Separating Contract from Governance

Abstract

This paper contends that there is an important distinction between governance structure and contractual form, and that organizational boundaries, defined by governance structures, need not explain contractual form. The basic idea is that governance refers to the general environments and instruments that structure and "govern" specific terms of trade negotiated in "contracts." Problems of verifiability and observability of contractual performance are hypothesized to drive the differential effects on governance structure and contractual form. Spefically, transaction cost factors known to result in employment as a general governance structure do not automatically result in contracts characterized by the payment of fixed-wages. Instead, incentive pay and the delegation of decision-making authority to workers may be preferred by firm owners. The paper proposes that the relationship between a firm and a worker involves a two-part decision-making framework in which one choice is the type of governance that structures the second choice regarding the specific characteristics of the contract linking the worker to the firm.

JEL Classification: D23, L2