Vertical integration, appropriable rents, and the competitive contracting process

More than forty years have passed since Coase's fundamental insight that transaction, coordination, and contracting costs must be considered explicitly in explaining the extent of vertical integration. Starting from the truism that profit-maximizing firms will undertake those activities that they find cheaper to administer internally than to purchase in the market, Coase forced economists to begin looking for previously neglected constraints on the trading process that might efficiently lead to an intrafirm rather than an interfirm transaction. This paper attempts to add to this literature by exploring one particular cost of using the market system – the possibility of postcontractual opportunistic behavior. Opportunistic behavior has been identified and discussed in the modern analysis of the organization of economic activity. Williamson, for example, has referred to effects on the contracting process of “ ex post small numbers opportunism,” and Teece has elaborated: Even when all of the relevant contingencies can be specified in a contract, contracts are still open to serious risks since they are not always honored. The 1970's are replete with examples of the risks associated with relying on contracts … [O]pen displays of opportunism are not infrequent and very often litigation turns out to be costly and ineffectual. The particular circumstance we emphasize as likely to produce a serious threat of this type of reneging on contracts is the presence of appropriable specialized quasi rents. After a specific investment is made and such quasi rents are created, the possibility of opportunistic behavior is very real.