critically on court ordering. Ceteris paribus, it is important to keep down the costs
of reaching and enforcing agreements so that the potential gains from trade can be
realized. It is also important, however, to provide efficient incentives for the various
members of the firm by establishing desirable property-rights allocations. In general, it
would seem that all of the firm's organizational features that affect profits should be
considered as factors that influence contracting.
5 The concept ofefficiency
The literature has long recognized that a firm contemplating entry into an industry is free
to choose its production arrangements from among a multitude of different input
combinations and technical processes. Indeed, when multiperiod operation is considered,
and it is understood that the firm can adopt different forms of internal organization, use
inputs of varying quality, follow any of diverse types of corporate culture, etc., the
existing "state of the arts" implies the presence of a vast number of feasible production
alternatives. The fact that enormous technological/organizational complexity
characterizes real-world conditions is something that has to be faced by an adequate
theory of the firm. At the same time, however, if it is accepted that the firm's operations
are to be conducted in a neoinstitutional environment in which transactions are costly
and decision-makers are boundedly rational, the orthodox idea that the firm can move
confidently and swiftly to an optimal configuration has to be abandoned. What seems
evident is this basic truth: when a transition is made from the frictionless neoclassical
world to the neoinstitutional, the process by which decisions are reached on the firm's
organization must change profoundly. It also follows that ideas about the meaning of
economic efficiency have to be reconsidered (Furubotn 1999).
Given positive transaction costs and bounded rationality, each firm in the system
discovers that the general process of learning about technological opportunities and
prices, and of choosing a favorable operating position, becomes a costly activity (Conlisk
1996). Inevitably, significant expenditures of time, human effort, and material resources
become necessary even to achieve knowledge of only a small sub-set of the options that
are, in theory, available in the society as a whole. Cost-saving choice methods are
essential to enterprise survival. Yet, whether a firm is commencing production de novo,
or is adjusting its structure to meet competition or improve its performance, all that an
entrepreneur can do is undertake a limited trial and error procedure (for reviewing
alternatives) with the object of bringing about an acceptable level of profit. How far any
decision-maker should go in expending resources on search and evaluation activities,
and what particular choice methods she should employ, are open questions. Presumably,
though, different entrepreneurs will tend to solve this key allocation problem differently,
and will reach different results.
It can also be noted that since Knightian uncertainty prevails, the firm is not in a position
to adjust its structure optimally for operation over time. In particular, decision-makers
cannot rely on probabilistic calculations. It is not possible to say that: if S denotes the
possible set of states of the system, one of these states will emerge as the true state.
When the future is unknowable, the problem is not simply that we do not know which
state of the set S will be the actual future. What we do not know is the content of S.
Hence, it is not feasible to establish credible probability values in the manner suggested
by much of the current literature (Wiseman 1991, pp. 151-2).
From what has been said, then, it can be argued that the New Institutional Economics
requires analysis to be very clear in explaining how the boundedly rational entrepreneur
makes decisions and acquires information, and in indicating how much information he
can reasonably be expected to acquire in any situation. Relative to this standard,
Williamson's "remediableness criterion" for efficiency is open to criticism (Williamson
1996, p. 7). The Williamson concept holds that "an extant mode of organization for which
no superior feasible alternative can be described and implemented with expected net
gains is presumed to be efficient" (2000, p. 601, emphasis in the original). It is certainly
useful for Williamson to emphasize that various obstacles exist in practice that can
prevent the selection and implementation of organizational options that may appear, at
first view, to be highly attractive. By distinguishing between the total set of alternatives
and the economically feasible set, the number of possible organizational configurations
open to use is reduced, but the number of possibilities remaining must still be very large.
Williamson's definition, however, presupposes that it is practicable to discover the "best"
feasible alternative from among extant or newly proposed options, and thus a question
exists concerning how "best" is to be interpreted. Is the efficient alternative superior to
others in the sense that it is the most rewarding (feasible) mode of organization to be
found in the system as a whole? If this is the case, the implication is that each of the
many feasible options known to society can be considered by a decision-maker and
compared with all other feasible options in order to determine the optimal or efficient
choice. Such an approach, involving very extensive information about the firm's
alternatives, and exhaustive search among them, is clearly beyond the capacity of the
boundedly rational decision-maker constrained by a limited budget. It is possible to point
to at least five reasons why this kind of careful choice behavior cannot take place in a
neoinstitutional environment, and why the "best" option is not discoverable:
1. The number of different technological/organizational configurations that
may conceivably be implemented by a firm anticipating long-run
profitability is large even if options based on current innovation are ruled
out.
2. A clearly defined set of feasible technological/organizational blueprints is
not available for examination by interested parties - if for no other reason
than that such knowledge is widely decentralized and in the possession
of many different individuals (Nelson and Winter 1982).
3. The cost of exhaustive search is prohibitively high because a firm
possessed of limited resources (including cognitive capacity) cannot
allocate very large amounts of valuable factors to such a search program.
4. Each firm currently in profitable operation has reason to keep the details
of its technology and internal organization confidential.
5. Each firm has its own characteristic decision procedures and will tend to
establish a search budget that is different from that of other firms. Thus,
each unit can be expected to employ (greater or lesser) resources
differently and secure information on different sub-sets of the possibilities
in the hypothetical grand set of feasible options. The overall result must
be that each firm will reach a different conclusion concerning the nature
of the "efficient" option (Hayek 1945).
To limit search outlays, and reduce uncertainty, a firm entering a competitive industry
may seek to imitate existing production units that appear to be profitable. That is, the
intention may be to adopt what is viewed as a "best-current-practice" arrangement that
seems to be generating adequate profits. But even when imitation is the objective,
precise duplication of a currently profitable enterprise is not so easily accomplished. The
existence of "noise" means that mistakes can easily be made. Uncertainty exists about
the structural details and actual profit positions of the firms being copied, and there can
be no assurance that any firm chosen for imitation is the best possible model since the
search for an appropriate model by an entering firm will not be exhaustive. Entering firms,
therefore, will show deviations from the patterns chosen for duplication. The general
result will be a scattering of solutions within a certain neighborhood representing
technological/organizational options that have proved relatively successful, but neither
these firms nor those that have searched more widely on a trial and error basis can be
expected to discover the hypothetical optimum. An emergent order that is consistent with
the neoclassical optimum is not an outcome that is assured even in theory (De Vany
1996, pp. 433-4). As a practical matter, of course, the situation is still less encouraging.
Since the "ideal" solution cannot be known by any human agent in a neoinstitutional
system, a decision-maker will never be aware that she has achieved it even if, by chance,
she has done so.
Depending on the degree of success realized by entrepreneurs in designing basic
enterprise structure, and in their search and contracting activities, the firms they lead will
secure greater or lesser profits. The least well-adapted organizations may be forced to
leave the industry as superior units cause price to fall. But, as indicated earlier, survival
does not require a firm to attain some theoretically "ideal" configuration, or a
configuration that is close to the "ideal." Positive profits and relative efficiency suffice for
viability. How effective a firm must be in its production routines always depends on what
other firms in the industry have achieved. This state of affairs, however, means that the
concept of efficiency cannot be defined with great precision when a neoinstitutional
system is being considered.[8] For example, efficiency defined as constrained
maximization (De Alessi 1983, p. 69) suggests that every equilibrium reached is
"efficient," but this approach denies the essential meaning of the term "optimization"
(Leibenstein 1985, p. 11). It seems necessary, therefore, to move to some other
(independent) standard for assessing outcomes in a neoinstitutional economy.

