Risk Propensity, Trust, and Transaction Costs in Relational Contracting

Article excerpt

Abstract

Critics of transaction cost economics (TCE) argue that TCE is not able to explain variations in governance arrangements between the extremes of market and hierarchy. They further dispute the assumptions of opportunism and risk neutrality underlying the theory. While TCE proponents have developed approaches that address each of these criticisms separately, we propose that combining the approaches to simultaneously address both challenges alters the nature of the predictions. We explore the roles of risk propensity and trust within a TCE framework. We then test the ability, of these variables to predict variations in governance between the extremes of market and hierarchy.

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The increasing prevalence of a broad class of organizational forms that are neither market nor hierarchy has challenged traditional notions of organizational relationships. Perhaps nowhere are these challenges more clearly seen than within the study of transaction cost economics (TCE) (Coase, 1937; Williamson, 1975). Critics have challenged both the market/hierarchy dichotomy that originally served as the foundation for TCE and the behavioral assumptions that underlie the theory.

In response to these challenges, researchers have proposed modifications to the basic TCE theory. Proposed adjustments include moving from a dichotomy to a continuum, where hybrids fall between the end points of market and hierarchies (Williamson, 1985; 1991), and the inclusion of behavioral variables as moderators within the model rather than as underlying assumptions (Chiles and McMackin, 1996). While each of these proposed modifications is built on a reasonable logic, there has been little, if any, empirical assessment of the predictions. More importantly, because each modification was proposed independently, the effect of concurrently including both of the modifications within the model has not been considered. When they are, the predictions of the model may be very different from what either would individually propose.

To help advance our understanding in this area, then, the current study includes trust and risk propensity in a TCE framework and examines their influence on the form of governance taken within a particular exchange relationship between firms. We begin by briefly reviewing TCE and its assumptions regarding opportunism, risk, and the role of trust. Next, we explore alternative ways that these concepts might be handled within a TCE context and develop hypotheses regarding the role of each of the variables. We then describe an empirical test of the hypotheses and discuss the results. A discussion of the implications of the results both for TCE in particular and for organizational forms in general concludes the paper.

Literature Review

In transaction cost economics (TCE), three characteristics of a given transaction are purported to influence the choice between market and hierarchical governance mechanisms: the need for transaction-specific investment, the likelihood of repetition, and uncertainty of performance (Coase, 1937; Williamson, 1975). As the level of each characteristic increases, the transaction becomes more likely to be governed using hierarchical rather than market governance mechanisms. Three assumptions regarding human nature are critical to this calculus. Bounded rationality addresses managerial behavior which is "intendedly rational, but only limitedly so" (Simon, 1961 : xxiv). Under bounded rationality, decision makers do not possess or are not able to process complete information. Opportunism, defined as "self-interest seeking with guile" (Williamson, 1975: 26), requires not that all actors behave opportunistically, only that some do and that it is difficult or costly to determine which actors will behave opportunistically. Risk neutrality means that decision makers are indifferent between certain and uncertain returns as long as the expected value of the uncertain returns is equal to that of the certain returns over the longer term (Aoki, 1984). …