A Paradigm Shift in Comparative Institutional Governance: The Role of Contract in Business Relationships and Cost/Benefit Analysis

Stewart Macaulay’s research on the ways that Wisconsin manufacturers transact debunked the centrality of contract law by revealing a disinclination to consult contract documents or invoke legal sanctions. This research revolutionized contracts scholarship, highlighting that a contract, instead of being viewed as an inevitable necessity of exchange, should be viewed as one of many institutions that might be available to parties as a solution to problems and a method for facilitating exchange. Macaulay’s research further revealed that the cost of legal sanctions, the importance of maintaining business relationships, and the desire for informal solutions actually push parties to conclude that formal contracts are either non-viable or less desirable. Parties, thus, structure their exchanges and adopt governance models that minimize their costs. Macaulay’s insights into the cost minimization paradigm influenced analysis of the role of courts in contractual intervention, committee decision-making, mitigation of opportunistic behavior, and institutional development. Macaulay’s research challenged scholars to reconceptualize contract. Instead of seamlessly and effectively sanctioning breaches, contracts now served as a repository for how-to provisions governing production, a “scaffolding” for inter-organizational cooperation, or a means of cementing relationships through information transfer. His recognition of the importance of self-adjustment and the dysfunction of contract law also led to a burgeoning field exploring customs and norms as “purposive” non-legal solutions to problems. His view also made contract a variable that parties could choose to employ or not. In this new understanding, parties build their relationships with a goal of “keeping the law out,”(L. Bernstein) representing a paradigm shift away from contract as a means for legal and formal enforcement. Macaulay believed that context mattered in business relationships. In cases where relationships are strong, informal adjustment can provide an alternative to contract. Where relationships were weaker and new, as in the innovation context, parties rely on contract in a new way: not to enforce performance obligations, but to build trust and clarify obligations over time. His work in determining why parties rely on informal adjustments rather than formal modifications to contract also helps explain why contracts might remain incomplete. Parties see no need to reach completely contingent contracts when later adjustments could be made informally in changed circumstances. This recognition that the paper contract might fail to capture implicit assumptions (the “real deal”) led to systematic exploration of when and why to fill in these incomplete contracts. Macaulay’s work has encouraged a vast array of important scholarship in the study of contracts and the underlying transactional relationships. For example, his work presaged Bob Ellickson’s analysis of Shasta county cattle farmers engaging in private non-legal solutions to cattle disputes, Lisa Bernstein’s work documenting the efforts of diamond merchants to opt for private arbitration, and Oliver Williamson’s work exploring alternative governance to hierarchy and markets. In addition, Macaulay’s work on how parties make decisions using a comparative weighing of benefits and negative effects encouraged the rich recent scholarship analyzing the arrangements governing external relationships in the supply chain. Lastly, Macaulay inspired scholars to consider a variety of other topics including informal enforcement mechanisms, committee structuring to solve myriad risks, “managerial” provisions that discard the traditional role of contract, and the avoidance of long-term agreements in favor of purchase orders. His insight that the decision to let contracts remain incomplete was based on a cost/benefit analysis of contract and informal practices provided a cost minimization paradigm for how parties structured exchange—work that prefigured current neuroscience research on brain reactions to cost minimization tools. That justificational analysis has widespread implications for understanding business decisions and laid the foundation for later scholarship on decision-making within hybrid organizations. Although not explicitly discussed by Macaulay, he outlined a comparative cost-benefit analysis for when organizations should bypass contracts and resort to alternatives. When this framework is applied to hybrid organizations, litigation and formal contract enforcement is often bypassed in favor of informal resolution due to mutual investments, partnerships, lengthy duration, and entrenched relationships. This article will focus on the reality that parties in exchange seek to control durable problems, such as opportunism, in the least costly way. It will build on Macaulay’s legacy by using a cost minimization lens to explore and to link diverse topics including: (1) organizational and contractual choices in the governance of external relationships using empirical data; (2) legal advice for business clients, given the “use and non-use” of contract law; (3) interactions between non-legal norms and legal sanctions (complement vs. substitute); (4) legal interventions that go beyond the parties’ express terms and contract interpretation; (5) the failure of private networks and the implications for legal enforcement and private counterstrategies; and, more broadly, (6) decisions on when to intervene by statute or leave solutions to private ordering or the common law.