Our ﬁctional story of person A’s building project was designed to highlight some of the diﬃculties everyone encounters at some time or other in the process of contracting. It is now necessary to look at the issues involved from a more analytical viewpoint. Perhaps the most important point about the hapless A is that his problems all derive from various forms of infor- mation deﬁciency. Were information costlessly available and all transac- tions costlessly enforceable most of his worries would be over. Consider now the various points at which A confronts the problem of his own igno- rance.
1. Adverse Selection or ‘Hidden Information’
1.1 Examples of adverse selection
The ﬁrst problem was that A did not know the location, skills or reliabil- ity of the tradespeople he required. Finding out this type of information requires time spent in search. More consideration will be given to the ques- tion of search in Chapter 3, but it should be evident from the discussion in Chapter 1 that to search exhaustively – that is to search until informa- tion is complete – would be to do nothing else. At some stage the costs of further search in terms of the perceived opportunities forgone will out- weigh the beneﬁts in terms of the expected new opportunities potentially discoverable. Further, certain types of ignorance are in their nature costly to dispel through search. Ignorance of the price of a very well-deﬁned product can be mitigated by asking for quotes from an increasing number of sellers, but overcoming ignorance of product quality is more diﬃcult. It may be worth paying more for the services of a more skilled person, but how is person A to tell a good and reliable craftsperson from a poor one ex ante? Clearly, this problem ultimately derives from the diﬃculty of pre- cisely specifying what services are required in a contract. If a contract between person A and a craftsperson were clearly and unambiguously speciﬁed the ‘reliability’ or ‘skill’ of that person would not be an issue. Either the provisions of the contract are fulﬁlled and the craftsperson demonstrates suﬃcient skill or they are not fulﬁlled in which case the absence of suﬃcient skill results in a speciﬁed penalty. A skilled and reli- able craftsperson is valuable to person A because he may not have the tech- nical knowledge required to specify precisely what is to be done. The absence of this knowledge, however, will make it diﬃcult for A to discover the credentials of his potential workforce. All craftspeople, skilled or oth- erwise, will have an incentive to overstate their expertise in the process of negotiation, and the truly skilled will have diﬃculty in communicating their status to the doubting person A.
The problem which we have uncovered here is in fact of very widespread interest in economics. Essentially it relates to any transaction in which one of the parties is better informed than the other. Such transactions are said to be characterised by a structure of information which is asymmetric. Akerlof (1970) gives as an example of a market with asymmetric informa- tion; transactions in second-hand cars. It will often be very costly for a buyer of a second-hand car to determine accurately its true quality. He or she may or may not buy a ‘lemon’ (an American expression for a bad car) but ex ante there is not much that can be done to avoid it. Ignorance on the part of buyers will imply therefore that both good and bad second-hand cars sell for the same price. Sellers of these cars, however, will have much better knowledge of their history and characteristics and therefore corre- spondingly better judgement about the probability of obtaining good or bad service in the future. The upshot will be that owners of good cars will tend to feel that the second-hand market value seriously understates their (better informed) valuation. The owners of ‘lemons’, on the other hand, are more likely to sell. As the average quality of second-hand cars oﬀered for sale falls, the price that they fetch falls with it, and this accentuates the ten- dency for only the worst to be oﬀered. It is at least possible to develop a model in which this adverse selection problem is so serious that no transac- tions will take place at all, even though better-informed buyers would stand to gain.2 Note the implied assumption, however, that contracts cannot be drawn up in such a way that failure of a car to meet the standards claimed for it would elicit penalties from the seller.
Perhaps the classic instance of adverse selection brought about by asym- metric information is in the realm of insurance. A provider of insurance against some undesired contingency (say ill health) may be less well informed about the probability of the occurrence of this event than the person seeking insurance. The terms quoted by an insurance company will be based upon certain basic pieces of information such as the age and medical history of the person buying the insurance; information which may be obtained at relatively low cost. This information may not be detailed enough, however, to distinguish with suﬃcient subtlety between relatively good and bad risks. Once more, people with good health prospects will regard the insurance terms oﬀered as rather unfavourable while people with bad prospects will ﬁnd the terms attractive. The people who are therefore most inclined to take out health insurance are those most likely to require health care. There is an ‘adverse selection’ problem based upon asymmetric information. Ex ante it may be very costly for an insurance company to dis- tinguish between good and bad risks, just as, by assumption, buyers of cars in the last paragraph could not distinguish good and bad cars, and person A in our story found it diﬃcult to distinguish between good and bad crafts- people.
