Credible Commitments: Using Hostages to Support Exchange
Oliver E. Williamson
The American Economic Review
Another Entry in the Goldstein Law Firm’s Series Entitled:
Summaries of Great Academic Articles on Law, Economics, and Philosophy in Franchising, Distribution and Life
In franchising, credible commitments are created to address the risk of opportunism—e.g., franchisees may be tempted to reduce quality after signing the contract, exploiting the overall reputation of the franchise system.
Economic Theories of Credible Commitments and Their Applicability in Distribution and Franchise Contexts
- General Theory of Credible Commitments
Williamson distinguishes between credible commitments and credible threats, both of which are relevant primarily in the context of irreversible, specialized investments. Credible commitments are reciprocal actions undertaken to support alliances and promote exchange, serving efficiency by safeguarding relationships where opportunism and incomplete contracting may undermine cooperation. Such commitments are especially vital when parties make transaction-specific investments that are difficult to protect through simple contractual or legal mechanisms alone. The study of credible commitments otherwise receives less attention than credible threats, largely due to the assumption that courts efficiently enforce contracts—an assumption Williamson challenges.
Williamson emphasizes “private ordering,” where parties to exchange relationships develop their own governance structures (such as self-enforcing agreements, use of “hostages,” and bonding mechanisms) to manage the risk that one party will act opportunistically after the other commits irreversible assets. The creation of credible commitments is central to such governance structures, as it deters actions contrary to the mutual interest and substitutes for, or supplements, reliance on legal enforcement.
- The Hostage Model
Williamson’s “hostage model” provides a theoretical and formal framework to understand how parties can design contracts that make commitments credible in the presence of transaction-specific investments. The model distinguishes between general purpose (non-specific) and special purpose (specific asset) technologies. Special purpose investments are more efficient for steady demand but involve bigger upfront commitments that are largely unrecoverable in alternative uses (.
The central economic hazard addressed is the risk that, after a party makes such a sunk investment, the counterparty will act opportunistically (e.g., renegotiating terms, cancelling orders). The hostage—some asset or bond that the buyer posts, which the seller may keep in the event of a breach—serves as a private ordering device to align incentives and deter opportunism. For the hostage to be effective, its value and conditions of forfeiture must be structured so that the cost of breaching (or opportunistically exploiting) the contract deters such behavior.
Three types of contracts are analyzed:
Contract I: Buyer owns and assigns specific assets, efficient only if these can be easily redeployed (low asset specificity).
Contract II: Seller invests in specific assets; buyer pays only if demand materializes; buyer suffers no penalty for cancellation, leading to higher prices or suboptimal investment.
Contract III: Buyer posts a hostage, forfeited to the seller upon cancellation, set equal to the sunk investment; this replicates efficient vertical integration, ensuring the more efficient but riskier technology can be used without undue exposure to opportunism.
The model is extended to asset specificity of several types (site, physical, human, dedicated), with the more specific the asset, the higher the associated hazard and the greater the need for credible commitments.
- Application in Distribution and Franchise Contexts
- Distribution Arrangements
In distribution contexts, credible commitments are frequently used to support efficient contracting where one or both parties must commit significant transaction-specific assets (e.g., dedicated distribution facilities, marketing infrastructure). These assets would not be created but for a specific contractual arrangement, and their value is low in alternative uses. To safeguard such investments, parties employ several mechanisms:
Entry Fees/Capital Commitments: Distribution arrangements may require new entrants or prospective buyers to invest in dedicated assets (“entry fee”—such as building or acquiring distribution capacity). This serves as a commitment device, aligning incentives and ensuring that each party has “skin in the game”. The Canadian Petroleum Study described in the document provides evidence that new participants must make capital investments in refining or distribution facilities to be allowed to participate in favorable long-term supply arrangements. Failure to make such investments results in exclusion or less favorable terms .
Territorial and Marketing Restraints: Contracts may include territorial and growth restraints, limiting expansions and third-party sourcing. While often scrutinized under antitrust law, Williamson argues these provisions can serve to maintain symmetrical incentives, avoid defection, and protect dedicated investments, thereby making exchange sustainable and efficient .
Reciprocal Exposure: Bilateral commitment through reciprocal trading (e.g., both buyer and seller investing in specific assets or agreeing to mutual exchange) can provide mutual hostage mechanisms. This mitigates the risk of expropriation and discourages opportunistic renegotiation, as both sides are exposed and, in the event of contract breakdown, retain their own “hostage” (a dedicated asset) rather than transferring it to the other party.
