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Contract enforcement across cultures.

Introduction

The majority of the literature in economics and management on contract enforcement has focused on the use of formal, legally enforceable agreements. Recently, Barney (1990) and Noorderhaven (1992) have analyzed the important role of uncertainty and how this may often lead to different types of agreements from the formal, legally enforceable ones. Noorderhaven notes that a major difference between the economists' agency theory approach and the sociologists' approach to organizations is that economists assume an individual utility maximization function, but this assumption can often fail to help explain various types of agreements that are prevalent in the real world. Choi (1993) has also touched upon these ideas with applications to examples in Eastern Europe.

The economists' agency theory approach to legal-contract enforcement has been discussed in such works as Jensen and Meckling (1976), Baiman (1982), Choi and Maldoom (1992). However, it has been shown empirically by Macaulay (1963) and Beale and Dugdale (1975) that legal enforcement only plays a minor role in actual business agreements. In contrast to such legal-contract enforcement, Schelling (1960) in his classic work and, more recently, Williamson (1983) have developed the ideas of non-standard contracts, whereby mutual 'hostages' create incentives for contract enforcement:

'The ancients exchanged hostages, drank wine from the same glass to demonstrate the absence of poison, met in public places to inhibit the massacre of one by the other, and even deliberately exchanged spies to facilitate transmittal of authentic information.' (Schelling 1960)

The purpose of this paper is to analyze actual examples of how mutual hostage arrangements help contract enforcement. This analysis is carried out using examples from three regions of the world: Eastern Europe, East Asia and Southeast Asia.

Organizations and Eastern Europe

One important distinction about transactions within Eastern Europe may be the lack of legal enforcement of contracts. As noted by Olson (1992), legal enforcement of contracts and property may be key factors in future business arrangements with Eastern Europe:

'Many of the gains from trade cannot, however, be attained through spot transactions. They require legal and governmental institutions that guarantee, among other things, individual rights to impartial enforcement of contracts and property. The order in Soviet-type societies came from administration -- from official discretion -- rather than from the rule of law.' (Olson 1992)

In Eastern Europe, the enforcement of business contracts has been somewhat discretionary, carried out by government administration rather than by a fixed rule of law. This kind of random discretion has, in turn, discouraged foreign firms from undertaking business ventures with Eastern European firms. Enforcement of contracts has always been more difficult in international transactions than in domestic ones. In Eastern Europe, this problem has become magnified the more blurred the distinction has become between the private and public sector.

Lipson (1991) has analyzed in detail the various issues that generally make international agreements difficult, and why informal, rather than legal or formal agreements are often used. Olson (1992) has noted that Eastern European economies contain many types of illicit, semi-licit, informal and implicit markets. They are in stark contrast to the smoothly functioning markets advocated by traditional neoclassical economic analysis. As noted earlier, we believe that organizations in Eastern Europe have responded to such conditions by engaging in transactions that involve mutual hostages. As noted by Schelling:

'. . . in a lawless world that provides no recourse to damage suits for breach of unwritten contracts, hostages may be the only device for partners to strike a bargain.' (Schelling 1960)

Countertrade and Hostages

Countertrade, which comprises over one third of all Eastern trade may be one type of 'organizational' response to the lack of legal institutions and enforcement. There are four major types of countertrade: barter, offsets, counterpurchase and buybacks. Barter is the direct exchange of goods between two parties, without foreign exchange. Counterpurchase is the promise of one party to purchase goods at a later date in return for accepting goods at the present time. Buybacks occur where one party provides an input into the production process of another party, in return for promising to purchase a proportion of the resulting output. Offsets take place when a seller partially offsets the costs of the buyer by agreeing to subcontract or co-produce with the buyer. Caves and Marin (1992), in their detailed empirical work, have shown that despite the liberalization and opening up of Eastern European societies, countertrade continues to play a key role in business relations between Eastern European firms and those of other countries.

All types of countertrade have a 'hostage' aspect in that there is a link in the transactions between the parties involved. It is this hostage element which in turn allows organizations or firms to reach a non-legal agreement to trade. Such hostage situations tend to be of a 'bilateral' nature, with only the involvement of the two parties. Most of the economics literature on agreements and legal enforcement has tended to show the advantages of legal enforcement, especially in a multilateral setting, where many organizations or parties are involved. In reality, though, many agreements tend to be of a bilateral rather than a multilateral nature. We now analyze two major types of countertrade: buybacks and offsets.