1.2 Adverse selection and ‘reputation’
In this context it is useful to note the importance of ‘reputation’ or ‘good- will’ in markets with asymmetric information. As was seen in the exchange game of Chapter 1, if knowledge of cheating becomes widely known ex post, traders will have an incentive to remain in good standing. A seller of second-hand cars who has established a reputation for providing good cars will be able to charge higher prices or establish markets where none existed before. Similarly, person A found it expedient to use craftspeople with a good local reputation. The existence of ‘goodwill’ economises on transac- tions costs by reducing search, thus enabling trade to take place in higher- quality products and services than might otherwise be possible.
1.3 Adverse selection and ‘signalling’
Another response to the adverse selection problem is to think of ‘signalling’ or ‘screening’ mechanisms. A signal is an activity which convinces buyers of the quality of a seller’s wares. It is convincing because it is so structured that a seller of poor-quality products would be irrational to undertake the activity. As Hirshleifer and Riley (1979, p. 1406) express it: ‘Signalling takes place when sellers of truly higher-quality products engage in some activity that would not be rational for those selling lower quality products.’ Examples of possible signalling devices include the following:
- Advertising Advertising may be more rational for producers of high-quality goods than for providers of low-quality goods. By engaging in an expensive advertising campaign, producers are expressing conﬁdence in the ability of their product to attract and keep customers. A shoddy product that may fool customers on a single occasion but for no longer is unlikely to be worth extensive advertising.
- Education qualiﬁcations Educational credentials can act as a signal if the marginal cost of education is lower for higher-quality workers. Oﬀering higher wages for people with certain qualiﬁcations will be most attractive for those who ﬁnd these qualiﬁcations the least costly to achieve. A more detailed exposition of this mechanism will be pre- sented in Chapter 6.
- Insurance deductibles In insurance markets, higher quality risks can signal their status to insurance companies by a willingness to accept a big deductible (that is, less than full coverage).
Signalling may develop in the presence of information asymmetry and adverse selection. It should not be assumed that the results are always socially advantageous. As will be seen later, signalling can lead to a waste of resources. If the signal is costly to transmit and the private gains to sig- nalling are all derived from someone else’s private losses, the end result will be a simple redistribution of income with resources dissipated in the process. Where, therefore, the information conveyed by a signal permits a more eﬀective allocation of resources, signalling may be both privately and socially beneﬁcial. Some signals, though, may have the opposite eﬀect. In Chapter 9, for example, we will discuss how ‘signalling’ to the stock market by managers of joint-stock companies might result in a form of ‘short termism’.
1.4 Ignorance of contractual results
Where information remains hidden ex post and the buyer can never really tell the quality of the services he or she has received, the adverse selection problem is yet more diﬃcult to overcome. Suppose, for example, that A attempts to draw up a set of state-contingent contracts with his workpeo- ple. He agrees, for example, that if certain geological conditions are found to prevail, the foundations will need to be strengthened or extra drainage installed. He agrees that if weather conditions are unfavourable, construc- tion may be delayed and speciﬁed extra expenses incurred and so forth. This type of contract clearly requires that A and his workpeople can agree on what ‘state of the world’ actually pertains. If, for example, it proved very costly for A to verify the correct position, the workers would have an incen- tive to ‘observe’ any state of the world which they felt was most favourable to their own interests. Where it is expedient to discover problems, the worker will duly discover them, and where it is inexpedient they will be ignored. When workers inform person A that they have ‘hit problems’, they are saying ‘I have observed a state of the world which permits me to take the following actions under the terms of our contract and which commitsyou to extra expenditure.’ In many cases, the problem will be suﬃciently obvious to both parties, but in others person A may have to trust the worker. Asymmetric information therefore turns out to be at the root of A’s diﬃculties once more.
In the circumstances of person A’s building project it is perhaps unlikely that this extreme form of information asymmetry will pose intractable diﬃculties. Nevertheless, there are situations in which the quality of a service is diﬃcult to assess by the purchaser even after it has been delivered. As will be seen in Chapter 11, this possibility lies behind some recent think- ing concerning the rationale of the non-proﬁt enterprise.
2. Moral Hazard or ‘Hidden Action’
A second important problem facing A was that even after striking a bargain he did not know whether the other parties were fulﬁlling their obligations. The electrician seemed to have wired his house, but was it safe? Was the architect actually exerting him or herself on A’s behalf ? Was the plumber using unnecessarily expensive equipment? Whereas under section 2.1 the problem was that ex ante a buyer might be ill-informed about the qualities of a potential purchase or the diﬃculties encountered by people working on their behalf, the problem being considered now concerns the diﬃculty of observing or deducing the actions of the supplier.
