Economizing on Transaction Costs: Bounded Rationality and Opportunism

Jan 12, 2015 — Neil Boyle

The integrity of economic exchange is decided within the transaction. Transaction costs deriving from the bounded rationality and opportunism of contracting parties diminish the integrity of contracts. By economizing on these costs, contract integrity and efficiency are restored through economic governance. While integrity refers to a contractual relationship between two parties, efficiency does not have this contractual or relational reference in it. Integrity attributes have to do with alignment, stability, bilateral relations, and mutuality of interests. Efficiency attributes have to do with the productive usage of economic inputs in a production process. Integrity and efficiency are interactive.  Williamson defines efficiency for TCE differently from the orthodox definition, in that, a transaction is efficient to the extent that there are no alternative governance institutions that can be implemented with net gains over and above the selected alternative.

When considering the potential transaction costs involved in FDI/PPP investments, it is necessary to understand the identities of the parties, who they are and whether they are capable of managing the kind of complexity that is typical of FDI / PPP investments. Indeed, comprehending whether the parties have the capacity to execute the management of a project which requires skills in autonomous bilateral trading, farsighted contracting, loss mitigation, credible commitment, private ordering and disclosure is essential in assessing FDI/PPP feasibility. Understanding these elements and how they affect transactional efficiency and integrity require extension of the analytical frontier beyond hyperrationality, describing “man as he is, acting within the constraints imposed by real institutions” (Coase, 1984, p. 231). Instead, humans need to be modeled as boundedly rational and prone to opportunism.

Limitations of economic agents – The behavioral assumptions of bounded rationality and opportunism when acted upon by uncertainty and small number exchange, respectively act as friction in a machine essentially preventing a transaction from being completed efficiently or smoothly.  Here is how friction works.  The market parameter of uncertainty acts on bounded rationality and depending on their relative magnitudes worsens it.  Correspondingly, small number exchange acts on opportunism and worsens it.  Hence, bounded rationality or limited cognitive capacity is worsened when uncertainty is high; and opportunism or self-interest with guile is worsened when small number exchange is significant.  This transformation of the twin assumptions is the intervening variable that acts on the independent variable–the transaction attribute of asset specificity.

Bounded rationality is the idea that humans are rational, but only limitedly so. Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information.  Opportunism is a notion beyond the simple self-interest of neoclassical utility maximization. Rather, opportunism is self-interest with guile, which adds the dimension of intent to the concept of self-interest. The self-interest of opportunism is “self-interest with an agenda”, which comes in three forms: (Williamson, p. 553, quoting Simon) [1]

a)          blatant self-interest (e.g., lying, stealing, cheating),

b)          subtle self-interest (e.g., deceit, deception, strategic obfuscation), and

c)          “normal” self-interest (e.g., errors, omissions, and shirking).

Even though no one is totally free of cognitive overload or strategic obfuscation, we consistently fail to negotiate safeguards to deal with these kinds of contract hazards. There are two related reasons for this omission: an approach that focuses on “who” rather than on “what to do now”; and unfamiliarity with designing cost effective institutional safeguards, particularly those that mitigate the internal organization hazards of counterparty organization.

Focusing on “who” instead of “what to do now” –  An approach to designing contracts that address the character of the members of the transaction is unverifiable, that is, the cost of verification is prohibitive and pursuing it leads to untold complexity and confusion.  Instead, by assuming that bounded rationality and opportunism assuredly exist, which they do, the question of the character of the parties is silent to the more practical question of how to specifically safeguard against the threat of opportunism. Emphasis should thus be placed on prevention rather than on a cure for the malady; the focus is on a positive sum contractual solution rather than on expensive future court proceedings viz. corruption. Potentially, this will foster a legal and economic environment that promotes mutual benefit rather than blame.

Unfamiliarity with safeguard design – Due to the fact that contract hazards are perpetual, safeguards must be negotiated and contracted both ex-ante (to the extent that hazards are identified before contracts are signed), and ex-post (after contracts are signed) to deal with hazards when they actually occur, many of which cannot be predicted. Ex-post hazards can be hidden in misalignments and lie obscured but nonetheless discounted by the counterparty as a risk premium.  Ex-ante and ex-post are interpreted simply as before contract signing and after contract signing, respectively.

Contract hazards are also located in difficult to reach places as within the counterparty’s internal organization which may be off-limits to negotiators. Internal organization should be on the agenda of all contract parties who are contemplating PPP project investments.  Contract hazards form a part of the system of economic exchange. For example, the internal organization of a government executing agency comes into play in the “review and approval” task that government has to fulfill whenever a disbursement voucher needs clearance. The principal machinery for this task is outside the purview of the PPP infrastructure project company and is buried deep inside of the bureaucracy of the executing agency. To the extent that the accounting office carries out its task efficiently, there is no problem. However, to assume they will act efficiently is foolhardy and flies in the face of experience and the behavioral assumptions of bounded rationality and opportunism. As implied by Williamson 1996, wherever there is bureaucracy, there are bureaucratic disabilities, and their occurrence must be safeguarded.

