Digitization of Transaction Terms within TCE: Strong Smart Contract as a New Mode of Transaction Governance

Abstract

We use Transaction Cost Economics (TCE) to define the Digitization of Transaction Terms shift parameter that describes institutional changes associated with increased digitization in society. We then draw on legal scholarship to analyze how strong smart contracts, which refer to agreements with automatic execution and enforcement that are not reversible by courts, rely on a new level of Digitization of Transaction Terms. Specifically, they rely on standard digital infrastructures such as blockchain systems that guarantee automatic execution and non-reversibility. Strong smart contracts represent a distinct mode of transaction governance compared to markets, hierarchies, or hybrids. This is because each classic governance mode is distinguished by how ex-post adaptation is handled — through public courts, managerial fiat, or both. In contrast, strong smart contracts prevent ex-post adaptation altogether. We propose that when strong smart contracts can be fully specified, they will dominate other governance modes based on certain tradeoffs. These tradeoffs include weighing the benefits of avoiding the holdup problem and lowering contract enforcement costs against the downsides of high ex-ante specification costs and the elimination of flexibility to make ex-post adjustments in a changing environment. Our discussion elaborates on which institutional conditions can further facilitate this institutional shift.

Keywords: Smart contracts, Blockchain, TCE, Firm Boundaries, Shift Parameter, Digitization