PRAGOTI

Oliver Williamson, co-recipient with Elinor Ostrom of this year's Nobel memorial prize for Economics, may have never thought of himself as an agony aunt. But it was his ideas that taught me the value of commitment in personal relationships.

A decade or so ago, as a youngster well-trained in neoclassical economics, commitment seemed like a very silly idea to me. Life is an optimization problem. The passage of time brings in new data and sometimes this new data means a change in the optimal policy. If in the light of tomorrow's information, the best thing for us is to move apart, won't it be so suboptimal (and in those days suboptimal equalled bad for me) for us to stay together because of promises in the past. Why should we make our future selves hostages to the wishes of our current selves?

So proud was I of this reasoning that I would expound it whenever I got a chance. I would get looks of either sympathy for the insane or horror at a psychopath. But I was not going to let myself be swayed by public opinion. I would give up my opinion only if someone gave me hard proof. I finally found that proof in the work of Williamson and his followers.

Suppose Asha and Brajesh are in a relationship. In the course of this relationship they must dedicate resources to keep the relationship alive. Some of these investments are in stuff that have a value outside of the relationship--they may buy new clothes, or learn each other's native language. But they would also be spending a lot of effort to understand and adapt to each other and bond together, effort that would go completely to waste were the relationship were to break apart. In fact in the event of a break-up the investment may turn out to have a negative value in the form of the pain of heartbreak. It is this relationship-specific investment which is at the core of Williamson's argument.

Suppose that Asha and Brajesh have do not have any commitment to each other. In this case they know that once they have put in investment in the relationship, they are at the mercy of each other. Each would try to turn the relationship in their favour, knowing that the other would hesitate to walk out and scrap the effort already put in. If both of them have equal amounts of relationship-specific investment and equal bargaining power, it would lead to a wearying push and pull. If one of them is in a stronger position becuase they have put in less investment or better alternatives, then he/she can dominate the other.

Anticipation of these outcomes means that at the beginning of the relationship itself both Asha and Brajesh would hesitate to put in enough investment even though both would have enjoyed a relationship with greater investment to one with less. The relationship falls apart before it has even started.

Commitment is one mechanism to solve this problem, since if both commit to the relationship in a way from which it is difficult to renege later, then they know that there is less chance of being held to ransom later by their partner. Commitment is not the only solution. It may be the case the Asha and Brajesh know that in case of trouble in their relationship they can seek the arbitration of friends and elders who would be fair. In Williamson's terminology all these mechanisms of resolving conflicts once relationship-specific investments have been made are known as 'governance' and according to him it is the quest to provide the most efficient forms of governance which in a large part shapes the economic institutions of capitalism.

Of course, not being a writer of agony-aunt columns, Williamson sets his problem in more economic contexts. For example think of Chandan as an automobile manufacturer while Dipika is a vendor who is supposed to manufacture the bodies for a new model of car. In this case Dipika must invest in expensive tools and dies that are specific to the particular model of car. She can rightly fear that once she has installed the tools, she will face pressure from Chandan to reduce her price, since now she must sell to Chandan or let her entire investment go to waste. This fear may lead her to not install the required tools in the first place. In the commercial world, one solution to this problem would be a vertical merger so that the investment is made by the same entity that gains from it. But commitment, or arbitration may work as well. And even when merger happens, the problem of governance is not solved, it is only translated into the problem of governance within the hierarchal organization that is the firm.

A neoclassical economist would have proposed another solution to Chandan and Dipika's problem, if not Asha and Brajesh's. It would be to write a detailed contract specifying clearly the actions to be taken by each party in each possible contingency. The first component of Williamson's approach is the recognition that contracts at this level of detail cannot be written both because we cannot enumerate each possible future contingency at the outset of a relationship and because we are creatures of limited cognitive powers who cannot make such detailed plans. Therefore there will always be some residual contingencies on which any prior contract will be silent. The second component of Williamson's approach is the recognition that actors in economic situations are opportunistic and therefore when they find themselves in such a situation where contracts are silent they will expend resources to make sure outcomes go in their favour rather than that of their partner. [Diehard romantics will say that people in love are not as opportunistic as people in business and therefore my prognosis of Asha and Brajesh's relationship in the absence of commitment was too pessimistic. All I can say to that is, "Amen".]. The third and final component of Williamson's approach is the existence of relationship-specific investments which mean that entities already inside a relationship have fewer options than they had before they entered the relationship.

Williamson sees economic institutions as evolving to provide the most economical solution in the presence of these three forces. If we see different transactions taking place under different institutional structures, for eg. some within a firm compared to others between firms, Williamson in the first instance would have us seek the cause in difference in contract incompleteness, opportunism or the relation-specificity of investments.

Williamson's work which he labels "transactions cost economics" and which he sees as a part of a "New Institutional Economics" is a major component of an effort by economists over the last few decades to better understand the economics of organizations. It has its antecedents in the work on Ronald Coase on the importance of transaction costs and of Herbert Simon on bounded rationality. It is complemented by the work on information economics and mechanism design which looks at conflicts of interests among economic agents and how far they can be addressed by prior contracts (in contrast to Williamson's work which look at the governance mechanism which resolve conflicts once a relationship is in place). At a broader level it is part of a silent revolution in the field of microeconomics, where the supposedly universal verities of neoclassical economics in which firms are black boxes which perfectly maximize profits given technocratic production functions is giving place to a world populated by conflicts, hierarchies, uncertainities and rules of thumb. It is a world where norms, beliefs and institutions matter. It is a much less neater, much less precise a world than Samuelson's paradise. Williamson has hardly used any mathematics in his work and attempts to mathematically formalize the idea of incomplete contracts or bounded rationality have not been very successful so far. But that does not worry the new microeconomics since it is much more empirically-minded than the older microeconomics and looks at not just logic and but also the real world to test its theories. That is how it must be in any science.