The problem of contract enforcement in economic organization theory

Abstract

Recently, economists have directed attention to the phenomenon of organization. An important difference between the newly developed economic theories of organization, such as for example agency theory, and sociological theories of organization is the fact that economists explicitly employ an individual utility maximization assumption. In this paper, it is reasoned that this assumption, if used as in agency theory, entails logical inconsistencies if we try to explain the existence of the kind of agreements that purportedly form the basis of organizations. However, if the condition of uncertainty -- to which agency theorists merely pay lip-service -- is taken seriously, the observed inconsistencies can be reconciled. A classificatory scheme of four `sources of obligation' is proposed for the analysis of the basis of agreements. Taking all four sources into consideration in the analysis of organizational agreements can help to avoid one-sided attention to, for example, formal, legally enforceable agreements. The findings of empirical research suggest that two basic dimensions lie at the root of the proposed classificatory scheme. Further research is needed to check this supposition and its implications.

Introduction

The phenomenon of organization has long been neglected by the economic discipline. In neoclassical theory, firms are traditionally treated like single loci of decision-making, indicating that even though these firms actually consist of up to hundreds of thousands of individual actors, this fact is considered to be irrelevant to the analysis. However, of late, new branches of the neoclassical tree have directed attention to the nature of organization. Transaction cost analysis (Williamson 1975, 1985) juxtaposes markets and hierarchies as alternative mechanisms for coordinating transactions. Agency theory (Alchian and Demetsetz 1972; Jensen and Meckling 1976; Fama and Jensen 1983) focuses on decision structures in which one party acts for, or on behalf of, the other party, structures that may be considered to be the basic elements out of which organizations are built.

These newly developed theories are interesting because they constitute competitors to existing theories of organization, predominantly rooted in sociological paradigms. The economists' attitude to and evaluation of organizational problems seems to be radically different from those of most organization sociologists. Some economists do not hesitate to predict a revolution in the field of study, that is seen as still being in its infancy (Jensen 1983).

Of the two branches of economic organization theory mentioned above, transaction cost theory and agency theory, I will concentrate on the second in this paper. The reason for this concentration on agency theory is twofold. In the first place, transaction cost theory, although ostensibly discussing hierarchical organization, can perhaps be typified most adequately as a theory of internal and external markets and market failures, because the nature of hierarchy is scarcely explored in this literature (Granovetter 1985; Kay 1987). Agency theory, on the other hand, investigates the ways in which a principal can discipline the behaviour of an agent, and consequently the agency relation can be characterized as inherently hierarchical. Hierarchy, in turn, may be considered as the quintessence of organization.

The second reason to concentrate on agency theory here is that this school of thought is a major stumbling block to organization sociologists, many of whom object to the view on human behaviour that is displayed by its proponents. According to Perrow (1986: 232-236), agency theory is dangerous because it can be used to rationalize and encourage selfish behaviour and cheating. Perrow states that the central assumption of agency theory, the assumption of individual utility maximization can, at best, partially explain human behaviour, and that agency theory should make clear under which circumstances individual utility maximization may be assumed and under which circumstances other, possibly conflicting goals have to be considered. Etzioni (1988) postulates a dual human nature, with aspiration to individual utility and compliance with moral imperatives as constituent elements. Donaldson (1990) points at the narrow account of human motivation offered by economic organization theorists, and proposes an alternative view of organization members acting in the interest of the organization as a whole, rather than driven by self-interest.

Thus the individual utility assumption seems to form the crux of the controversy between agency theorists and organization sociologists. Therefore this assumption, and its ramifications, take an important place in this paper. Below, I will first sketch, very shortly, the rudiments of agency theory, indicate the importance of the individual utility assumption for this theory, and discuss the fundamental differences between agency theory and sociological organization theory that are related to this assumption. After that I will focus on the concept of `contract', used in agency theory to refer to voluntary agreements between principal and agent and, by means of an impossibility argument, attempt to show that the existence of such contracts cannot be explained in an agency-theoretical analysis. Subsequently, I will consider the question of whether the existence of these voluntary agreements is completely irreconcilable with the basic assumptions employed in agency theory. In my opinion, this is not the case, if the conditions of uncertainty and positive information costs are given appropriate weight. A classificatory scheme of four `sources of obligation' is presented that can be used in the study of exchange between parties striving after individual utility under these conditions. It is shown that empirical research points at two basic dimensions underlying the four `sources' discerned. Finally, some tentative conclusions are drawn.