Integration of the Legal System

The legal system protects exchange relationships by ensuring that contracts are enforced (Kahkonen & Meagher, 1997). This may discourage opportunism because dishonest actors

may fear facing the consequences of their actions. This complements incomplete contracting because court enforcement provides guarantees that the state may enforce the agreement in the event of one party reneging on the agreement (Bridgeman, 2009). However, the strength of the legal system varies between countries, with many developing and transitional economies having weaker legal systems than developed countries (World Bank, 2008). Even when the legal system is weak, firms still sign contracts (Beave & Saussier, 2010) but then supplement contractual exchange protection with alternative or non-state forms of enforcing business agreements (Vinogradova, 2006). For example, Li, Xie and Peng (2010) studied the formal and social control mechanisms in domestic and international buyer-supplier relations in China and found that social and formal control mechanisms are complements in international relationships. Norms that firms may use include restricting access to the trading network to only those members who have continuously shown commitment to quality through previous transactions (Podolny, 1994). Also collective (peer) sanctions can occur where a group of traders may impose group sanctions on a member or members who violate group norms and values (Borgatti et al., 1997). This shows that norms may play an important role in providing added exchange protection in situations where the legal system is weak. Thus integrating the legal system not only helps improve contractual safeguards, but it is also complemented by norms in cases where the legal system is weak or inefficient. The result is a further improved contracting framework that takes the form:

“Contract = Specified duties and obligations (TCE incomplete contract) complemented by monitoring and incentives (agency theory contract), relational norms (relational exchange theory contract) as well as court enforcement mechanisms.

The above contract framework is therefore the one that is developed and adopted for this research. It appreciates the exchange protection qualities of TCE incomplete contract, agency theory monitoring and incentives, relational exchange theory‟s norms and commitments as well as the threat of enforcement provided by the legal system. The support offered to the TCE contract by all these exchange frameworks help ensure the stability of contracts and thus reduces the need to internalise transactions even when transactions are exposed to hazards associated with incomplete contracting.

It is important to point out that removing any of the additional mechanisms proposed in this multi-paradigm exchange protection framework would result in the weakening of the framework and removing all would collapse it back to the base case scenario or the TCE

incomplete contract. The integrated exchange framework discussed above is presented in the table below.

Table 3-1: The multi-paradigm theoretical framework Transaction Cost

Theory

Agency Theory Relational exchange theory

Legal System Multi-paradigm Theoretical Framework Objective: Reduce actors‟

opportunism. Reduce agent‟s opportunism. Reduce actor‟s opportunism Enforce agreements Offers a multi-variable protection of exchange relationships Modalities of achieving the objective Complex contracting to try to capture as many contingencies as possible. Goal alignment (incentives and monitoring) to ensure similar goals Building of norm based relationships to reduce the incentive for cheating. Enforcing contract violation remedies, even if it means force (fiat). Integrated approach encompassing, complex contracting, goal alignment, trust and court contract enforcement to provide a holistic approach to exchange protection. Behavioural assumptions

Actors are self centred and are always ready to cheat and deceive in their quest to meet their self interest.

Principals and agents are self interested and thus have conflicting goals. Agents are risk averse and principals are risk neutral.

Trading partners are cooperative and have common goals. E.g. both want to engage in future

transactions.

Actors are self interested, hence the need for a third party mediation to control their opportunistic tendencies.

Trading partners may be both self-centred and common goal oriented. Thus, no single approach is enough to address opportunism, hence the need for an integrated approach.

Theoretical focus

The transaction The contract The relationship Contract enforcement

Exchange environment. That is, the transaction, contract and relationship. Nature of

relationships

Arms length for non asset specific transactions. Otherwise adversarial relationships requiring strategic interventions such as complex contracting and vertical control. Adversarial relationships requiring an optimal contract that aligns principal and agent‟s goals. Cordial relationships based both on past interactions and expected future interaction and mutual benefit. Adversarial relationships, hence the need for third party enforcement.

Relationships can either be cordial, adversarial or have elements of both, requiring an integrated approach (strategic, goal alignment, mutual norms based and third party enforcement) to address opportunism.

Time Dimension

Short term for non asset specific transactions and long term for asset specific transactions.

Ex ante – with all incentives and monitoring tools agreed before signing the contract. No ex post re- negotiations.

Long term – with relationships built over time and expectations for continuation of the relationship.

Instantaneous. I.e. when the principal calls for contract enforcement. This assumes an efficient legal system

Short and long term. The integrated approach ensures that appropriate tools are used as and when the need arises. That is, it moderates both ex ant and ex post time dimensions.

Figure 3-1: A conceptual model of the multi-paradigm framework Multi-paradigm Contract Relational theory (norms and commitments) Legal contract enforcement Agency theory (monitoring and incentives) TCE incomplete Contract Arms length relationships Vertical Integration

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The above model suggests that in real life, transactions that are free from specificity are carried out through the arms-length governance structure (Lambert et al., 1996; Williamson, 1991). Once transactions involve specific assets, companies use the multi-paradigm contract to protect exchange relationships. This contract is more resilient than the TCE incomplete contract. That is, companies safeguard exchange relationships through a combination of the TCE contract which specifies duties and obligations, agency theory monitoring and incentives mechanism, relational theory norms and commitments as well as the efficacy of the legal system. Thus, the day to day contract used by firms is a multi-paradigm contract but not a typical TCE incomplete contract. As stated above, this contract is more resilient than the TCE contract and this may explain why firms use contracts even though in purely TCE context they expose exchange relationships to opportunism. Firms also have an option to internalise transactions (vertical integration). This governance mode is used when companies believe that potential contractors cannot meet the required standards. They do not necessarily integrate to control opportunism; they integrate to ensure certain standards are achieved. Thus, vertical integration is more a response to concerns about contractors‟ capabilities rather than deliberate intentions to mislead or take advantage of the contracting partner(s). Hence firms have the options of using the spot market/arms-length governance mode, multi-paradigm contract (which includes the exchange protection qualities of the TCE incomplete contract, agency theory, relational exchange theory and the legal system) and vertical integration.

This notwithstanding, the framework developed for the current research cannot be said to be faultless or complete. While it is expected to provide better exchange protection than the TCE contracting framework, it is not free from problems associated with bounded rationality and hence this assumption is still valid even with the new framework. That is, it does not cover all possible future contingencies. However, the new framework helps reduce the problems that arise due to bounded rationality or contract incompleteness by complementing the TCE contract with other exchange protection mechanisms.