- Franchise Systems
In franchising, credible commitments are created to address the risk of opportunism—e.g., franchisees may be tempted to reduce quality after signing the contract, exploiting the overall reputation of the franchise system (a “demand externality” problem). Williamson discusses Klein and Leffler’s insight that franchisees may be required to make significant transaction-specific capital investments (e.g., lease rather than own the land for their outlet, invest in unique franchise-specific facilities or training). These investments act as hostages: upon breach or termination, the franchisee faces a capital loss greater than what could be gained by cheating (e.g., quality shading).
In more detail:
Franchisee Asset Investments: The requirement that franchisees make non-salvageable investments ensures they have a strong disincentive to act opportunistically because termination will impose a substantial penalty. For example, short-term leases (rather than ownership) may expose the franchisee to capital loss on termination, acting as collateral against cheating.
Termination Penalties: Termination clauses are credible threats only when franchisees have substantial assets at risk—i.e., cheating leads to a real capital loss. Provisions preventing resale, or only permitting resale under tightly controlled circumstances, reinforce this safeguarding effect.
System Governance: The document discusses how franchise systems may establish quality monitoring, implement periodic checks, and structure contracts to ensure compliance and deter free-riding. The system’s overall value is protected by credible commitments backed by hostages and contractual design.
- Tradeoffs: Efficiency Versus Risk (Expropriation, Opportunism)
The economic benefit of such arrangements is that they permit the parties to use the most efficient (but risky) technology or business structure, by mitigating hazards of ex post opportunism through credible commitments. However, the creation of hostages and similar contractual penalties also introduces risks of expropriation or abuse—if not properly balanced, a party may exploit the hostage arrangement opportunistically (e.g., induce default to seize the hostage, or create contract terms that unfairly penalize one side). Therefore, the value, form, and conditions for forfeiting the hostage must be carefully designed so that both parties’ incentives are aligned and neither can unilaterally exploit the situation.
- Private Ordering and Supplementing Formal Legal Enforcement
Williamson argues that formal legal enforcement is often costly or inadequate in the context of contracts involving transaction-specific assets. As a result, parties rely on private ordering—hostages, reciprocal investments, specialized arbitration, and other governance structures—to induce credible commitments and resolve conflicts that are beyond the courts’ effective reach. These arrangements often operate “in the shadow of the law,” but their primary function is to fine-tune incentives in ways that general legal rules cannot.
- Summary and Implications
Hostages and similar private ordering devices are widely used to create credible commitments in contexts where specialized, irreversible investments are at risk.
These mechanisms underpin many non-standard contractual practices in distribution and franchising, such as capital requirements, entry fees, exclusivity and territorial restrictions, and termination penalties.
The economic logic is to align incentives, deter opportunism, and permit the use of more efficient technologies or organizational forms, even though such arrangements may appear restrictive or “unfair” by conventional legal standards.
The theory recognizes that risks of expropriation by either party require careful contract design and, often, supplemental governance structures such as arbitration or bilateral reciprocal arrangements to be effective and justifiable.
All discussion above is directly supported by the cited source material. If more specific detail or examples from the document are required, they may be provided upon request.
Brief Summary
Williamson’s concept of credible commitments, a cornerstone of his transaction cost economics (TCE), refers to actions taken by transacting parties that bind them to a relationship and increase mutual trust. These commitments are necessary when exchanges involve specialized, irreversible investments and a risk of opportunistic behavior by a partner.
The concept is most relevant for long-term contracts where one or both parties have made significant “asset-specific” investments that are not easily redeployable.
The problem of asset specificity
Asset specificity refers to investments that have a higher value within a particular transaction than they would in their next-best use.
For example, a parts supplier might build a specialized machine just for one customer. If that customer suddenly terminates the contract, the supplier is at a disadvantage because the machine is “stuck” and cannot be easily used to serve another buyer. The customer, knowing this, could exploit the situation by demanding a price reduction, a form of post-contractual opportunism.
This risk discourages parties from making such productive investments in the first place, leading to potential economic inefficiency.
The solution: Credible commitments
A credible commitment is a way to protect against opportunism and encourage parties to make specific investments that support a long-term exchange. By providing safeguards, credible commitments make the promises of each party believable, or “credible”.
Williamson’s famous “hostage model” provides a powerful analogy:
In medieval times, two kingdoms could guarantee peace by exchanging royal hostages. Neither side would dare break the peace and harm the other’s royal offspring for fear of their own child being harmed in retaliation.
The “hostages” in the business world are the mutually agreed-upon safeguards that create a predictable outcome and give both parties a vested interest in the relationship’s success.
