That Great Klein (1996) Paper

21 January 2009 at 5:36 pm 5 comments

| Peter Klein |

No, not this one. I’m talking about Ben Klein’s 1996 Economic Inquiry paper, “Why Would Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships.” It’s from a special issue honoring Armen Alchian, the entire contents of which are worth reading. Klein’s paper extends the Klein, Crawford, and Alchian (1978) model by explaining why, in equilibrium, holdups can occur, even if parties are farsighted. The basic story — that parties deliberately leave “gaps” in their contracts because the marginal costs of filling in the gaps exceed the marginal benefits — is closer in spirit to neoclassical economics than is Williamson’s Carnegie-style appeal to bounded rationality. Writes Klein:

[In an uncertain world where complete contractual specification is costly, transactors use incomplete contracts that deliberately do not take account of every contingency. As a result, transactors knowingly leave themselves open to the possibility of hold-ups.

The costs associated with contractual specification that lead transactors to use incomplete and imperfect contracts involve much more than the narrow transaction costs of writing down responses to additional  contingencies. In addition to these extra “ink costs,” complete contractual specification entails wasteful search and negotiation costs associated with discovering and negotiating prespecified contractual responses to all potential contingencies. Because most future events can be accommodated at lower cost after the relevant information is revealed, much of this activity involves largely redistributive rent dissipation with little or no allocative benefit. Transactors are merely attempting to obtain an informational advantage over their transacting partners, hoping to place themselves in a position where they will be more likely to collect on (and less likely to pay for) hold-ups.  Therefore, rather than attempting to determine all of the many events that might occur during the life of a contractual relationship and writing a prespecified response to each, the gains from exchange are increased by the use of incomplete contracts.

Transactors also use incomplete contracts because writing something down to be enforced by the court creates rigidity. Since contract terms are necessarily imperfect, once something is written down transactors can engage in a hold-up by rigidly enforcing these imperfect contract terms, even if the literal terms are contrary to the intent of the contracting parties (p. 447).

Klein introduces the concept of the “self-enforcing range,” the set of external factors that could change without triggering holdup, because parties acting opportunistically (in Williamson’s term, not used by Klein) face a loss of market reputation and possible retaliatory behavior by their current trading partners.

The discussion revolves partly around the Fisher-GM case, on which a huge literature has emerged since 1996. Independent of that case, however, the general argument is well taken, and stated as clearly here as anywhere. For instance, as I frequently explain to students, the “primary goal in Klein, Crawford and Alchian was not to explain the existence of hold-ups, but rather the institutions adopted by transactors to avoid hold-ups” (p. 445).

Here’s how the paper opens:

One of my most enjoyable intellectual experiences was working with Armen Alchian on the Klein, Crawford and Alchian [1978] hold-up paper. In this paper I extend the basic framework presented in that paper, pointing out what I now consider to be its shortcomings and providing insights into the nature of hold-ups and the form of contracts chosen by transactors to avoid hold-ups. The major analytical extension entails combining hold-up analysis with my work on private enforcement [e.g., Klein and Leffler, 1981 — PK]. Because private enforcement capital is limited and written contract terms are necessarily imperfect, transactors must optimally combine court-enforced written terms together with privately enforced unwritten terms to define what I call the self-enforcing range of their contractual relationship. Hold-ups occur when unanticipated events place the contractual relationship outside the self-enforcing range. This probabilistic framework, where transactors enter contractual relationships knowing that a hold-up may take place (but believing that the expected gains from trade outweigh the expected rent-dissipating costs associated with the hold-up risk), is shown to have important implications for understanding the structure of contracts adopted by transactors in the marketplace.

See also: Ben Klein’s Contributions to Law and Economics.

Entry filed under: - Klein -, Law and Economics, New Institutional Economics, Papers, Strategic Management, Theory of the Firm.

Robert Burns and Adam Smith Keynesian Economics in Four Paragraphs

5 Comments Add your own

  • 1. Joe Mahoney  |  23 January 2009 at 10:37 am

    The game of chess has zero uncertainty but with the brain as the bottleneck and the fact that the size of the decision tree is mind-boggling, the game even after centuries of play still offers delightful surprises.

    Given bounded rationality we do not even need uncertainty to have incomplete contracts. As the game of chess illustrates all we need is complexity!

    In many business decisions the concepts of Uncertainty and Bounded Rationality are both desciptively accurate and sufficient to explain incomplete contracts.

    What pragmatically is gained by the mental gymnastics of writing pages of explanation to establish incomplete contracts without assuming bounded rationality?

    If a theory predicts no better and is descriptively inferior as an explanation of real-word phenomena, why does anyone regard that as an advance?

    Because the reconstucted logics are elegant? If you want elegance, better to go to a tailor.

  • 2. Peter Klein  |  23 January 2009 at 3:19 pm

    Joe, I think the tendency among TCE scholars and property-rights economists today is to take contractual incompleteness as given, while remaining agnostic about its causes. In other words, behavioral concepts like bounded rationality may be sufficient to explain incompleteness, but they are not necessary, so most applied researchers would rather not open up that particular Pandora’s Box.

    The same is true, to some extent, with regard to opportunism:

  • 3. Joe Mahoney  |  23 January 2009 at 5:11 pm

    I believe that Williamson’s Markets and Hierarchies is agnostic neither about about the existence of bounded rationality nor the existence of opportunism.

    Neither was the TCE theorist Billy Shakespeare: “Is he a knave (opportunism) or a fool (bounded rationality) ?”

    Nothing is more fundamental in our social science agenda than our premises, Peter. I maintain that intellectual finesse to avoid use of these fundamental premises detracts from the management discipline.

    In the TCE enterprise, economizing on bounded rationality and attenuating opportunism are the fundamental problems of management that cannot be assumed away.

    Further, from a functionalist perspective, our institutions of capitalism are understood better though this TCE lens.

    Where is the fight in you man? If some orthodox economists from elite universities try to bully folks into not opening the “Pandora’s Box” of bounded rationality join me in saying to them: “Bring it on” We are both tenured now, so what the heck?

    IF you think the two human factors of TCE are right, then take up the fight!

  • 4. Peter Klein  |  23 January 2009 at 5:33 pm

    Joe, no one admires your fighting spirit more than I do. But I’m busy fighting other battles at the moment, and there are only so many hours in the day. . . . I may join you later in this Great Crusade!

  • 5. Joe Mahoney  |  24 January 2009 at 9:29 am

    As an Irishman I also suggest to your audience to think of this fundamental issue as a a public brawl where anyone can join in.

    Herbert Simon was almost the lone ranger in his day, but he would have had more support today (even within economics)

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