Complex transactions under uncertainty : Brazil's machine tool industry

Drawing on the new institutional economics, the author's study of Brazil's machine tool industry extends an earlier study of the garment industry in two ways. First, it broadens the original study to a second industry, which could either confirm or amend the original conclusions. Second, it looks at the effect of economomic uncertainty and expensive formal means of resolving conflict on an industry where enforceable contracts appear necessary for normal business transactions. The machine tool industry is characterized by longer-term contracts and by commitments of resources to products that could not easily be sold to another customer (asset specificity). More formalistic approaches to law and development would suggest that only a legal system that enforces promises in a"knowledgeable, sophisticated, and low-cost way"would allow transactions in the industry (Williamson). By contrast, the new institutional economics looks at other means of governing agreements -- including what Oliver Williamson describes as"bilateral efforts to create and offer hostages."The results show that, while the Brazilian machine tool industry has suffered from a reduction in protection and the effects of a turbulent macroeconomic environment, long-term contracts form specialized equipment are unexpectedly secure. Responses to an enterprise survey show that problems with formal conflict resolution rank low, although the machine tool industry is characterized both by greater compliance with formal rules and by greater reliance on specific, long-term contracts than the garment industry. In fact, machine tool firms report a higher rate of customers honoring orders and making timely payments than do garment firms. Compliance is indeed assured by a sort of"exchange of hostages."The supplier's hostage is the irretrievable investment of physical and human capital in a product difficult to sell to another customer. The customer's hostage is the specific technology bound up in the machine being produced and a payment system that ensures a substantial sunk investment in the machine by the time of delivery. The only attribute of contracts that is frequently renegotiated is the indexation of payments, motivated by macroeconomic instability. Qualitative evidence suggests that this process adds substantially to transaction costs. Not surprisingly, machinetool producers, like their counterparts in the garment industry, place a high priority on a more stable macroeconomic and policy environment.