Separating Contract from Governance

The purpose of this paper is to demonstrate that governance structure and contractual form are two distinct concepts and that they should not be used interchangeably in both theoretical and empirical studies of transaction cost economics. Specifically, the choice of governance structure does not necessarily determine the choice of contract. The distinction between governance and contract exists because the dual problems of verifying and observing contractual performance result in different types and manifistations of transaction costs, thus requiring different, though certainly not unrelated, transactional solutions. At a very basic level of analysis, the reason for the differential effects of transaction costs on, and the distinction between, governance and contract is simply that problems of verifying typically involve third parties, while problems of observability do not. The presence of a third party to the transaction cost problem of verification necessitates a more extensive framework governing the interactions of the contracting agents and the third party contractual "verifiers" and "enforcers" than do solutions to the transaction cost problems of observability, which often involve only the two contracting parties. Consequently, governance structures best resolve problems of verification and contract enforcement, while contractual solutions best resolve problems of observing, measuring, and monitoring worker activities. An important implication of this analysis is that how researchers do a transaction cost analysis depends on what it is they want to examine. A transaction cost study of governance structures (the boundary problem) is not the same as a transaction cost analysis of contractual form (the agency problem), although both are relevant, related, and interesting problems