Summary of JOIE article (24 April 2025) by Geoffrey M. Hodgson International Management, Loughborough University London, London, UK. The full article is available on the JOIE website.

Contracts, money, and applications

Part I of this article reviews major differences in definitions by six leading authors of the transaction concept (Hodgson, 2025). Part II develops toward a new approach, starting with the legal notion of a contract. This identifies a narrower and more specific type of transaction, empowered by both legal forces and non-legal or cultural norms or rules. The sharper concept of contracting cost is derived. Contracting costs are the costs of obtaining, formulating, negotiating, and administering legal contracts. They do not include the costs of the work and other inputs required to fulfil a specific contractual agreement. Legal contracts are historically specific phenomena, applying only to modern societies with developed legal institutions. By making the analysis more specific, we emphasize factors of greater relevance in modern market economies.

The concept of contracting cost relies heavily on the legal nature of the contract. We need to understand how contracts function in real world economies and the costs they incur. Alternative contracting arrangements can then be compared. What matters is how the law is interpreted and enforced, and how it guides dispositions and behaviours. A focus on legal phenomena does not imply that other (informal) rules and institutions are unimportant. On the contrary, they are vital to ensure economic cooperation and sustain social order, in systems with or without (state) legal institutions.

A legal contract is a voluntary agreement by two or more parties with the shared intention of creating legally binding obligations. The Oxford Dictionary of Law (Law, 2022, pp. 166-7) defines a contract as a legally binding agreement, resulting from an offer from one party and its acceptance by another, subject to the following requirements:

1. There must be some ‘consideration’, legally meaning an agreed act or payment in return for the completion of the promise of the other party (Law, 2022, pp. 156-7). 
2. The parties must each have an intention to create legal relations, under a single legal authority.
3. The parties must have the legal capacity to contract, thus excluding minors, and those suffering from severe mental disorders, alcohol, or drugs (Law, 2022, p. 96). 
4. The agreement must take an acceptable legal form. Depending on circumstances and precedents, it may be verbal, written, or a mixture of both. 
5. The agreement must itself be legal and not rendered void in law.

These stipulations are found in English common law. Although there are variations from state to state in US common law, the principles are broadly similar. The US-based Merriam-Webster Dictionary of Law defines a contract briefly as ‘an agreement between two or more parties that creates in each party a duty to do or not do something and a right to performance of the other’s duty or a remedy for the breach of the other’s duty’ (Merriam-Webster, 2016, p. 101). Similar stipulations are found in other legal systems, including in Napoleonic law. 

Contracts are voluntary agreements to establish legal relations and mutual obligations. In the five-point legal definition of a contract above, points (1) and (2) are the most important. The law recognises that details in the ‘promise’ specified in (1) can be a matter of dispute. These may result from the limitations of language, the flexibility of interpretation, the impossibility of specifying all conditions or circumstances, and so on. There are also ‘implied terms’ that are unspecified in the agreement, which the law finds good reason to add. All contracts are subject to some imprecision, incompleteness, and uncertainty. 

From this legal starting point, the article goes on to analyse the legal and non-legal pressures that can help to enforce contracts. It is emphasised that legal forces can include moral motivations to obey the law and to keep agreements, as well as the threat of legal sanctions for default. This is line with modern research by Tom Tyler (2006) and others, on why people obey the law. 

Many contracts, under the matter of ‘consideration’ in (1) above involve promises to pay money in return for contracted goods or services. This contrasts with the absence of money in much of economic theory (Hahn, 1980). The stress of the role of money in contracts is in line with the works of John R. Commons (1934).

Sections 5 and 6 apply the concepts of legal contract and contracting cost (as defined above) to two relevant areas of analysis. The first application is to the theory of the firm. It is argued that when a firm is understood as a legal entity, with the power to own property and make contracts with others, many of the pressing questions concerning the nature of the firm and its boundaries are answered (Gindis, 2016; Deakin et al., 2017). 

The second application concerns costs in healthcare systems. Standard ‘transaction cost analysis’ has paid relatively little attention to healthcare. On the other hand, there are several comparative studies of contracting costs in healthcare systems, but these are often in medical journals, and they rarely mention standard transaction cost analysis or its mentors. These empirical studies in healthcare are consistent with the concept of contracting cost promoted in this article. They show that healthcare systems differ widely on their contracting costs. The contract-intensive system in the US is generally found to have the highest overall administrative and contracting costs. 

A law-based approach to transactions was originally suggested but not developed by Harold Demsetz (1968). By focusing on contracting costs, the approach outlined in this article offers a fertile way forward that is rooted in the legal and other realities of modern economic systems. It supersedes the vague and ambiguous concept of transaction cost. 

References

Commons, John R. (1934) Institutional Economics – Its Place in Political Economy (New York: Macmillan). 

Deakin, Simon, Gindis, David, Hodgson, Geoffrey M., Huang, Kainan, and Pistor, Katharina (2017) ‘Legal Institutionalism: Capitalism and the Constitutive Role of Law’, Journal of Comparative Economics, 45(1), February, pp. 188-200. 

Demsetz, Harold (1968) ‘The Cost of Transacting’, Quarterly Journal of Economics, 82(1), February, pp. 33-53.

Gindis, David (2016) ‘Legal Personhood and the Firm: Avoiding Anthropomorphism and Equivocation’, Journal of Institutional Economics, 12(3), September, pp. 499-513. 

Hahn, Frank H. (1980) ‘General Equilibrium Theory’, The Public Interest, Special Issue, pp. 123-138. 

Hodgson, Geoffrey M. (2025) ‘Transactions and Legal Institutionalism: Part I – six leading thinkers’, Journal of Institutional Economics, pp. 1-17, e13. doi:10.1017/S1744137425000049.

Law, Jonathan (ed.) (2022) A Dictionary of Law, 10^th edn. (Oxford and New York: Oxford University Press). 

Merriam-Webster (2016) Merriam-Webster’s Dictionary of Law (Springfield, MA: Merriam-Webster). 

Tyler, Tom R. (2006) Why People Obey the Law, second edn. (Princeton and Oxford: Princeton University Press).