Buybacks

Buybacks, are a type of contractual joint venture in which two organizations or parties provide some inputs to a production process and the good produced is allocated to the two organizations in pre-arranged fixed proportions. An example of a typical buyback is the case of Japan's Mitsui Corporation, which provided $1.5 billion dollars worth of capital and technology for a fertiliser plant in Eastern Europe. Mitsui then bought back part of the output in this plant as part of its buyback agreement.

The hostage in this type of agreement is that part of the resulting output which is 'shared' between the two organizations. The quality of the output is dependent on the technology supplied by Japan's Mitsui Corporation, and the labour force supplied by the Eastern European firm. In Eastern Europe, there is usually no legally enforceable mechanism for writing a contract conditional on the quality of either input, technology or labour.

The advantage of the buyback business arrangement is that revenue is more responsive to changes in quality. In a standard type of joint venture, if one of the organizations or parties deviates, i.e. because of opportunism (Williamson 1983) the two parties can change the allocation between the markets. Under the buyback arrangement, there are stronger incentives to maintain the quality of inputs, since the parties are subject (Schelling 1960) to a greater potential loss of profit should they reduce the quality of inputs. Buybacks thus provide a far more powerful commitment than is possible under the traditional, free trade, market allocated contract.

This means of overcoming opportunism is, of course, not the only explanation for the high prevalence of buybacks in Eastern Europe. Other plausible reasons would include resource scarcity, a lack of marketing experience by Eastern European firms, and external coordination by supervisory bureaus. Some of these other issues have been analyzed in Choi and Maldoom (1993). We believe that the lack of legal enforcement of business contracts between organizations, has created a need for a non-standard contract, similar to the 'hostage' idea developed by Schelling (1960) and Williamson (1983). In a sense, buybacks are a good example of how organizations have responded to different environments.

Offsets

The other major type of countertrade is offsets. The purpose of an offset is to compensate the buyer of a good for some of the costs of purchase through other ancillary transactions. There are two major types of offsets. Direct offsets involve ancillary transactions in goods related to the one purchased; for example, licensing and joint ventures of product components. Indirect offsets involve goods or services which are not directly related to the good purchased.

In an offset contract, the seller incurs an obligation to generate an ancillary transaction of a certain value to offset the initial buyer's capital expenditures. In some cases, this can be over 100 percent of the original transaction. An example of a typical offset contract was the purchase of civilian aircraft by Yugoslavia from McDonnell-Douglas. This was offset by the purchase by McDonnell-Douglas of Yugoslav ham.

Offsets, which often involve defence-industry purchases are very large and usually last for several years. The long-term nature of these contracts raises the possibility of opportunism occurring whereby the agreement is broken before the whole transaction has been completed. For example, McDonnell-Douglas has to make substantial fixed investments in order to build planes for Yugoslavia. If Yugoslavia were to accept the first few planes and then break the relationship, McDonnell-Douglas would have no legal recourse.

In this example, the Yugoslavian hams are the 'hostages'. Yugoslavia has the additional benefit from ham sales which it would lose by reneging on the contract. Thus the offset contract provides incentives to the purchaser to abide by the agreement, despite a lack of legal enforcement. Offsets raise the general commitment problem between organizations over a long period of time. From governments to central banks, it is well known that what is the optimal policy choice at a certain point in time is not necessarily optimal when it actually comes to carrying out the policy; a topic analyzed initially by Kydland and Prescott (1977). Offsets and other large, long-term investments can last for considerable periods of time, which may be longer than the term of most governments. It is a feature of many constitutions that administrations cannot bind the actions of successive administrations.

Informal Contracts in East Asia

In this section, examples of informal contracts and agreements in an East Asian context are analyzed. East Asia is here defined as Japan, Korea, Taiwan, Hong Kong. Reputation, whether it be personal or the reputation of a firm or organization, can often play an important role in reaching agreements in East Asia: '. . . it is common for Lia-Ka Shing, Hong Kong's wealthiest businessman to agree to deals of hundreds of millions of dollars without a written contract . . .' (Fortune 1992). Lia-Ka Shing, Hong Kong's wealthiest billionaire businessman has become famous for his success in business deals throughout the world. One aspect of his business philosophy is his use of informal, or verbal contracts. Some of Lia-Ka Shing's largest business deals have been done without a written legal contract.