One possible solution is to interpret the efficiency criterion as a crude device that can be
used simply to separate relatively more socially desirable activities from less desirable
ones. Thus, in the case of complex (multidimensional) problems such as that of
[9]
determining an appropriate technological/organizational configuration for the firm, it is
plausible to argue that efficient arrangements can be differentiated from inefficient
arrangements on the basis of whether a firm is earning an economic profit or not. The
core idea here is that, given transaction costs and bounded rationality, the system can
do no better than to ensure that resources flow to those firms that are able to produce
outputs that sell for prices that cover (or exceed) production and other legitimate costs,
and to deny resources to firms that register losses. Unfortunately, however, this "positive
profit" criterion is not very helpful. It reveals nothing about dynamic efficiency; and,
indeed, even the fact that a firm makes large profits in one period does not imply that the
firm in question is well organized to secure a succession of profits in future periods.[10] In
the end, then, it seems that the notion of economic efficiency does not fit readily into the
analysis of enterprise behavior in a neoinstitutional environment. What must be sought
are not the marginal conditions for a stable equilibrium end state, but some
understanding of how the firm conducts a more or less continuing search for
arrangements that promise adequate profits and survival.

[8]
From a formal standpoint, a firm can be said to achieve a constrained optimal solution if it is
assumed to move to the most advantageous position permitted by the particular set of
constraints it faces.

[9]
While the firm's overall structural and organizational problem cannot be solved with the aid
of orthodox technical methods, it is possible that the neoclassical approach can be employed
to solve lower-level or sub-problems that appear within the firm.

[10]
The fact that profits can arise from monopoly or imperfect competition complicates the
attempt to use the existence of profits as an indicator of efficiency.
6 Concluding thoughts
The neoinstitutional firm, unlike the frictionless neoclassical firm, is assumed to consider
a range of different activities (and costs) associated with the general process of
optimization. Broadly speaking, the optimization costs that arise can be understood as
the costs of planning and implementing a design for the firm, plus the monitoring and
other supervisory costs of running the structure that has been created. The various
uncertainties that characterize the neoinstitutional environment make it essential that the
individual guiding the policies of the firm act as an entrepreneur and render judgments
about how to employ the organization's limited resources for decision-making as well as
for active use in production, marketing, finance, etc. In other words, in a neoinstitutional
context, decision-making, as such, becomes an element of cost, and such cost must be
accounted for in the overall profit-seeking program.[11] Some fraction of the firm's
resources has to be allocated to secure and process information about economic
alternatives but, as discussed earlier, how large the allocation should be is not easily
decided. More investment in information and deliberation may lead to improved planning,
more beneficial contracts, and superior institutional arrangements. Nevertheless, beyond
some level, the accumulation of more information and the expenditure of more time on
deliberation can involve costs that offset advantages, and so diminish profit. Given the
complexity of the firm's multidimensional organizational problem, it seems clear that
different entrepreneurs will reach different decisions concerning how to proceed with this
aspect of profit-seeking behavior. Each entrepreneur will have to decide, inter alia,
whether to allocate greater or lesser resources to information gathering and deliberation.
Whatever the allocation made, however, each entrepreneur will, presumably, exert some
effort to use the resources effectively. In this limited sense, then, it can be said that
"economization" takes place.

