Two main limitations of the TCE contracting schema can be singled out. First, the combination of the two assumptions of bounded rationality and opportunism makes it tenable that exchange relationships would be exposed to hold up under the TCE framework. From a theoretical stand point, it is reasonable to assume that opportunistic agents will almost always take advantage offered by incomplete contracts. Therefore, under this theory‟s incomplete contracting framework, transactions are not adequately protected because opportunistic agents will most likely take advantage of their trading partners. TCE underpinnings therefore fail to fully control for opportunism because its incomplete contract expose transactions to the holdup problem due to potential ex post renegotiations.
Second, despite the above limitation (contract incompleteness), empirical research has found contract use to be prevalent (D'Silva, Uli, & Samah, 2009; Dawes et al., 2009; Fraser, 2005; Goodhue et al., 2003) especially within the agricultural sector, and in particular the wine industry, which is the focus of this research. Frazer (2005) found that 85 per cent of growers in Australia had written contracts and 15 per cent had oral or handshake contracts with wineries; while Goodhue et al., (2003) reported a 90 per cent grape contracting by the California wineries. Further, reviews of TCE empirical studies (Carter & Hodgson, 2006; David & Shin-Kap, 2004) also found that despite contract incompleteness, asset specificity does not always lead to vertical control. This raises the key theoretical question that this research seeks to address, and that is:
What explains the fact that trading parties do not always take advantage of their partner(s)’vulnerability even though contract incompleteness offers them the opportunity to do so?
This question arises because from a theoretical stand point, TCE fails to explain why contracts are still widely used despite the associated exchange hazards arising from bounded rationality and opportunism. The theory not only fails to offer adequate exchange protection due to its incomplete contracting framework but also fails to explain the continued use of contracts despite their vulnerability to hold up. Despite these limitations, TCE cannot be said to be a complete failure when it comes to controlling trading partners‟ opportunism. The limitations suggest that despite the theory‟s exchange protection qualities, opportunism remains a serious threat to exchange relationships. Empirical studies suggest that TCE does indeed provide exchange protection. However, these studies also exhibit the limitations pointed out by the theory itself.
Saussier (2000) tested for the determinants of contractual relationships between French state owned electricity company (EDF) and its coal transporters. The study intended to find out why some contracts are more detailed than others, and why other contracts often leave contracting parties‟ obligations more vague than others. A database consisting of 29 contracts signed between 1977 and 1997 for the transportation of coal to EDF power plants was used for the study. The results showed that contracts characterised by high degree of asset specificity were likely to be more complete than those characterised by low degree of asset specificity. This was meant to protect the specific assets from opportunism, and this corroborates the propositions of the TCE. An interesting observation about this study is that it shows a positive and significant correlation between specific assets and contract complexity. But as has already been stated, contracts are incomplete and despite their complexity, the threat of holdup remains. In spite of this threat, EDF did not internalise the transportation services. This study, did not explain the reasons for EDF‟s continued use of contracts even though they exposed it to holdup by the opportunistic transporters. Hence, like TCE, this study did not shed light on the continued use of contracts regardless of their vulnerability to hold up. Hirschhausen and Neumann (2008) investigated the determinants of the duration of producer- importer contracts under changing technical, economic and institutional conditions (high environmental uncertainty) within the natural gas industry. They found out that duration of contracts involving asset specific investments extend, on average three years longer. What
is not explained by this study is why firms would expose transactions to risk for a further three years.
Hence, what emerges from these studies is that they appear to overly rely on specific terms and conditions in the formal contract as a safeguard against opportunism. Bounded rationality implies that contracts are incomplete, and the current research is of the view that increasing the complexity of the contract on its own would not protect exchange relationships against opportunism. It is against this background that Baker and Krawiec (2006) argue that contract incompleteness may create opportunities for holdup leading to renegotiation as the future unfolds. As this happens, TCE suggests that firms will integrate their transactions as a way of protecting exchange relationships against opportunism (Lyons, 1995). But as already stated, contracts are still widely used. Therefore, like TCE, these studies do not provide an explanation for the continued use of contracts when it comes to exposing transactions to hold up. Therefore, there is a need to develop a theoretical framework that explains the continued use of contract despite their incompleteness. This research will develop a multi-paradigm framework that is believed to protect offer better protection to incomplete contracts and hence explain the continued use of such contracts. The premise for this framework will be that contracting parties do not take advantage of each other‟s vulnerabilities even when incomplete contracts offer them the opportunity to do so because other theoretical underpinnings and mechanisms such as relational norms, monitoring and incentives as well as the threat of litigation complement incomplete contracts and hence help explain the continued use of incomplete contracts. The framework will also help address TCE contractual inadequacies associated with bounded rationality and opportunism.
In summary, TCE advocates for the adoption of a governance form that minimises transaction costs. In particular, it posits that market governance is an efficient governance mode when no specific investments are involved, while hybrid governance is best when transactions are asset specific and there are no costly contractual breakdowns. Once there are contractual breakdowns, TCE suggests that transactions are better protected by assimilating them into a unified structure. However, there are limitations or flaws to the logic informing the TCE exchange protection framework. First, given that agents are opportunistic and contracts are incomplete, transactions are forever exposed to hazards under the TCE framework. Hence, the theory fails to offer complete contractual protection to exchange relationships. Second, since the theory fails to provide adequate contractual stability, it is logical to expect no contractual arrangements in the face of contract incompleteness and the opportunistic agents. Instead,
vertical integration is expected to be the sole governance mechanism when exchange relationships involve specific assets (given the assumptions of bounded rationality and opportunism). However, this is not the case. Relationships continue to be protected through contractual relationships (Fraser, 2005; Goodhue et al., 2003). TCE therefore fails to explain why incomplete contracts are used despite their vulnerability to holdup.
2.3.2 Agency Theory
2.3.2.1 Introduction and Background
Agency theory is concerned with addressing agency problems that arise in relationships or agreements in which one party (the principal) engages another party (the agent) to undertake some function(s) or action(s) on the principal‟s behalf (Bergen, Dutta, & Walker, 1992; Logan, 2000; Worsham & Gatrell, 2005). The ideas embodied within this theory can be traced to the writings of the early economists such as Adam Smith. Writing on the relationship between land owners and their tenants (farmers), Adam Smith (1776 (1869)) argues that the farmers have “a plain interest that the whole produce should be as great as possible, in order that their own proportion may be so” (p. 392). This represents goal alignment between the farmer (agent) and the land owner (principal). However, Adam Smith‟s insights were forgotten for some considerable time and during this time the firm was perceived in neo- classical economics terms, simply as a production function that explains the combination of capital and labour that could be used given some fixed technologies (Kiser, 1999). As discussed in section 2.2, the firm was modelled as “an entrepreneur who maximises profits in an environment in which all contracts are perfectly enforced at no cost (Jensen & Meckling, 1976). However, this view changed within the agency literature following the work of, among others, Ross (1973) on the economic theory of agency. These early works were then followed by the publication of a paper on the Theory of Firm by Jensen and Meckling (1976) which arguably gave prominence to agency theory.