Another assumption we must recognise is that human agents are capable of behaving opportunistically. Conventional economics assume that once contracts are signed, then agents will live up to those contracts but Williamson argues that this fails to recognise that opportunism is always a possibility such that agents can often exploit loopholes in contracts and behave badly through pursuing our ‘self-interest with guile.’ (Williamson 1981: 554)
The initial relationship between Fisher Body, a producer of auto bodies, and General Motors was a long-term contract of ten years. Such contract agreed that GM would only purchase its metal bodies from Fisher body with a price formula set to equal Fisher Body’s variable cost plus 17.6 percent. (Klein 1998: 241) One would then ask why this was necessary since it restricted GM from being able to switch to other partners and use the market as its efficient government structure? The answer lies on specific investments. In order to produce metal bodies for GM, Fisher Body had to invest in very specific pieces of equipment that meant they could not have been able to use the same stamping machine to supply other automobile manufacturer. Once Fisher Body had made its specific investments, General Motors could have threatened Fisher Body in switching suppliers of its bodies unless they reduced its prices. (Klein 1998: 241) Fearing this hold-up problem was the attempt to draw up a contract before any such investments were to be made so to reduce both parties from behaving opportunistically.
However according to Masten (1996: 388), ‘as transactions become more complex and the environment more uncertain, the limitations of contracting as a safeguard against opportunism grow.’ An unforeseen substantial increase in demand for closed metal automobiles in 1920 allowed Fisher Body to hold up General Motors by taking advantage of the contractual incompleteness (Klein 1998: 241). By adopting a highly labour-intensive production-process and locating their plant far away from General Motors’ production facilities, Fisher Body was able to inflate its variable costs and placed a ‘17.6 percent surcharge on their transportation costs.’ (Klein 1998: 42) But by exploiting loopholes in the contract, the hold-up by Fisher Body had proved to be very costly for General Motors. This would not have been the case if the changes in market conditions were anticipated since GM would obviously have include such contingency in its contract.
In 1926, General Motors decided to integrate its transactions by acquiring Fisher Body. According to Williamson this was logical because where the ‘three critical dimensions of transactions’ (Masten 1996: 390) namely: frequency, degree of uncertainty, and asset specificity was present, the most efficient government structure emerged, this being vertical integration. Where GM integrated backwards in their supply chain in order to internalise transactions within one organisational structure, markets and hierarchies represent alternative government structures. If General Motor’s assets were non-specific, then they could have purchased its assets through a normal market relationship based on relevant prices. But as we can see with such market structure, it poses the possibility for agents to act opportunistically. With GM and Fisher Body, we see the emergence of a vertically integrated firm as an efficient response to the transaction cost associated with market-type coordination.
Therefore, by adopting Transaction Cost Economics as a way of analysing organisations we can predict that vertical integration hierarchies will take place within an industry, like that of Fisher Body and General Motors, through the present of these three distinct dimensions1: i) the frequency of a transaction, ii) the uncertainty surrounding the transaction and iii) the level of asset specificity associated with the transaction.
However, the predictive validity of Transaction Cost Economics in an attempt to explain the Fisher-GM case study has been closely scrutinized when comparing the hold-up with Williamson’s behavioural assumption of opportunism. In Klein’s account of the hold-up problem between Fisher Body and GM, he proposes that ‘explanations of hold-up behaviour based upon transactors deception are often clearly inconsistent,’ in which ‘there was no real evidence of any precontract deception on either contractors’ part.’ (1998: 224) Both parties were aware of the possibilities of a hold-up due to the incomplete contracts they entered into yet they believed it would have been more costly to write a more complete contract covering every possible angle. (Klein 1998: 224) If both parties were to cover every contract criteria and contingency then not only would that be timely to write down, but also costly in having the need to inform, confer and verify with each other continuously. And if we add the concept of bounded rationality, a complete contract is likely to be unrealistic because contractors simply cannot ‘determine all of the many events that might occur during the life of a contractual relationship and write a prespecified response to each.’ (Klein 1998: 242) As a result we can see that the contract between the two parties was, to some extent, infused by trust so that the costs of negotiating, writing and monitoring the contract could be economised. Hence, ‘trust economises on transaction costs’. (Todd 1996: 88) Transaction Cost Economics’ behavioural assumptions offered by Williamson neglected this important aspect of trust. The statement made by Williamson that agents are "self-interest seeking with guile" (Williamson, p554) therefore does not necessarily justify why GM had accepted such an imperfect and incomplete contract with Fisher Body. Where Fisher Body and GM had entered into a long-term contract, the role of trust rather than opportunism, can in fact alter the choice of government structure. (Todd 1996: 88) In his revisited paper in 2006, Coase makes a similar argument when he points out that ‘the contractual arrangements and working relationship prior to the 1926 merger exhibit trust rather than opportunism.’