The particular approach taken by a firm toward investment in the acquisition and
assessment of information will be influenced by the personal characteristics of the
decision-maker (including his willingness to accept risk), and by such factors as the level
of competition in the industry, the ability of the firm to raise capital for its operations, and
the apparent opportunities for technological change in production methods. Decision-
making is subjective and since entrepreneurs will tend to hold different views of future
economic developments, the possibility must exist that even firms in the same general
circumstances will reach quite diverse solutions with respect to firm design. All firms,
however, will not necessarily prosper or, indeed, survive. The critical condition for any
firm is how well the design chosen for it at a particular point in time conforms to the
requirements of the market, and how successfully the design is made operational
through efficient contracting.
Once the firm's overall design has been established consistently with the entrepreneur's
vision, contracts have to be negotiated with certain individuals and organizations so that
the desired plan can be implemented. Contractual activity is obviously important, but it
represents only one part of the firm's total optimization process. In other words, it is
apparent that while effective contracting can contribute to the profitability of the firm, it
[12]
does not guarantee that a survival profit will be achieved. When viewed from this
standpoint, it is also clear that TCE does not explain the total organizational structure of
a firm, and economization on transaction costs, to the extent it occurs, is best
understood as a procedure designed to realize a sub-goal of the firm. In short, it can be
argued that TCE, by focusing largely on transaction characteristics and governance,
neglects consideration of certain types of optimization costs, and fails to call sufficient
attention to the role that entrepreneurial decision-making has on enterprise organization
and the general direction that contracting takes.
In estimating the degree to which transaction costs can be reduced by careful selection
of governance structures, a key factor influencing the outcome is the complexity of the
choice problem. What must be emphasized is that, given a neoinstitutional environment,
it is not appropriate to assume, implicitly or explicitly, that the decision-maker is free to
devote unlimited time and resources to the task of finding an ideal solution. When the
situation is such that numerous possible options exist, discovery of the ideal alignment of
a transaction with a governance structure (via efficient sorting) may not be feasible even
in the long run. An imperfect result can be expected because when the choice set is very
large, exhaustive search is prohibitively costly. Thus, the entrepreneur's judgment
concerning the amount and direction of expenditures on search is important, and there is
an incentive to make whatever resources are allocated go as far as possible by using
simplified decision procedures for both finding and administering contracts.

A further complication in establishing efficient contracts arises from the fact that the
collection of information about alternatives and the assessment of the economic data
collected has the character of an investment - with outlays and benefits spread out over
a succession of time periods. Then, since accurate knowledge of future economic
developments is crucial to the making of a sound investment, an entrepreneur in a
neoinstitutional system faces difficulties. His information about the future is always
imperfect and, thus, if he happens to make the wrong predictions, the solution he
reaches will be much less than ideal. In other words, arriving at an "ideal" contract
oriented toward circumstances that will never arise represents a policy error. And even if
modification of the ill-designed contractual and organizational arrangements can take
place over time, losses will be incurred. In the end, what seems to be true, given the
preceding arguments, is that TCE comes into its own and has straightforward
interpretation under certain special conditions. That is, when the choice set faced by the
decision-maker is relatively small and the economic circumstances of prime importance
to the firm's situation are relatively stable and predictable, the TCE paradigm yields
[13]
valuable insights. Such a result represents no small accomplishment, however, since
many real-world cases in which TCE analysis has been applied seem to conform closely
to the required conditions.

At any time when contracts are established and in play, the firm's optimization plan is
proceeding in its operational phase. Inputs are secured and the production and sale of
the firm's output takes place consistently with the various decisions that have been made.
Attention now centers on whether profits are large enough to meet or exceed the
minimum requirement for survival. In simplest terms, the firm's residual at any period can
be defined as the total revenue from sales minus: (a) the planned outlays on factors of
production, (b) the total transaction costs incurred in implementing contracts (including
monitoring and transactions' safeguarding costs), and (c) the effective costs that are
attributable to the investments in information search and deliberation. Profitability is
important but neoinstitutional firms may display a wide variety of behaviors because
relatively inefficient and marginally profitable firms can remain as active members of an
industry. All firms, however, do face the need to preserve their viability by undertaking
periodic adjustments to sustain or improve their competitive positions. In other words, a
firm can be expected to alter at least some features of its organizational structure with
considerable frequency since economic conditions are constantly being changed by
industry members searching for improved institutional and contractual arrangements.
Stable long-run equilibrium cannot be regarded as the characteristic outcome in a
neoinstitutional world.