Examples of credible commitments in business
Companies use various mechanisms to create credible commitments:
Specialized investments: A customer may build a custom facility next to a supplier’s factory. This “site specificity” creates a mutual dependence that discourages either party from walking away.
Equity stakes and joint ventures: A company may take an ownership stake in a key supplier. This aligns the two firms’ interests, as the customer now also has an interest in the supplier’s overall health and profitability.
Reputation: In repeat transactions, both parties have a strong incentive to uphold their agreements to protect their reputation in the market.
Complex contracts: While imperfect, detailed contracts are a way to legally bind parties to their agreements and outline remedies for unforeseen contingencies, thereby reducing uncertainty.
Credible commitments vs. credible threats
Williamson distinguishes between credible commitments, which are reciprocal actions designed to promote an exchange, and credible threats, which are unilateral efforts to preempt an advantage in a rivalry or conflict. For Williamson, the study of cooperative credible commitments is the more fundamental aspect of economic organization.
What are some criticisms of Williamson’s credible commitment theory?
The credibility commitment theory developed by Oliver Williamson is a cornerstone of transaction cost economics (TCE), but it has faced significant criticisms over the years
Critics argue that the theory oversimplifies human behavior and organizational complexity, overlooks important non-economic factors, and struggles to account for the dynamic nature of markets.
Neglect of social factors
Williamson’s credible commitment theory has been criticized for being overly economic and individualistic, neglecting crucial social elements that influence business relationships.
Trust: Critics argue that TCE underestimates the role of social trust, which is often a more powerful and less costly mechanism for ensuring commitment than formal contracts or asset-specific investments. When trust exists, parties are less likely to engage in opportunistic behavior, and complex safeguards may be unnecessary.
Reputation: Beyond simple self-interest, reputation can be a powerful driver of cooperation. A firm’s desire to maintain a good standing in the market can serve as a strong deterrent to reneging on commitments, a factor that is often underemphasized in TCE.
Power dynamics: TCE is often criticized for overlooking the role of power relationships in shaping transaction outcomes. The strategic bargaining process, and the power imbalances within it, can significantly influence how commitments are made and enforced.
Oversimplification of human behavior
The behavioral assumptions underpinning TCE, particularly the notions of “bounded rationality” and “opportunism,” have been challenged.
Narrow view of opportunism: Williamson’s definition of opportunism as “self-interest seeking with guile” has been criticized as being too pessimistic and all-encompassing. This perspective can overlook situations where cooperation and honest dealing are the norm, rather than the exception.
Inadequate account of learning and capabilities: Theories focused on capabilities, such as the knowledge-based view of the firm, argue that organizations are more than just transaction-governing structures. They highlight how firms develop unique capabilities and knowledge through learning and innovation, which can serve as a more fundamental reason for their existence than simply minimizing transaction costs.
Theoretical and practical limitations
Difficulty with empirical testing: Many of TCE’s core concepts, including “transaction costs” themselves, are notoriously difficult to define and measure in a determinate way. This ambiguity can make it challenging to conduct robust empirical research that definitively proves or disproves the theory’s predictions.
Static vs. dynamic contexts: TCE is better suited for analyzing stable, recurring transactions than dynamic, evolving ones. The focus on aligning governance structures with transaction attributes can struggle to account for the constant flux of market changes, innovation, and learning.
Neglect of production costs: Critics argue that TCE’s focus on transaction costs leads it to disregard the role of production costs and efficiency. By fixating on reducing transaction hazards, the theory may miss cases where a firm accepts higher transaction costs in order to achieve greater productive efficiency.
Alternative perspectives
Numerous alternative and complementary theories have emerged to address the perceived shortcomings of Williamson’s credible commitment theory:
Internalization theory: This approach, which shares common foundations with TCE, places more emphasis on market imperfections arising from factors like information asymmetry and weak property rights.
Resource-based view of the firm (RBV): The RBV argues that a firm’s competitive advantage comes from its unique and hard-to-imitate resources and capabilities, rather than just its ability to minimize transaction costs.
Behavioral theory of the firm: This perspective emphasizes how internal organizational processes, routines, and bounded rationality shape decision-making in ways that are more complex and less predictable than TCE suggests.
arm’s-length relationship, where parties seek to limit their commitment and control each other’s actions through contractual terms.
Application: Suitable for simple transactions with low uncertainty, like purchasing a standardized product.
Relational contracts
Relational contracts are best suited for long-term, complex, and highly interdependent relationships where collaboration is key.
Reliance: Heavily on trust and the ongoing relationship between parties.
Completeness: Explicitly acknowledges its own incompleteness. It provides a flexible framework that guides how parties will resolve unspecified issues.
