Why have contracts?

This was originally provoked by a question and answer here.


One of the most productive questions ever asked in economics is: “why do firms exist?” Why are not all economic agents sole traders? Alternatively, why is there not one big firm? Why, indeed, do firm structures vary so noticeably across industries?

The question was famously posed by Ronald Coase and he answered it with what became known as transaction costs. (A useful summary and appreciation of his work is here [pdf].) In effect, firms existed to minimise transaction costs: if it is cheaper to do a transaction in-house, then it is. If it is cheaper to do purchase a good or service externally, then it is. Firms are alternatives to coordination by the price mechanism. In a sense, they are areas of the suppression of the price mechanism. (Original article is here [pdf].) This was very productive question because it transformed organisational and institutional analysis -- many subsequent Nobel prices in economics were awarded for work based on use of transaction costs.

But is a firm defined by a transaction costs boundary? Or is it, as Yoram Barzel has argued, defined by the range of the guarantee of the equity capital? By the range across which expenditure to match obligations is guaranteed (and, if the guarantee fails, bankruptcy occurs). Firms then become mechanisms to deal with both risks and transaction costs. It is the intersection of comparative transactions costs and risk coverage that sets the boundary of the firm. Noting that it is existence of a realm where it is beneficial to replace the price mechanism (Coase’s point) that creates the range of expenditures needing the equity guarantee (as identified by Barzel) in the first place.

Coase’s analysis in itself does not explain why firm ownership is purchased and why the owner is the recipient of the residuum (the net income of the firm, whether positive or negative after all expenditures are paid for): adding Barzel’s analysis does. While Barzel's analysis does not identify why there is a range of transactions needing the equity guarantee in the first place (as Coase's analysis does.)

So, why do contracts exist? Why are not all transactions just on-the-spot swaps?

Lots of transactions are, after all. Not only are there spot markets, but retail markets are dominated by such on-the-spot swaps, where prices are free to move between transactions.
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Contracts exist for the same reasons firms exist, to lower transaction costs and manage risks. Contracts structure, and thereby permit, economic interactions that extend beyond a caveat emptor swap on the spot. A contract is any agreed transaction or series of transactions across time. So, any purchase which is not on a caveat emptor basis has some contractual element, as there is an obligation across time. (So even spot markets can have contractual elements.)

This is easiest to see with regard to labour markets. While spot markets for labour have existed, they tend to be relatively rare. Generally, people providing goods and services they do not make or provide themselves need to use labour with some regularity, and labour with specific skill sets and characteristics (such as reliability). A contract offers income to the provider of the labour on the basis of providing particular skill sets and personal characteristics. The promise of future income (to the labour provider) and future use (to the hirer of the labour) gives the hirer of the labour reason to engage in necessary training (even if only in the procedures of the firm) and a reasonable expectation of the labour being available. The hirer can then have a reasonable expectation of providing the goods or services he can then offer to customers.

The point can be extended to any good or service that is a regular part of the production process.

So, contracts exist to manage interactions across time. They are more than simply repeated games (such as one has with a regular customer/purveyor: though these can involve built-up expectations which can become implicit contracts). Contracts structure any interactions where there is a delay between provision and payment. So, ordering a meal in a restaurant is a contract, since you are promising to pay at the end of the meal. Even if payment for an on-the-spot swap is immediate, if a transaction is not caveat emptor there will be some continuing obligations about quality which make the transaction a contract.

In common law, a contract is a matter of offer and acceptance (i.e. mutual assent) and consideration. That is, a contract involves mutual agreement for some benefit (typically, an exchange of benefits). The mere matter of assent and benefit simply makes it a transaction: it is having explicit or implicit operation over time that makes it a contract.

Contracts reduce transaction costs – in particular, you do not have to keep searching for providers, negotiation costs are reduced (particularly if standard contracts, whether customary or statutory, are used) – and they reduce risks: you can act on the basis of reasonable expectations, with means of redress if there is a failure to provide as promised, making planning ahead easier. Since time-range transactions are so common, contracts are ubiquitous in human economies. So much so, that customary contracts evolve to an extent that people are not even conscious of being engaged in an (implicit) contract, as in purchasing a restaurant meal. By creating a structure one that allows transactions that operate across time (that is, loosen the time constraint) a contract also allows much more complex interactions than would otherwise be practical.

Having high levels of social trust and effective contract law enforcement greatly increases the range of transactions that it is reasonable to engage in. The biggest single economic advantage to high levels of social trust may well be the expanded ability to engage in contractual (i.e. time-range) transactions.

While there is some minimal trust element in on-the-spot swaps, there is so little that even black markets can engage in them easily. To engage in time-delay transactions generally requires an enforcement/recourse mechanism. This accounts for much of the overt menace in black markets, since such enforcement have to provided by the purveyor themself. (The rest of the menace and violence comes from the need to privately enforce property rights, making them much more “up for grabs”, and to deter assisting the state to enforce its ban of those transactions.)

So, a contract is a way of reducing transaction costs and managing risks thereby permitting transactions that have some element across time. Which leads rather naturally into the notion of a firm as a nexus of contracts.

Unlike firms, contracts are not generally suppressions of the price mechanism: typically, they are ways of extending its operation – that is, they bring a wider range of possible transactions into the market. What is distinctive about the contracts of a firm is that they provide the basis for alternatives to the price mechanism in coordination and their operation is within the guarantee of the equity capital. Noting that firms are a nexus of contracts does not, of itself, appear to add anything to the combined Coase-Barzel analysis of firms outlined above.

It is more that firms are a particular nexus of contracts. That is, firms and contracts are both ways of reducing transaction costs and managing risks: it is just that a firm uses contracts to create a specific realm of coordination and equity guarantee. Contracts are the mechanism, the firm is a particular conjunction of the use of contracts.