[11]
As Conlisk has pointed out: "deliberation about an economic decision is a costly activity,
and good economics requires that we entertain all costs" (Conlisk 1996, p. 669). (See also
Conlisk 1988.)

[12]
Insofar as complexity and cost make it impossible to secure anything more than imperfect
solutions for the firm's technological/organizational problem, it is not necessarily useful to find
"ideal" answers to lower-level problems (See Ricketts 1994, pp. 346-8.)

[13]
It can be noted, however, that the criticism made by Hellwig (1988, p. 200) can hold even in
this case. (See section 4.)
Notes
1. It was, after all, Williamson who coined the term "New Institutional
Economics" (1975, p. 1).
2. Only the "observing economist" of theoretical treatises is fully informed
and capable of determining a Pareto-efficient solution.
3. Even with a simplified model of technology, it is easy to show that the
number of alternative production arrangements capable of generating a
given commodity can run in the millions. (See Furubotn 2001.)
4. See section 6 for a discussion of Williamson's remediableness criterion
for efficiency.
5. Examples of some of these policies include: the flexibility built into the
firm's technical facilities that enable it to adapt readily to different types of
raw materials or to new lines of production, the tautness of managerial
control over workers maintained to ensure high productivity, the
measures taken to promote the safety of the firm's production workers,
etc.
6. In the usual interpretation, TCE asserts that organizational form is a
function of such variables as asset specificity, uncertainty, complexity,
and frequency.
7. Since each firm tends to have its own decision-making procedure and to
possess different stocks of information, it is reasonable to assume that
firms will show quite different organizational configurations, have different
boundaries between themselves and markets, and negotiate different
kinds of contractual arrangements.
8. From a formal standpoint, a firm can be said to achieve a constrained
optimal solution if it is assumed to move to the most advantageous
position permitted by the particular set of constraints it faces.
9. While the firm's overall structural and organizational problem cannot be
solved with the aid of orthodox technical methods, it is possible that the
neoclassical approach can be employed to solve lower-level or sub-
problems that appear within the firm.
10. The fact that profits can arise from monopoly or imperfect competition
complicates the attempt to use the existence of profits as an indicator of
efficiency.
11. As Conlisk has pointed out: "deliberation about an economic decision is
a costly activity, and good economics requires that we entertain all costs"
(Conlisk 1996, p. 669). (See also Conlisk 1988.)
12. Insofar as complexity and cost make it impossible to secure anything
more than imperfect solutions for the firm's technological/organizational
problem, it is not necessarily useful to find "ideal" answers to lower-level
problems (See Ricketts 1994, pp. 346“8.)
13. It can be noted, however, that the criticism made by Hellwig (1988, p.
200) can hold even in this case. (See section 4.)
Law and Economics
Part III:
Chapter 6: The Contract as Economic Trade
Chapter 7: Contract Theory and Theories of Contract Regulation
Chapter 8: Economic Reasoning and The Framing of Contract Law-Sale of an Asset of
Uncertain Value
Chapter 9: A Transactions-Costs Approach to the Analysis of Property Rights
The Contract as Economic Trade
Chapter 6:
Jacques Ghestin
1 Introduction
1.1 A contract as a legal concept
There is no such thing as "contractual pith and substance" (Truchet 1987) or "contract by
nature" (Sinkondo 1993). Therefore, we must abandon any attempt to construe the
contract in terms of a generalized abstraction, and accept rather that we must reduce it
to a more modest, but precise, notion, that of a legal concept, whose only purpose is
[1]
functional (Sacco 1999). Moreover, this notion pertains only to a legal category,
necessarily incomplete as an intellectual construct because of its diversity and
inconsistency (Rouhette 1965), but nonetheless identifiable and distinguishable from
other categories. This requires, however, that all contracts share at least one
characteristic separating them from any other legal category and allowing them to be
identified with certainty.
Sacco (1999) distinguishes between two different ways of defining a contract. The first
consists of naming one essential element shared by all contracts and necessary for their
existence. This aspect may not suffice to guarantee their recognition as contracts by
substantive law, however. Additional features may be required to make contracts legally
binding. The second way of defining a contract lists all the elements required for it to be
recognized as such under substantive law - which may, in fact, be differentiated from the
conditions under which it is enforceable. This route generates multiple solutions as to the
domain of the contract. Under common law bequests are not contracts, nor is bailment,
nor actions that transfer property or create securities, except in the case of the sale of
movable property. In German law, the key element is the legal transaction,
Rechtgesch¨aft, since the contract, Vertrag, is defined in the B¨urgerliches Gesetzbuch
(BGB) as a bilateral legal transaction. The contract transfers properties or creates
securities only over the delivery of movables or the creation of a notarized deed in the
case of immovables. In French law bequests are contracts, but they must assume
certain forms to be recognized under substantive law. Conversely, the transfer of
property is realized by simple mutual consent.