Enforcement: Primarily self-enforced through the desire to maintain a mutually beneficial relationship. It may include formal legal safeguards, but its effectiveness relies on mutual commitment.
Governing principle: Reciprocity and collaborative spirit, driven by the “shadow of the future”—the mutual interest in continuing a productive relationship.
Application: Ideal for joint ventures, strategic partnerships, and complex outsourcing arrangements.
Comparison of key differences
| Aspect | Formal (Transactional) Contracts | Relational Contracts |
| Duration | Short-term or for a single transaction. | Long-term or indefinite. |
| Foundation | Legally binding, written terms. | Trust, cooperation, and social norms. |
| Flexibility | Rigid, attempting to cover all contingencies. | Flexible, allowing for adaptation to changing circumstances. |
| Goals | Focuses on specific obligations and predefined outcomes. | Focuses on shared goals and overall relationship success. |
| Enforcement | Relies on external legal mechanisms (courts). | Primarily relies on self-enforcement through reputation and mutual interest. |
| Disputes | Resolves issues by strictly adhering to the contract’s explicit terms. | Resolves issues through collaborative negotiation guided by principles of good faith. |
The convergence of formal and relational elements
While these concepts are distinct, modern business often features hybrid contracts that combine elements of both. A formal relational contract, for instance, is a written, legally enforceable agreement that also explicitly codifies principles of good faith, shared goals, and collaborative governance mechanisms. This approach provides the stability of a legal framework while still fostering the flexibility and trust of a relational exchange.
Brief Summary
Williamson’s concept of credible commitments, a cornerstone of his transaction cost economics (TCE), refers to actions taken by transacting parties that bind them to a relationship and increase mutual trust. These commitments are necessary when exchanges involve specialized, irreversible investments and a risk of opportunistic behavior by a partner.
The concept is most relevant for long-term contracts where one or both parties have made significant “asset-specific” investments that are not easily redeployable.
The problem of asset specificity
Asset specificity refers to investments that have a higher value within a particular transaction than they would in their next-best use.
For example, a parts supplier might build a specialized machine just for one customer. If that customer suddenly terminates the contract, the supplier is at a disadvantage because the machine is “stuck” and cannot be easily used to serve another buyer. The customer, knowing this, could exploit the situation by demanding a price reduction, a form of post-contractual opportunism.
This risk discourages parties from making such productive investments in the first place, leading to potential economic inefficiency.
The solution: Credible commitments
A credible commitment is a way to protect against opportunism and encourage parties to make specific investments that support a long-term exchange. By providing safeguards, credible commitments make the promises of each party believable, or “credible”.
Williamson’s famous “hostage model” provides a powerful analogy:
In medieval times, two kingdoms could guarantee peace by exchanging royal hostages. Neither side would dare break the peace and harm the other’s royal offspring for fear of their own child being harmed in retaliation.
The “hostages” in the business world are the mutually agreed-upon safeguards that create a predictable outcome and give both parties a vested interest in the relationship’s success.
Examples of credible commitments in business
Companies use various mechanisms to create credible commitments:
Specialized investments: A customer may build a custom facility next to a supplier’s factory. This “site specificity” creates a mutual dependence that discourages either party from walking away.
Equity stakes and joint ventures: A company may take an ownership stake in a key supplier. This aligns the two firms’ interests, as the customer now also has an interest in the supplier’s overall health and profitability.
Reputation: In repeat transactions, both parties have a strong incentive to uphold their agreements to protect their reputation in the market.
Complex contracts: While imperfect, detailed contracts are a way to legally bind parties to their agreements and outline remedies for unforeseen contingencies, thereby reducing uncertainty.
Credible commitments vs. credible threats
Williamson distinguishes between credible commitments, which are reciprocal actions designed to promote an exchange, and credible threats, which are unilateral efforts to preempt an advantage in a rivalry or conflict. For Williamson, the study of cooperative credible commitments is the more fundamental aspect of economic organization.
What are some criticisms of Williamson’s credible commitment theory?
The credibility commitment theory developed by Oliver Williamson is a cornerstone of transaction cost economics (TCE), but it has faced significant criticisms over the years
Critics argue that the theory oversimplifies human behavior and organizational complexity, overlooks important non-economic factors, and struggles to account for the dynamic nature of markets.
Neglect of social factors
Williamson’s credible commitment theory has been criticized for being overly economic and individualistic, neglecting crucial social elements that influence business relationships.
Trust: Critics argue that TCE underestimates the role of social trust, which is often a more powerful and less costly mechanism for ensuring commitment than formal contracts or asset-specific investments. When trust exists, parties are less likely to engage in opportunistic behavior, and complex safeguards may be unnecessary.