Gaining access to the issue of the internal organizational performance of a government agency is difficult for two reasons. First, the government official who manages the transaction has no incentive to admit to errors, omissions, or corruption on the part of government staff in other offices. Second, many governments operate under severe official business rules where personnel can be “charge-sheeted” and could lose their pension or a portion thereof for an infraction such as described above; the rule often leads to an implicit organizational norm: “I won’t rat on you if you won’t rat on me.”  When the first reason and the second are joined, the hurdle to gaining access is considerable, but not impossible.

Internalization of behavioral assumptions – The internalization of bounded rationality and opportunism into the TCE model reduces some of the stress involved with client relations. Client relations refer to the relationship an investor has to a government entity. Internalizing bounded rationality and opportunism relieves the counterpart from the stress of having to confront a sensitive issue where beforehand he knows that he will meet with hostility and perhaps even a ruptured career. This suggests that project preparation and negotiation activities have to be supported by special sessions for orienting government counterparts on TCE to inform them beforehand on the meaning and use of bounded rationality and opportunism. TCE advises internalizing bounded rationality and opportunism into the overall process and fabric of negotiations and project design and implementation to the extent that all parties are subjected to a common set of expectations and standards, i.e., all are subject to bounded rationality and opportunism; there is no favoritism; hence the hazards of argument and insult are removed, allowing for dispassionate focus on the design and application of corrective safeguards.  And keep in mind that bounded rationality and opportunism are intervening variables once transformed by the objective market parameters of uncertainty and small number exchange, respectively.

Economizing on behavioral assumptions in markets, firms, and hybrid modes – When the twin human assumptions of bounded rationality and opportunism are economized two things occur: (1) bounded rationality and opportunism as transaction costs are reduced and the transaction should operate more efficiently; and (2) it follows that market governance structures are complete by reason of economies of bounded rationality and self enforcement by reason of economies of opportunism. It follows because the attributes of the transaction under consideration and the mode of governing it are aligned in a discriminating way (i.e., a unique and remediable way),[2] while hierarchy governance structures of internal organization are incomplete by reason of diseconomies of bounded rationality and not self-enforcing by reason of opportunism. Hybrid governance structures are intermediate between markets and hierarchies and are incomplete by reason of diseconomies of bounded rationality and not self-enforcing by reason of opportunism.

Economizing on bounded rationality is the same as reducing the hazard of limited cognitive capacity of human agents in a transaction. Several mechanisms of varying degrees of effectiveness will achieve this, for example: we can specify increasing training, or detailed job descriptions; we can specify new criteria for recruitment of project staff (government agencies are generally resistant to this kind of intrusion); or we can focus on how to better motivate project staff with better incentives. We could insist that the project management unit operate as a team where the manager/team leader is paid according to residual claimant rights and members of the project staff are paid according to team output. Another way of describing economies of bounded rationality is by comparing markets with hierarchy. Market governance structures automatically economize on bounded rationality because of their attributes of autonomy, appropriability of returns on every margin, strong incentives and their capacity for low cost adaptability to changing economic circumstances. Hierarchy by contrast does not automatically economize on bounded rationality.

REFERENCES

Coase, Ronald. 1988a. The Firm, the Market, and the Law. Chicago: University of Chicago Press.

Hayek, Friedrich. 1945. “The Use of Knowledge in Society.” American Economic Review 35 (September): 519-30.

Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and Antitrust Implications. New York, N.Y.: The Free Press

______________1981. The Economics of Organization: the Transaction Cost Approach. American Journal of Sociology 87:548-577.

______________.1985. The Economic Institutions of Capitalism. New York: Free Press.

______________.1996. The Mechanisms of Governance. New York: Oxford University Press.

 



[1] Williamson, Oliver (1981). The economies of organization: the transaction cost approach. American Journal of Sociology 87: 548-577.

[2] TCE describes alternative modes of governance (markets, hybrids, hierarchy, bureaus) as syndromes of related attributes on which governance structures differ from one another in discrete structural ways. TCE thus employs discrete structural analysis rather than marginal analysis. Remediableness is a basic rule of TCE whereby relevant comparisons are with feasible alternatives all of which are flawed. Efficient outcomes are defined if no superior alternatives can be described and implemented with net gains. (Williamson, 1996)

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