1.2 The contract domain

In our endeavors to fix a meaning for the word "contract" we thus find it necessary to
retain the first method, even though this forces us to forgo the hope of assigning a
specific meaning to the term. The question arises as to whether this method is not
incompatible with a unique definition of the contract.
Sacco seems inclined to opt for this inconsistency, as he presents four possible
definitions applicable to this domain. In the first instance he observes that the expressed
meeting of minds seems characteristic of contracts, but also that the notion of free and
sovereign wills underlying that definition may be qualified as metaphysical and unrealistic.
He adds that common law, in emphasizing the consideration, treats the contract, and the
trade it governs, as identical. English and North American laws distinguish between the
contract and the bargain, i.e. the exchange of benefits or obligations. Moreover, the
consideration, which may be largely symbolic, does not capture the essence of the
exchange. The reference to economic analysis of the contract, also in Sacco, seems
more significant (Poughon 1985). He again emphasizes the doctrine of the legal
transaction, particularly developed in Germany, which creates a tight linkage between
the transaction and autonomy and views the contract as an autonomous act. Finally, he
retains a fourth definition, which he deems the most relevant to law and jurisprudence:
the promise having given rise to an expectancy, a reliance, the need for two different
wills, or of the meeting of an offer and an acceptance, disappears.

1.3 Unique concept of contract
The difficulty of establishing a unique concept of the contract is thus clear. It is
nonetheless reasonable to hope that the various elements identified by Sacco, rather
than being incompatible, may be combined and reconciled to create a synthetic definition
of the contract. To simplify, we shall limit our discussion to the exchange of onerous
goods and services for the moment. Indeed, according to von Mehren (1982), the
classical contract model essentially corresponds to the exchange of goods and services,
for which the contract is the preferred instrument. Michel Villey observes that, historically,
the contract grew out of procedurally simple operations in which a good was transferred
from one estate to another, with no requirement for consensus (Despotopoulos 1968;
Gomaa 1968; Villey 1969).
This important function of the contract, the transfer of value, was emphasized by the
celebrated thesis by Poughon "L'Histoire Doctrinale de l'Echange et du Contrat" (the
doctrinal history of trade and the contact) (Poughon 1985), which transcends a simple
historical analysis of a minor form of contract, barter. Indeed, for a long time trade was
not viewed as a contract, but rather as a broader concept including all bilateral
operations. This conception was abandoned by the authors of the Code Civil, but has
been rehabilitated by economists.

1.4 Trade
Ever since Roman Law the act of trading has been conceived in two different ways. If
trade, in the narrow sense of the word (permutatio), is in some sense a contract, it can
also be said that all contracts are trade in a broad sense.
In legal tradition predating the civil code, the sixteenth-century doctrine assimilated the
concepts of permutatio and do ut des. As to the economic aspect of trade, it was
retained with the substitution of the concepts of nominate and innominate contracts by
those of onerous and gratuitous contracts. Trade, which is nothing other than the
sunallagma found in Aristotle, provides the model for the former, and bequests that for
the latter. Trade, or the onerous contract, is typified by the exchange of valuables. This is
[2]
the justification and the cause of the contract, which appears more as an exchange of
benefits than as an exchange of consents: trading the unnecessary for the necessary.
The school of natural law oscillates between the two conceptions of the contract. The
same can be said of the seventeenth-century's Domat, which nonetheless represents a
consensual view of the contract as an exchange of consents. This view was adopted by
the architects of the Code Civil, who retained the notion of the onerous contract, however.
As to trade in the narrow sense, in the Code Civil it loses all significance, remaining only
as a shadow of the sale.

1.5 Reciprocated transfer
It was economists who, in the eighteenth century, rehabilitated the concept of trade.
Their starting point was precisely that which legal scholars had neglected, the real and
broad aspect of trade, from which they set out to reconstitute the law. For them, the
trader is less a creature expressing a will than a person characterized by desires and
needs. All trade is voluntary, of course, but it primarily serves to satisfy desires.
Economists thus uncovered the idea, noticed and then abandoned by legal scholars, that
trade is the pursuit of necessities. They completed this idea with the concept of value,
concluding that all trade is the reciprocated transfer, not of objects, but of values; the
object becomes irrelevant except as a repository of value. Each individual acquires or
relinquishes a value, either of usage or trade. This broad definition of trade allows
economists to reconstruct contract law. Distinctions between various private rights - sale,
leasing, and lending - disappear and merge into a single definition of the exchange of
values. Similarly for public rights, the government produces services and utilities and
trades them for taxes paid by citizens (Poughon 1985, nos. 178 and following).
This economic analysis of the contract has attracted the attention of some legal scholars,
who have drawn certain elements from it to justify a return to a more realistic conception
of the law in general, and of the contract in particular. The contract is defined as "an
economic operation founded on the objective or subjective equilibrium of the exchanged
values" (Poughon 1985, no. 238)."All contracts can be reduced to an exchange of values.
A sale, in particular, is only a trade" (Poughon 1985, no. 239).

1.6 The meeting of minds
While bearing in mind the importance of economic trade in the general theory of the
contract, we must not neglect the particular form it assumes: the meeting of minds.
Indeed, we must synthesize the strictly legal conception, which makes the meeting of
minds the essential subjective aspect of the contract, and the notion, both ethical and
economic, originating in our Greco-Latin and Judeo-Christian tradition, making the useful
and the just the objective end of the contract.

