Opportunism, Appropriable Quasi-Rents, and Exploitative Exchange

The next task is to consider how these attributes of transactions, together with the conditions of bounded rationality and opportunism, create the conditions for exploitative exchange.

The fundamental transformation is a ubiquitous phenomenon; the main reason it occurs is that it permits transactions cost economies. One of the most important of these involves the development of valuable but relatively transaction-specific assets (both physical and human) that accompany a long­term commercial relationship. A supplier becomes intimately familiar with the needs of his customer. The supplier builds equipment or facilities to ser­vice a particular customer, and these investments cannot be easily redeployed. The purchaser finds he cannot easily purchase a particular input, tailored to his specifications, from another source of supply. Search costs would be quite high, alternative sources of supply would have to be developed from scratch, and production and sales would be disrupted. As contracts are periodically renewed, learning-by-doing economies are realized, and personal relation­ships among both principals and subordinates develop. These personal rela­tions permit effective communication and foster trust. Once this fundamen­tal transformation is under way, other bidders are effectively shut out.

When assets are nonspecific and transactions are frequent, the funda­mental transformation does not occur, even if the parties repeatedly deal with one another. Wheat is a relatively nonspecific commodity (both physically and Iocationally) and is frequently purchased by its customers. If a particular grain supplier sells frequently to a particular miller, it is because each party effectively competes on a regular basis with alternative purchasers and sup­pliers. However, most transactions are not like these wheat transactions. Most are supported in some way by relatively specific assets. Some of the value of these specific assets constitutes what have come to be called quasi-rents. In an important article on vertical integration written in the late 1970s, Klein, Crawford, and Alchian explain this concept and the related concept of appro­priable quasi-rents as follows: “Assume an asset is owned by one individual and rented to another individual. The quasi-rent value of the asset is the excess of its value over its salvage value, that is, its value in its next best use to another renter. The potentially appropriable specialized portion of the quasi-rent is that portion, if any, in excess of its value to the second highest- valuing user” (1978, 298).

To illustrate, suppose that the amortized fixed cost of a roller-skating rink is $500 a day and that a particular rink operator is willing to pay that much to lease it from its owner. Suppose, further, that the next most valuable use for this building is as a warehouse and that there are a number of warehouse operators would pay $ 100 a day (but no more) for it. This represents the sal­vage value of the asset. The difference between the revenue that the asset actually generates and the asset’s salvage value is the quasi-rent (in this case, $400).

If this rink operator is the only rink operator in town, the entire quasi­rent is vulnerable to appropriation by the leaseholder.

It might be thought that value of the asset has been reduced (and along with it, the quasi-rent) because conditions in the roller-skating industry have changed for the worse and that therefore there has not been a massive appro­priation of a quasi-rent. But the reader, like the owner of the building, does not know all of the details. The rink operator has recently fired his entire workforce and hired his family to replace them. He hired his wife as the bookkeeper for an annual salary of $38,700, although the going rate for bookkeepers is about $20,000. He has hired his five children to work in the concession stand, skate rental shop, and so on for $30,000 each per year, although the going rate for that labor is about half that. He hired his mother to play the organ for $75,000 a year; organists, suppose, make about $45,000. All this information is private and/or too costly for the owner of the building to obtain. All he sees is an audited financial statement, which supports the operator’s claims. This asset (the building) still has quasi-rents associated with it; they have simply been appropriated by the operator’s family—or the oper­ator himself, to the extent that he gets kickbacks from his family members.

This opportunistic appropriation of quasi-rents is a instance of economic exploitation. To see why, recall that an exploitative exchange is one in which a person does not get the value of what he gives up in an exchange and is in a position in which he has no real alternative but to make that exchange.

Suppose now that the story is changed a little. Assume that there is another rink operator in town who would be willing to pay $300 a day to rent the building. The quasi-rent remains at $400 a day, since the value in the next best use (which is still as a warehouse) remains at $100 a day. However, now only $200 of that quasi-rent is appropriable; if the renewal offer fell below $300 a day, the owner of the building would simply rent it to the other oper­ator. The rest of the quasi-rent is effectively protected by the existence of the potential competitor.