For Klein, much emphasis was placed on the presence of specific investments as an explanation of the hold-up between Fisher Body and GM such that the physical assets Fisher Body employed were highly specific for GM thus, making it costly for transactors to switch partners. However, a limitation to this account is the failure to see its human-specific asset as equally, if not more, important to the Fisher-GM case study. In fact, Coase claims that such ‘holdup never occurred’ but rather, there was ‘the desire to acquire and retain the specialised knowledge and services’ (Freeland 2000: 40) of Fisher Body to prevent competitors, like Ford, from using Fisher’s services. This is true when the demand for closed metal automobiles increased and since ‘General Motors lacked both the knowledge and the facilities necessary for manufacturing closed bodies’ (Freeland 2000: 40) there was fear that Ford, one of its major competitor, would have snatched the baton first.
So where Klein’s explanation of the acquisition of Fisher Body by GM as a way of reducing transaction costs and overcoming the hold-up problem, Coase on the other hand believes that human asset specificity played a major role in the lead up of the acquisition of Fisher Body. Coase argues that it was crucial for GM to acquire the human assets of Fisher Body, namely the Brothers1, which is why they had entered into a contract at the start. The contract contained ‘powerful financial incentives designed to induce the Fishers to stay and manage body operations’ (Freeland 2000: 43) which shows that GM had a far more interest in Fisher Body than just supplying its bodies. Thus, the objectives and motivation for GM to enter into a contract deal with Fisher Body was much more complex than simply reducing incentives of opportunistic behaviour.
On drawing up the contract between Fisher Body and GM, the Fisher Brother’s ‘requested an option to leave Fisher if they became unhappy with the agreement,’ (Freeland 2000: 44) and on compromising, they agreed that the Brothers had to remain with Fisher Body for 5 years. Whilst they had entered into a ten years contract with a cost-plus deal, there was however the pressure for GM to devise a way of securing Fisher Body’s human assets once the 5 years service obligation was coming to an end. As a result, ‘it was the threatened expiration of these provisions, not holdup, that was the primary source of contractual difficulty between GM and Fisher.’ (Freeland 2000: 44)
Along with these limitations as stated by opposing economists such as Coase and Freeland, further dispute was made to the validation of a hold-up in the Fisher body-GM case study. These include accounts of how Fisher Body’s decision to move its plants away from GM was in fact not true (Freeland 2000), and it was also stated by Coase (2006: 265) that Fred Fisher, one of the Fisher brothers, became a director of GM in 1922 thus, making it inconvincible that Fisher Body adopted an inefficient production process. But what is important to note is not the number of arguments presented by either opposition, rather Transaction Cost Economics provides one of the many theories associating with industrial organisation. The classical example of Fisher Body and GM is one that illustrates the potential and explanatory power of the Transaction Cost Economics framework. Whether or not such theory purely describe firm behaviours, ‘TCE, with efficiency analysis at its core, has an important place in the multiparadigm world of organization theory, but to claim that it is the only paradigm would be foolhardy.’ (Todd, 1996: 95)
Bibliography
Coase, R. H, 2006, ‘The Conduct of Economics: The Example of Fisher Body and General Motors’, Journal of Economics and Management Strategy, Vol 15, No. 2, pp. 255 – 278.
Freeland, R. F, 2000, ‘Creating Holdup through Vertical Integration: Fisher Body Revisited’, Journal of Law and Economics, Vol. 43, No. 1, pp. 33-66.
Klein, B, 1998, ‘Hold up Problem’ in Peter Newman, ed, The New Palgrave Dictionary of Economics and Law, Vol. 2, Macmillan London.
Klein, B, 2000, ‘Fisher-General Motors and the Nature of the Firm’, Journal of Law and Economics, Vol. 43, No.1, pp. 105 -141.
Todd, H. C, 1996, ‘Integrating Variable Risk Preferences, Trust, and Transaction Cost Economics’, The Academy of Management Review, Vol. 21, No. 1, pp. 73-99.
Williamson, O. E., 1981, ‘The Economics of Organization: The Transaction Cost Approach’, American Journal of Sociology, Vol. 87, No. 3.