[1]
It is also possible to contrast, on one hand, the genotype, a historical construct based on the
idea of free will that is rooted in the general theory of the contract and of jurisprudence and,
on the other hand, the phenotype, a concrete actualization of contracts, i.e. the various
categories of actions recognized as contracts by substantive law, arising from legal practice.
For more on the application of these terms to contracts, see Sacco (1999).

[2]
The word "cause" here is taken directly from the French, where it carries the meaning of a
necessary condition for a contract to be valid. It pertains to the "why" of the obligation, i.e. in
trade it accounts for the agreed consideration, the existence and lawfulness of which must be
verified (trans.).
2 The meeting of minds, an essential subjective aspect of the
contract
Bearing in mind that the contract is a meeting of minds designed to carry legal weight, it
must be specified that its binding force depends upon its compliance with objective law
(Ghestin and Goubeaux 1994).[3]

2.1 The contract is a meeting of minds designed to carry legal weight
The creation of legally binding rules by a meeting of minds appears to be the shared
feature of all contracts, thus constituting their specific character. When such an
agreement does not underlie the legal situation under consideration, it cannot be
considered a contract. Thus, a single-proprietor business cannot be construed as a
contract of association, lacking a meeting of the minds, but rather as an institution whose
purpose is to enable a single businessman to dedicate a certain amount of money to a
specific economic activity (Champaud 1962; Chandler 1962).
The contract must be designed to have legal effect as a necessary condition for it to give
full weight to the expressed wills (Viandier 1980). Its purpose, on the level at which it
operates, is to create legal rules (Ghestin 1993; Ancel[4] 1999), and it requires that the
signatories participate in their formulation. In this respect it is important not to confuse
the ability to dictate rules with the ability to participate, through negotiation and dialogue,
in their elaboration (Cadiet 1987). It is not negotiation that makes the contract, but rather
the creation of the rules by a meeting of minds. Adhesion contracts remain contracts and
negotiated regulations remain rules imposed on the signatories.
Contracts result from the meeting of minds and not from a unilateral dictate. Thus, it is
essential that two wills, both free, join together to create a contract, which subsequently
exists independent of the individuals' wills. The contract, a voluntary act and free
exercise, is at the same time a voluntary alienation of freedom (Frison-Roche 1995). As
Macneil (1980) observes, consent expresses a freedom to choose that disappears the
moment it is exercised and that surrenders to the other party the right to restrict future
incompatible choices. A freely given word cannot be freely withdrawn. The binding force
of the contract is thus one of its essential elements; deriving from its definition as a
procedure that creates legal effects.
Macneil (1980, pp. 4-5), however, contests the necessity of enforcing the binding
character of contracts by substantive law. He deems the central issue, not the legal
sanctioning of the parties' commitments, but rather the contract's ability to determine the
terms of their future exchanges. Experience reveals, as I have personally witnessed in
business as well as family matters, that there are cases of non-performance involving
voluntary agreements that never make it to court or even arbitration. Nevertheless, the
parties consider them binding - but are we still dealing with contracts?
However, this meeting of the minds should not be considered simply a necessary
condition for qualification as a contract. It is rather its essential subjective element,
necessary for its existence and underlying its fundamental role in social relationships.
The will is the "motor," the dynamic subjective element that gives birth to the contract. It
[5]
is over these wills that agreement between two people's self-interest can be achieved.
It is, indeed, the interest, the distinctive utility, that the contract holds for each party that
motivates them to sign on. This is the "why," the reason for adhesion.
The will, transformed by the pursuit of this specific utility, is the preferred instrument of
individual liberty and responsibility, and is its required complement. Respect for the given
word is a moral precept that, in principle at least, appears to be universally accepted,
though not necessarily always respected. This appears as a natural extension to the
freedom to commit oneself. When a commitment is entered into freely, the obligation to
follow through is perceived by the promissor as a moral duty, which justifies the legally
binding force of the contract and governmental enforcement. Freedom of consent is thus
an essential element of its effective performance. These various considerations leave
room for each individual's freedom as well as for the responsibility that is its necessary
[6]
complement.
Wills must be free! However, this freedom needs to be subjected to some constraints; no
one would argue that the law can sanction any and all meetings of minds. The definition
of the contract must thus be completed by adding that its binding force depends upon its
compliance with objective law.
2.2 The binding force of the contract depends upon its compliance with objective
law