It might be thought that in either case, no owner would be so stupid as

to make such a deal initially. Because of the specialized value of the asset, he would insist on a much longer lease, or else he would require a penalty for nonrenewal before a certain time or the like. Suppose, then, that he has a thirty-year lease with the original operator. He could still have his quasi­rents appropriated by the lessee. The operator could simply state that the contract must be renegotiated because business has fallen off; unless the terms are altered, he will be forced out of business and thereby default on the lease.¹⁸

In principle, there are many possible solutions to the moral hazard prob­lem that this case poses.

Let us return for a moment to the original story. Suppose the building owner has his quasi-rents appropriated. He gets out of the business (too many sharks in the roller-skating industry for him), and the bank is left with the property. They then sell it—to the operator! At this particular roller-skating rink, then, there has been vertical integration. Imagine now that there are many different types of relationships between rink operators and building owners across the land. Suppose, however, that all relationships other than vertical integration are subject to such serious moral hazards that only the vertically integrated operations thrive. As time goes on, there are fewer and fewer of any other type of operation. People who are interested in getting into the business do some research and find that operators who own their own buildings tend to do much better than those who do not, so they figure that must be the best way to do it. They need not understand why that is so, but they imitate successful operations by owning the building themselves. In a few years or a few decades, all rinks are operator-owned.

This story has all the elements of a free enterprise thriller: appropriable quasi-rents, opportunism, exploitation, the extinction of a pattern of asset ownership, and the ascendancy of a better adapted pattern. With the passage of time, the quasi-rents of the relevant assets are protected and thus no longer appropriable, and justice reigns.

It is now possible to give a general statement of what makes exploitative exchanges possible in any market economy. Essentially, it is the following four facts:

1. The assets that support many exchanges are relatively specialized and thus have quasi-rents associated with them.

2. These assets get locked into a specific transaction or series of transac­tions in the sense that they are costly to redeploy once they are com­mitted. (This is the fundamental transformation.)

3. Owners of specialized assets suffer from bounded rationality, and they make transactions in an environment in which not all future contin­gencies can be foreseen.

4. Trading partners are sometimes given to opportunism—specifically the appropriation of quasi-rents, if and when quasi-rents are appropriable. The extent to which people are given to opportunism varies from per­son to person and is generally not knowable beforehand.

If any of these conditions (quasi-rents from relatively specific assets, the fundamental transformation, bounded rationality and uncertainty, and opportunism) were absent, it is unlikely that exploitation would occur. Con­sider each in that light, in reverse order.

First, if people had no penchant for opportunism, a “general clause” con­tract would suffice to prevent exploitation. This is a contract containing a clause to the effect that all parties will disclose all materially relevant infor­mation and act in a cooperative manner (Williamson 1985, 66). These clauses mean little in a world where people are given to opportunism and the extent to which they are so given is unknown—in other words, a world in which there are both lawyers and the need for lawyers.

Second, if rationality were unlimited and all future contingencies and their probabilities were foreseeable, all bridges could be crossed in advance in the contract. In other words, the contract would detail every contingency and specify how each party is to act in the face of that contingency. The terms of the exchange would reflect knowledge of the probabilities that these con­tingencies would eventuate.

Third, if transactions supported by relatively specific assets were fre­quently entered into with a variety of different parties, there would be “real alternatives” for the owners of these assets in the event that trading partners tried to appropriate their quasi-rents. In other words, if the assets were spe­cialized but there were a number of other potential users to whom it was just as valuable, the quasi-rents would not be appropriable.

Finally, if the assets involved were so nonspecific that they had another use that was just as valuable as their customary use, there would be no quasi­rents to appropriate. On either of the latter two scenarios, the assets are eas­ily redeployable, either to other uses or other users; they are what Williamson calls “assets on wheels,” and their owners cannot be exploited.

These four facts make exploitative exchange possible in any market econ­omy. One dimension along which types of market economies vary is how well their characteristic organizational forms deal with this potential for exploita­tion. The purpose of the next three chapters is to compare a free enterprise and market socialist system on precisely this point.