Although it is difficult to generalize across East Asia, it is commonly acknowledged that East Asian organizations or firms tend to place less emphasis on the use of written, or formal, legal contracts than their Western counterparts. Instead of formal contracts greater reliance is placed on a person or firm's reputation. As noted by Camerer and Vepsalainen (1988), reputation like any other asset, is more valued if it can be used in future interactions with other persons, organizations, or firms. The East Asian informal contract approach views the relationship over a much longer time horizon. As noted by Whitley (1990): '. . . the extensive use of sub-contracts in Japan involves much greater trust and sense of mutual obligation between the parties than simple spot market transactions.' Japanese firms such as Toyota often share technical information with their suppliers, exchange managerial staff, and thus create informal, but long-term commitments. In East Asian businesses and organizations, the notions of 'losing face' and personal obligation to the commitment may be stronger enforcement mechanisms than a western style formal, legal contract which tries to include all possible contingencies.

The concept of life-time employment, which is most widely seen in Japan, and also to a lesser degree in other Asian countries can also signal to other organizations that an employee has the incentive to establish and maintain a reputation and thus not renege on past commitments. When there is low employee turnover, or even life-time employment, managers, in turn, tend to make smaller distinctions between the firm or organization's reputation and their own personal reputation.

In a sense, the East Asian emphasis on reputation, whether it be the reputation of the firm or the manager, shows how important it is in affecting corporate culture and performance. The homogeneity of culture in East Asian countries such as Japan or Korea, may in turn allow the greater use of cultural rules or norms, allowing reputational effects to play a more important role in interactions between organizations, or between firms and consumers. The Japanese tradition of singing the company song every day, or of company employees training together in camps, all help to develop a strong loyalty to the corporate culture and rules of their organization.

The firm or organization's overall collective reputation is a public good, from the viewpoint of an individual employee. Thus, an individual employee can negatively affect a firm's overall reputation, including that of other employees, by reneging on a commitment, but will only suffer part of the costs him or herself. By having strong corporate cultures, Japanese organizations reduce such free riding incentives. Employees see the firm's overall reputation as their own personal reputation, because such negative effects are closely felt by all employees. In this sense, the firm or organization is a 'hostage', providing individual employees to uphold commitments and trust.

History and Reputation

History can play an important role in agreement in East Asia. In Korea, it is common for people who have recently met to inquire about the history of their names, families, or ancestors. In Japan, it is common for firms to advertise their age or history, or the number of generations that a particular firm has been run by a particular family. Such linkages to the past, in turn can play a role in interactions and agreements between organizations and people.

In a world of imperfect information, the history of a firm or organization can convey information about the firm and its products. A firm's history or age, e.g. established in 1889, provides consumers with the implicit information that it has survived or continued to be successful for a long time, by the mere fact that it is still existing; that, regardless of what the business environment was like in the past, the firm has been able to compete with rivals, while still providing a product of a quality that has satisfied consumers.

History may also play an important role for European or American firms in industries where high quality is especially important. For example, traditional Swiss watch firms tend to state in their advertising the year in which they were rounded -- a strategy also often used by famous jewellery firms. In this way, the firm's 'past' customers help to provide the firm's present or potential customers with a guarantee that the product will be of high quality. On the other hand, in certain industries, such as high technology computer industries, it may actually be an advantage for the firm to be young, because the desired image is one of a small, innovative firm.

The importance of firms' history and tradition is also evident in the reaction of East Asian consumers to various European firms such as Louis Vuitton, Chanel, Gucci which produce luxury goods. That these firms have attracted a major market in East Asia may, of course, be due to the prestige related to such famous brand names. However, there is also the implicit belief that past consumers have already tried the products over a long period of time and have been satisfied with them. European consumers may also be seen as being more knowledgeable about such luxury products, thereby strengthening confidence in the product.

Ethnicity as Enforcement in Southeast Asia

Southeast Asia is defined here as the ASEAN countries, including Singapore, Brunei, Philippines, Thailand, Indonesia and Malaysia. It is a well-known fact, documented in such works as Jesudason (1990), that ethnic Chinese businessmen dominate business and economic affairs throughout Southeast Asia. This is despite the fact that in most of the countries they form only a minority of the population.