As a source of rules and regulations, the contract is binding. Normally drawn up by
ordinary citizens, whence does it draw its binding force? The theory of the free will
cannot answer this question.
Positivist analysis has the merit of effectively raising questions about the dogma of free
will, demonstrating that it is positive law that confers the binding force to the contract,
while the meeting of minds simply plays a role as a specific procedure for the creation of
effective rights. The will, or agreement, expressed in contracts is no longer perceived
anywhere as the true foundation of its binding force. Several authors have even explicitly
ruled out the dogma of free will in favor of an external norm. Starck and Laurent and
Boyer assert, rather radically, that "the free will is an outdated myth" (Starck, Roland and
Boyer 1998). Terr©, Simler and Lequette describe a remarkable evolution (Weill and
Terr© 1980; Terr©, 1968) of the doctrine (Terr©, Simler and Lequette 1999). To them,
"The binding force does not originate with the promise, but rather with the value that the
law imputes to the promise The Code Civil does not escape from this rule. To contract
is not only to express a will, but it is also to employ a tool forged by law" (emphasis in the
original).[7]
The evolution of contractual relations and of substantive law has also prompted some
authors to conclude that free will cannot be absolute. They recognize that the legislator
and the judge must be able to ensure that the contract conforms to the public interest,
public order, and the public weal (especially, Mazeaud 1998, no. 127; Flour and Aubert
[8]
1998, 128, p.77). Some persist, however, in maintaining that this autonomy is the
[9]
underlying principle that must continue to inspire ordinary rules of contract law.
Solutions that are incompatible with this principle are presented as exceptions,
qualifications, or limitations. We may wonder, however, whether this negative view of
public order and, more generally, of the objective elements of the contract, with which
the "voluntarist" interpretation of the nineteenth and first three-quarters of the twentieth
century made us so familiar, is still reasonable (Hauser 1971).
The theory of free will survives to this day only because of its ambiguities. As the
exercise of a sovereign authority parallel to, and in competition with, the law, it is now
[10]
dismissed by most authors. Nonetheless, there is no reason to deny a certain
delegated competence,[11] granted to individual wills, to allow them to determine, or at
least choose, the rules that will govern their specific relations for a given legal operation.
It thus remains possible to speak of a certain freedom of the will, inseparable from a
[12]
certain contractual freedom.
Positivist analysis has also facilitated the evolution of legal civil-contract doctrine from
the dogma of free will toward a debate on the principles of freedom and contractual
security.

Whether or not they maintain freedom of the will as a fundamental principle, it is in fact
the essential usefulness of this dogma that some authors defend, contending that the
principle of contractual freedom, as a universal and timeless notion, is inherent in the
concept of a contract, and that any limitation to this freedom must necessarily be
exceptional. These same authors contend that the binding force of the contract, that is
the privity of contract, must under these same conditions be immune from derogation to
avoid interfering with the security of contractual relations. The true debate is thus
engaged on the basis of liberty and security as fundamental, even exclusive, principles,
which must underlie the contract regime.
Positivist analysis has demonstrated that the issue of contractual freedom is
fundamentally metaphysical or political in the broadest sense, and is not contingent on
the nature of specific contractual relations. No one contests that the contract has binding
force only if it is not detrimental to the public order, which aims to ensure its compatibility
with the public interest - break the basis, the end, and the check on the power of
authorities charged with ensuring its performance, if necessary using coercion. Thus, it is
reasonable that the public interest should underlie criteria for rules limiting contractual
freedom. This is not a universal or timeless principle, being necessarily subordinate to
ideological shifts that affect the relationship between public and private interests.
Unlike free will, contractual freedom is thus not fundamental to the notion of the contract,
at least not as a principle that can be over-ridden only exceptionally. Public order is not
outside the normal contract regime. It is rather a constituent aspect thereof, as it
specifies the conditions under which the law recognizes its binding force.
From Kelsen's observations one can conclude that the contract derives its binding force
from the legislator's willingness to sanction it.

Acceptance of this proposition is tantamount to recognizing that only positive law, i.e. law
explicitly enacted by the individual or collective will of the legislator, is truly law. This is
further equivalent to giving the legislator discretionary powers pertaining to contracts,
such as the right to decide that they may be executed in bad faith.
Now, this type of power cannot be ceded to the legislator. Objective law (Ghestin and
Goubeaux 1994) the concrete search for just solutions, supersedes positive law, which
must strive to express the former as perfectly as possible. It is not the law established by
the legislator that gives binding force to contracts. Courts did not await the arrival of
article 1134 of the Code Civil to begin sanctioning them. The contract has binding force
because objective law confers it legal effect, which it can do only because the public
interest, some would say the common weal, requires it: first, the social usefulness of the
contract and second, contractual justice, an element of social cohesiveness (Ghestin
1981, 1982).

That is why we have been advocating retention of utility and justice as guiding principles
for the rules of law governing contracts since 1981. The meeting of minds is the essential
subjective element of the contract, but it integrates into the latter's social utility as an
instrument of trade that must occur according to justice.
Utility and justice are thus the ultimate aims of the contract.

[3]
The heritage of statist positivism officially affirms the principle of obedience to rules,
especially to the law. It is also acknowledged, however, that legal scholars, and particularly
judges passing verdicts, must concretely search for solutions that are just. Reconciling these
two principles is the goal of an intellectual process characteristic of judicial thinking. Objective
law is the upshot of that concrete quest for a solution consonant with justice and social
utility.(Cf. Ghestin 2002.)

[4]
Ancel objects to the traditional representation of contracts that emphasize the binding force
and the creation of obligations. To him, beyond the creation of obligations, the contract has an
essentially normative effect.

[5]
Cf. Demogue (1934), according to whom agreement "between people with conflicting
interests is always of great significance." We prefer the term "self-interest," since the interests
are not necessarily opposed and, as we shall see, a certain level of cooperation is always
necessary.

