Post-Contractual Opportunism and the Boundaries of the Firm

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Organizational Economics and the Theory of the Firm

One of the central questions of organizational economics (or, somewhat equivalently, contract theory) is why firms exist.  Granted, this might seem a little strange, since firms (i.e. companies) are such an integral part of the economy that many people probably take their existence for granted.  Nonetheless, economists seek to understand specifically why production is organized into firms, which use authority to manage resources, and individual producers in markets, which use prices to manage resources.  As a related matter, economists seek to identify what determines the degree of vertical integration in a firm's production process.

There are a number of explanations for this phenomenon, including transaction and contracting costs associated with market transactions, information costs of ascertaining market prices and managerial knowledge, and differences in the potential for shirking (i.e. not working hard).  In this article, we are going to explore how the potential for opportunistic behavior across firms provides an incentive for firms to bring more transactions within the firm- i.e. to vertically integrate a stage of the production process.

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Contracting Issues and the Matter of Verifiability

Transactions between firms rely on the existence of enforceable contracts- i.e. contracts that can be brought to a third party, usually a judge, for an objective determination of whether the terms of the contract have been satisfied.  In other words, a contract is enforceable if output created under that contract is verifiable by a third party.  Unfortunately, there are a lot of situations where verifiability is an issue- it's not hard to think of scenarios where the parties involved in a transaction intuitively know whether output is good or bad but they are unable to enumerate the characteristics that make the output good or bad.

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Contract Enforcement and Opportunistic Behavior

If a contract can't be enforced by an outside party, there is a possibility that one of the parties involved in the contract will renege on the contract after the other party has made an irreversible investment.  Such action is referred to as post-contractual opportunistic behavior, and it is most easily explained via an example.

Chinese manufacturer Foxconn is responsible for, among other things, manufacturing most of Apple's iPhones.  In order to produce these iPhones, Foxconn has to make some up-front investments that are specific to Apple- i.e. they have no value to other companies that Foxconn supplies.  In addition, Foxconn can't turn around and sell finished iPhones to anyone but Apple.  If the quality of iPhones was not verifiable by a third party, Apple could theoretically look at the finished iPhones and (perhaps disingenuously) say that hey don't meet the agreed-upon standard.  (Foxconn wouldn't be able to take Apple to court since the court wouldn't be able to determine whether Foxconn had in fact lived up to its end of the contract.)  Apple could then try to negotiate a lower price for the iPhones, since Apple knows that the iPhones can't really be sold to anyone else, and even a lower than original price is better than nothing.  In the short run, Foxconn would probably accept a lower than original price, since again, something is better than nothing.  (Thankfully, Apple does not appear to actually exhibit this sort of behavior, perhaps because iPhone quality is in fact verifiable.)

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the Long-Term Effects of Opportunistic Behavior

In the longer term, however, the potential for this opportunistic behavior could make Foxconn suspicious of Apple and, as a result, unwilling to make investments specific to Apple because of the poor bargaining position it would put the supplier in.  In this way, opportunistic behavior can prevent transactions between firms that would otherwise be value-generating for all parties involved.

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Opportunistic Behavior and Vertical Integration

One way to resolve the standoff between firms due to the potential for opportunistic behavior is for one of the firms to buy the other firm- that way there's no incentive (or even logistical possibility) of opportunistic behavior since it wouldn't affect the profitability of the overall firm.  For this reason, economists posit that the potential for post-contractual opportunistic behavior at least partly determines the degree of vertical integration in a production process.

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Factors that Drive Post-Contractual Opportunistic Behavior

A natural follow on question is what factors affect the amount of potential post-contractual opportunistic behavior between firms.  Many economists agree that the key driver is that of what is known as "asset specificity"- i.e. how how specific an investment is to a particular transaction between firms (or, equivalently, how low the value of an investment is in alternative use).  The higher the asset specificity (or the lower the value in alternative use), the higher the potential for post-contractual opportunistic behavior.  Conversely, the lower the asset specificity (or the higher the value in alternative use), the lower the potential for post-contractual opportunistic behavior.

Continuing the Foxconn and Apple illustration, the potential for post-contractual opportunistic behavior on Apple's part would be pretty low if Foxconn could leave the Apple contract and sell the iPhones to a different company- in other words, if the iPhones had higher value in alternative use.  If this were the case, Apple would likely anticipate its lack of leverage and would be less likely to renege on the agreed-upon contract.

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Post-contractual Opportunistic Behavior in the Wild

Unfortunately, the potential for post-contractual opportunistic behavior can arise even when vertical integration is not a plausible solution to the problem.  For example, a landlord could try to refuse to let a new tenant move into an apartment unless they pay a higher than originally agreed upon monthly rent.  The tenant likely doesn't have backup options in place and is therefore largely at the mercy of the landlord.  Luckily, it is usually possible to contract on the rental amount in such away that this behavior can be adjudicated and the contract can be enforced (or at leas thte tenant can be compensated for inconvenience).  In this way, the potential for post-contractual opportunistic behavior highlights the importance of thoughtful contracts that are as complete as possible.