Moral hazard exists when the probability of a given ‘state of the world’ occurring is inﬂuenced by one of the parties to a contract but when the behaviour of this contractor cannot be observed. Insurance contracts again supply the classic case. Suppose that person A, in return for a speciﬁed payment now (an insurance premium), promises to pay to person B (who we will assume to be female) another speciﬁed sum in the event of person B being robbed. Our discussion so far has been limited to A’s problem of deciding whether B is telling the truth when she claims to have been robbed or whether in reality the only person being ‘robbed’ is person A. Even when the prevailing ‘state of the world’ is easily veriﬁed, however, there remains the possibility that the outcome was materially inﬂuenced by the activities of B. In other words, the probability of being robbed is not entirely independent of B’s behaviour. She is obviously more likely to be robbed if she spends long periods of time away from her house and habitually leaves the door open than if she installs a system of locks and alarms and never leaves her property unattended. This suggests the possi- bility that the insurance contract could specify conditions which commit person B to take certain precautions. Once more, the problem of asym- metric information is confronted, however. If the contract states that B must always lock her door when leaving her house, how is A to know whether this provision was or was not complied with when B was robbed? Further, although it is easy enough to think of a few basic precautions against robbery, it would be extremely costly to investigate the detailed cir- cumstances of person B in order to establish the actions required of her in every particular. Only B can have the kind of knowledge concerning speciﬁc circumstances necessary to determine all the options available to discourage thieves. Once the insurance contract is agreed, however, B will clearly have a much smaller incentive to engage in thief-discouraging activ- ities than before.
This general problem of verifying ex post whether a person’s actions have been compatible with the provisions of a contract is called the problem of moral hazard. In the context of insurance markets, Arrow (1962) sum- marises the issue as follows: ‘The general principle is the diﬃculty of dis- tinguishing between a state of nature and a decision by the insured. As a result, any insurance policy and in general any device for shifting risks can have the eﬀect of dulling incentives’ (p. 145). As we have already seen, however, these problems are not conﬁned to insurance markets. Any con- tracts drawn up in conditions of asymmetric information may give rise to moral hazard. As Demsetz (1969) puts it: ‘Moral hazard is a relevant cost of producing insurance; it is not diﬀerent from the cost that arises from the tendency of men to shirk when their employer is not watching them’ (p. 167).
3. Bounded Rationality
The third broad class of transactional problem facing person A which we may identify was the simple magnitude of the potential task of coordinat- ing the activities of his workpeople. This problem would exist even were information symmetrical; that is, available equally to A and the people he employs; and it is therefore logically distinct from the issues discussed earlier in this section. Not only were the provisions of each person’s con- tract interdependent but they would vary with all sorts of possible contin- gencies which might arise as work proceeded. The capacity of person A to imagine all possible future contingencies and then process the information required to allow for these diﬀerent contingencies in the contracts of each person he hires is obviously limited. Person A faces, in other words, a problem which is now usually referred to as ‘bounded rationality’.
The idea of ‘bounded rationality’ is especially associated with the work of H.A. Simon (1957, 1969, 1979) and O.E. Williamson (1975, 1985). Both writers use the example of the game of chess to illustrate the issues involved. Given the rules which govern the movement of the pieces on a chessboard, we might in principle consider constructing a list of all possi- ble games. We might start by recording all possible opening moves and then, for each one, record all possible legal responses, and so on, until we have built up an entire ‘decision tree’. The problem, of course, and the factor which prevents chess becoming a totally trivial pastime, is that the decision tree would be of such size and complexity that it beggars the imag- ination. Even the best chess players must make their decisions in the absence of a complete list of future contingencies which might possibly ﬂow from them, and resort must be made to a limited set of considerations which experience has suggested are important.
If rationality is conceived as selecting the best possible course of action for achieving a speciﬁed objective, chess moves evidently do not qualify. Yet most people would baulk at describing chess decisions as irrational. Indeed, chess is widely regarded as the board game requiring powers of reason in the highest degree. Chess problems are susceptible to the appli- cation of reason, but the complexity of the game is such that decisions are eﬀectively taken under conditions of uncertainty. This is why Williamson (1975, p. 23) argues that ‘the distinction between deterministic complexity and uncertainty is inessential . . . As long as either uncertainty or com- plexity is present in requisite degree, the bounded rationality problem arises.’
4. Asset Speciﬁcity and ‘Hold-up’
There is a ﬁnal contractual problem which plays an important role in the transactions costs theory of economic organisation. Where situations are complex and contracts are not absolutely ‘cast iron’ and perfectly enforce- able, there will be room for adjustments to contractual terms over time in response to changes in the bargaining power of the contractors. This problem is particularly serious when assets become ‘transaction speciﬁc’.
