Contractual Commitments, Bargaining Power, and Governance Inseparability: Incorporating History into Transaction Cost Theory

TLDR

Transaction cost and modern property rights theories of the firm treat the transaction as the fundamental unit for analysis. This paper investigates the limits of these theories when transactions cannot be analyzed and governed separately, i.e., when governance inseparability arises. The authors argue that prior contractual commitments with third parties and unexpected shifts in bargaining power jointly constrain the feasible governance mechanisms for current transactions. Using examples, the authors show that inseparability restricts outsourcing, subsidiary formation, and franchise terms, and they discuss how firm and environmental characteristics, uncertainty, and scope limits affect these outcomes.

Abstract

Transaction cost and modern property rights theories of the firm take the transaction as the fundamental unit for analyzing choices. This paper explores the limits of the theories when transactions cannot be analyzed and governed separately; that is, when they are subject to governance We argue that two sets of factors act individually, or in combination, to produce inseparability. First, prior contractual commitments with parties other than the immediate contractual partner can limit the feasible set of mechanisms for governing current transactions. Second, unanticipated changes in bargaining power can enable a party to place restrictions on the choices that a partner can make in future contracts with other parties. We use several examples to show how inseparability has constrained outsourcing, subsidiary formation, and the terms and conditions of franchise contracts. We draw implications for the affects of firm and environmental characteristics on choices, as well as the limits to, and impact of uncertainty on, firm scope.