Reputation: Beyond simple self-interest, reputation can be a powerful driver of cooperation. A firm’s desire to maintain a good standing in the market can serve as a strong deterrent to reneging on commitments, a factor that is often underemphasized in TCE.
Power dynamics: TCE is often criticized for overlooking the role of power relationships in shaping transaction outcomes. The strategic bargaining process, and the power imbalances within it, can significantly influence how commitments are made and enforced.
Oversimplification of human behavior
The behavioral assumptions underpinning TCE, particularly the notions of “bounded rationality” and “opportunism,” have been challenged.
Narrow view of opportunism: Williamson’s definition of opportunism as “self-interest seeking with guile” has been criticized as being too pessimistic and all-encompassing. This perspective can overlook situations where cooperation and honest dealing are the norm, rather than the exception.
Inadequate account of learning and capabilities: Theories focused on capabilities, such as the knowledge-based view of the firm, argue that organizations are more than just transaction-governing structures. They highlight how firms develop unique capabilities and knowledge through learning and innovation, which can serve as a more fundamental reason for their existence than simply minimizing transaction costs.
Theoretical and practical limitations
Difficulty with empirical testing: Many of TCE’s core concepts, including “transaction costs” themselves, are notoriously difficult to define and measure in a determinate way. This ambiguity can make it challenging to conduct robust empirical research that definitively proves or disproves the theory’s predictions.
Static vs. dynamic contexts: TCE is better suited for analyzing stable, recurring transactions than dynamic, evolving ones. The focus on aligning governance structures with transaction attributes can struggle to account for the constant flux of market changes, innovation, and learning.
Neglect of production costs: Critics argue that TCE’s focus on transaction costs leads it to disregard the role of production costs and efficiency. By fixating on reducing transaction hazards, the theory may miss cases where a firm accepts higher transaction costs in order to achieve greater productive efficiency.
Alternative perspectives
Numerous alternative and complementary theories have emerged to address the perceived shortcomings of Williamson’s credible commitment theory:
Internalization theory: This approach, which shares common foundations with TCE, places more emphasis on market imperfections arising from factors like information asymmetry and weak property rights.
Resource-based view of the firm (RBV): The RBV argues that a firm’s competitive advantage comes from its unique and hard-to-imitate resources and capabilities, rather than just its ability to minimize transaction costs.
Behavioral theory of the firm: This perspective emphasizes how internal organizational processes, routines, and bounded rationality shape decision-making in ways that are more complex and less predictable than TCE suggests.
arm’s-length relationship, where parties seek to limit their commitment and control each other’s actions through contractual terms.
Application: Suitable for simple transactions with low uncertainty, like purchasing a standardized product.
Relational contracts
Relational contracts are best suited for long-term, complex, and highly interdependent relationships where collaboration is key.
Reliance: Heavily on trust and the ongoing relationship between parties.
Completeness: Explicitly acknowledges its own incompleteness. It provides a flexible framework that guides how parties will resolve unspecified issues.
Enforcement: Primarily self-enforced through the desire to maintain a mutually beneficial relationship. It may include formal legal safeguards, but its effectiveness relies on mutual commitment.
Governing principle: Reciprocity and collaborative spirit, driven by the “shadow of the future”—the mutual interest in continuing a productive relationship.
Application: Ideal for joint ventures, strategic partnerships, and complex outsourcing arrangements.
Comparison of key differences
| Aspect | Formal (Transactional) Contracts | Relational Contracts |
| Duration | Short-term or for a single transaction. | Long-term or indefinite. |
| Foundation | Legally binding, written terms. | Trust, cooperation, and social norms. |
| Flexibility | Rigid, attempting to cover all contingencies. | Flexible, allowing for adaptation to changing circumstances. |
| Goals | Focuses on specific obligations and predefined outcomes. | Focuses on shared goals and overall relationship success. |
| Enforcement | Relies on external legal mechanisms (courts). | Primarily relies on self-enforcement through reputation and mutual interest. |
| Disputes | Resolves issues by strictly adhering to the contract’s explicit terms. | Resolves issues through collaborative negotiation guided by principles of good faith. |
The convergence of formal and relational elements
While these concepts are distinct, modern business often features hybrid contracts that combine elements of both. A formal relational contract, for instance, is a written, legally enforceable agreement that also explicitly codifies principles of good faith, shared goals, and collaborative governance mechanisms. This approach provides the stability of a legal framework while still fostering the flexibility and trust of a relational exchange.