Consider once more the relationship between person A and his architect. It is likely that, over time, the architect has accumulated all sorts of special information about the circumstances and preferences of A, the nature of his property, and the engineering and other diﬃculties associated with con- struction work in the area. Were A to change his architect, the new person would not have access to the same stock of information and might, there- fore, be much less eﬀective whilst undergoing the initial process of ‘learn- ing’ about the background. The existing architect has an advantage over an outsider in serving person A – a so called ‘ﬁrst-mover advantage’. Notice that, by assumption, person A has ﬁnanced the accumulation of this useful information by paying the architect a fee at least as great as could have been achieved elsewhere during the initial period of their association, but the information is in the form of ‘human capital’, and the human form is that of the architect, not person A. The architect, realising that he or she is a much more productive resource than any outsider, may therefore be tempted to raise his or her fee. Person A will not like this, but may be pre- pared to pay some increase because the alternative of employing a new architect carries an even higher cost.
The architect is more productive than any outsider, and this return in excess of what would be achievable using alternative human resources is a form of ‘rent’.3 There is a surplus associated with the use of the existing architect, a surplus accruing to a type of speciﬁc capital (specialised knowl- edge), and there is a danger that much eﬀort can be taken up in a ﬁght over who should receive it. Although person A has ﬁnanced it, the architect may attempt to take some of it by implicitly threatening termination. If person A succumbs to this threat, he is the victim of ‘hold-up’.
It is not necessarily always the buyer in a transaction who is vulnerable to ‘hold-up’, however. Suppose, for example, that A has such eccentric ideas that the plumber has to invest in material and equipment which he or she is most unlikely ever to ﬁnd a use for again and which has a very low value on the second-hand market. Once the plumber has invested in these assets, s/he in turn will be vulnerable to contract renegotiation. They are transaction- speciﬁc physical assets, and any return above their value in alternative uses is again a ‘rent’. Person A may try to push down the agreed price of the work thus appropriating some of the rent which accrues to these assets. The plumber will feel aggrieved but may be in a poor bargaining position for resisting some adjustment to contract terms. Any return on the assets in excess of their value elsewhere is, in principle, better than terminating the contract.
In practice, of course, these problems are unlikely to be of great signiﬁcance in a local community where reputational eﬀects are signiﬁcant. Further, a simple solution to the speciﬁc physical assets problem is for the plumber to insist that person A should ﬁnance them in the ﬁrst place. Person A will buy the specialised equipment and the plumber will use it when undertaking the work. The plumber cannot ‘hold up’ person A, since a threat to raise the agreed fee will be met with the use of another plumber. Person A cannot ‘hold up’ the plumber because a threat to lower the fee will result in the plumber working elsewhere. In other words, there is no longer a ‘rent’ element associated with the plumber’s services. The rent accrues to person A’s services as a provider of capital to himself, and it does not matter whether the return is seen as accruing to the provider or the user. That par- ticular transaction has been ‘internalised’.
Although there are circumstances, therefore, in which asset speciﬁcity poses no great problem, vulnerability to ‘hold-up’ in general plays a large part in the theory of economic organisation. The existence of transaction- speciﬁc assets (either human or physical) will play a signiﬁcant role in our discussion of the ﬁrm’s relationship with its employees (Chapter 6), its sup- pliers (Chapter 7) and its ﬁnanciers (Chapter 9). It is also associated with the question of the viability of cooperative and other forms of enterprise (Chapter 10). As will be seen, the modern approach to the ﬁrm emphasises that its capabilities are highly speciﬁc and related to the information and experience accumulated in its membership. This implies that a signiﬁcant part of any ﬁrm’s return is rent on its speciﬁc human assets. A high degree of trust is required if these rents are not to be dissipated in distributional squabbles. Casson (1991) argues that it is a crucial role of the business leader to engineer this trusting environment. We will concentrate more on the power of repeat dealing and reputation. There can be no doubt, however, that business structure both reﬂects the degree of trust that exists between transactors and inﬂuences its future development.
In the following section, consideration is given to a number of diﬀerent institutional responses to the problems we have been considering. Search costs, asymmetric information leading to adverse selection and moral hazard, bounded rationality, and vulnerability to ‘hold-up’ are factors which inevitably inﬂuence the ways in which people contract with one another. If gains from trade are potentially available, it might be expected that institutions will be developed to facilitate their realisation, and this will involve mitigating the eﬀects of some of the forces which stand in the way.
Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.
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