[6]
Cf. Portalis (1844). Also, with respect to consumers, cf. Cornu (1973).

[7]
Cf. Ghestin (1982, pp. 4-5) for developments along the following lines, "The contract is only
an instrument sanctioned by the law because it provides for socially useful operations"; "The
contract is foremost an indispensable instrument for individual projections"; and "The contract
is also the preferred instrument of individual freedom and responsibility."

[8]
Cf., especially, Mazeaud (1998); Flour and Aubert (1998).

[9]
For works previous to 1965, see Rouhette (1965, pp. 1-66). Cf. Coipel (1999), who observes
that, "while avoiding the excesses of the theory of free will, traditional civil law doctrine
continues to consider that the meeting of minds is the reason why objective law recognizes
the binding force of the contract."

[10]
Even those who continue to see free will as the "principle," or the "rule," admit that "the will
does not, as maintained by tenants of the pure theory of free will, create rights that are
simultaneously autonomous and prior," but that it "is only a delegated, and as such, regulated,
authority," and that "the law defines, in light of the social interest (which surely includes the
useful and the just) the extent and the specifics of the authority it cedes to individuals." This is
combined with the uncontested observation that "the will remains an authority proper to each
individual subject to the law, and which he may use autonomously within in the framework laid
out by the law" (Flour and Aubert 1998, 128, p.77).

[11]
We first presented this analysis in two articles on "la notion de contrat," in Revue Droits
(1990, p.7) and D 1990, Chroniques p.147.Cf. a related concept presented later in Terr©,
Simler and Lequette (1993, 1999), in these terms: "The contract derives its binding force, not
from itself, but from an external norm. The authority imputed to individual wills is not inherent,
but derived" (emphasis in the original).

[12]
Cf., for another illustration from the area of moral law, the necessary distinction between
freedom of the will or of reason and absolute sovereignty, John Paul II (1993).
3 Utility and justice are the ultimate aims of the contract
The contract cannot be studied independent of the issue of its social utility and justice.
These two concepts are closely linked since both advance the public good, that is to say
social harmony, and the institutional organization of contractual exchange is one of their
principal instruments.

This analysis is buttressed by the position occupied by these two values in the various
conceptions of the public interest originating in our European heritage of Greco-Latin and
Judeo-Christian thought. This is particularly true of inter-individual relations and relations
between individual and public interests, for which contracts are the preferred
[13]
instrument.

We may also note that today some authors define contractual freedom and the binding
force of the contract from the perspective of social utility and justice.[14] Thus, Flour and
Aubert, while retaining free will as a "principle" and a "rule," also see social utility and
justice as vindicating limitations imposed on contractual freedom and on the binding
force of the contract (Flour and Aubert 1998, 28, p.32). For their part, Terr©, Simler and
Lequette retain the will as the motor, but subordinate the contract regime to justice and
social utility (Terr©, Simler and Lequette 1999). In Belgium, building on our work, Coipel
(1999, 37: 28) has explicitly maintained that "utility and justice are the foundations for the
binding force of the contract."
The contract is binding only because it is useful and if it is just.

3.1 The contract is binding only because it is useful
It has been demonstrated, notably by Friedrich Hayek (1976), that the contract is an
essential element of a liberal social order. This utility translates into subordinate
principles of legal security and cooperation.
3.1.1 The subordinate principle of legal security
The contract is an indispensable tool of individual foresight. Its binding force is necessary
for the promissee's confidence.

It is primarily in its principal function of trade by the creation of obligations that the utility
of the contract becomes manifest."No seller would willingly surrender his good, no lender
his money, no landlord would allow the use of his property and no individual would
perform any service if the judicial principle of obligation did not guarantee them a return
of the expected and promised equivalent value" (Gounot 1912, p.355).
We here connect the notions of the promissee's legitimate confidence, as in Gorla, in
Italy, and Atiyah, in Great Britain, with that of detrimental reliance, and more recently with
legitimate expectancy, as in Dean Xavier Dieux[15] (Coipel 1999, 36: 27) in Belgium, into
a foundation for the binding force of the contract (also Chirez 1977). While this
confidence remains only one element of the contract's utility, it carries particular weight.
Any reduction of the binding force of the contract diminishes the promissee's confidence
and undermines the credit necessary for many operations of an incontestable social
utility (von Mehren 1982, no. 25). For the utilitarian, "any action able to influence mutual
confidence that human beings have to their words" (John Stuart Mill 1961) is an evil in
itself.
The promissor's confidence is also, on a moral level, a positive aspect of respect for the
given word. This moral rule may thus be justified, not only in reference to contractual
justice, but also for its social utility.

The subordinate principle of security must, however, be balanced with that of
cooperation.
3.1.2 The subordinate principle of cooperation
Economic analysis of the contract allows us to elaborate this cooperation. "Cooperation
means preferring a collective outcome to individual gain" (Brousseau 1996, p.23 citing
M©nard 1995). This cooperation is the hallmark of the contract. It comes into play in
varying degrees, depending on the type of contract. From the fraternity that animates
gratuitous contracts to the shared liability typified by corporations, we see the need for
basic coordination.

According to some economists, "The fundamental contractual mechanisms are

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