In Southeast Asia, people of ethnic Chinese origin have created an informal club, with its own rules of conduct, including the enforcement of informal contracts. Landa (1981) has analyzed the important question of whether, in the real world of contract uncertainty, people care who they trade with, in contrast to the impersonal exchange between anonymous traders that may exist in an ideal world of perfect contract certainty. Landa's works show that in societies where the legal framework is underdeveloped, club-like arrangements may serve as alternatives to explicitly enforceable contracts. Examples from Southeast Asia show that a person's ethnic origins may be the primary factor for acceptance in such a club:

'The calculus of relations, is an informally efficient screening device, because it enables an ethnically homogeneous middleman to pick up nonprice market signals directly from social characteristics of the potential trading partners (such as kinship, distance, ethnic identity, etc.), and hence predict the contractual behaviour of his potential trading partner with a high degree of accuracy.' (Landa 1981)

The analysis is a further application of Schelling's (1971) and later Spence's (1974) works on how individuals send signals to provide information or tacitly communicate that they are dependable, or of high quality. Because all the members of the club are ethnically homogeneous and, consequently, share similar cultural values, it is also easier to receive compensation if any of the members were to 'cheat' on an agreement. Homogeneity and standardization such as that among the ethnic Chinese helps to overcome the free-rider problem that occurs in club arrangements.

For example, if one member cheats on quality or reneges on a commitment, then the whole club is blamed, and there are negative repercussions on all members. Where there is homogeneity or standardization, there is an incentive for all members to monitor each other's behaviour. Because behaviour is standardized, it is much easier to 'identify' any deviations from the standards, norms or traditions of the club.

The more standardized or homogeneous the membership becomes, the greater are the effects of negative reputational externalities when one member cheats. The greater the standardization, the greater is the tendency for non-club members to generalize about the quality of the club members' products, and maintaining high standards and behaviour enhances the reputation of all club members. This reputational capital, which equates with the reputation of the ethnic Chinese businessmen's club, in turn allows efficient informal contract enforcement and economizes on the costs of legal contract enforcement and of acquiring information.

Members of any club have incentives to be opportunistic, or when they feel their cooperation is coming to an end. This is a well-known issue involving any types of cooperation or agreements among parties. However, as noted by Olson (1991), human interactions normally provide indefinite benefits; and the date of one's death is usually unknown. In the case of ethnic Chinese businessmen, opportunism may be avoided, even after death. This is because a businessman's descendants and relatives are indirectly linked to the club membership. Deviant and opportunistic behaviour is avoided not only because of personal punishment, but because families can be held liable for such behaviour. Such strong family and ethnic ties in turn help to create an efficient system of informal contract enforcement, which has led to the continuing dominance of the ethnic Chinese in Southeast Asian business.

Conclusions

In management research, there has been a growing interest in the different approaches to contract enforcement agreements. Examples of recent works include Noorderhaven (1992), Choi (1993), and Choi and Hilton (1994). The economics approach has focused on agency theory, and the assumption of individual profit maximization. The more sociological and management based approach has emphasized norms, traditions, and various aspects of informal agreements. The purpose of this paper was to try and address some of these various informal types of agreements, using the non-standard 'hostage' contracts first analyzed by Schelling (1960) and later by Williamson (1983). Such informal enforcement methods are analyzed using examples from different parts of the world: Eastern Europe, East Asia and Southeast Asia.

Schelling's (1960) hostage approach to agreements and contracts introduced the idea that agreements could be facilitated with hostages, or where both parties have a 'mutual' incentive to uphold their commitments. The analysis was developed with examples of how agreements are reached and enforced in Eastern Europe, East Asia and Southeast Asia. A common phenomenon in Eastern Europe is the wide use of countertrade, which is shown to be partly a response by organizations and firms to the lack of formal, legal enforcement and institutions. Countertrade provides a hostage type of mechanism which can help to ensure that agreements will be upheld.

In East Asia, it was shown that informal agreements may be due to the greater reliance in such countries on reputation, and long-term relationships between parties. The concepts of trust, norms and obligations play an important role in reaching agreements. In this sense, individual or firm reputation, can be seen to be also a type of hostage arrangement in that there are incentives not to renege on commitments. In Southeast Asia, the ethnic Chinese, through their close club relationships, have continued to dominate the economies of that region.

We believe that further empirical and theoretical work in this general area is warranted. One area would be a more empirical study of some of the major ideas introduced in this paper. Another would be a more in-depth comparison of these informal, 'hostage' approaches to agreements in Eastern Europe, East Asia and Southeast Asia with the more formal, legal enforcement systems present in Western Europe and the United States.

Note

* Some of the basic ideas in this paper originated from discussions with Thomas C. Schelling. A number of the ideas in this paper were presented at a research seminar at Templeton College, Oxford. All errors and shortcomings are of course, my own.

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Chong Ju Choi City University Business School, London, England.
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Date:Dec 22, 1994
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