Our ability to empathize and therefore sympathize with others is also diminished when hard is counterfactual in nature. Suppose B undertakes an act that does not reduce A’s welfare from what it is presently, but fails to increase it by as much as some other action would have. In many cases we are not obliged to increase the welfare [of] others, and certainly not to increase it as much as possible. But in case where, in return for something of value like a job, B has promised to do his best to maximize A’s welfare, then failure by B to take the most beneficial action because a different action produces more benefits for B amounts to reneging on a contract…
In large firms that are crucial for achieving general prosperity, the use of relational contracts is particularly important to deal with the local knowledge problem in a way that supports entrepreneurial decision making throughout the firm. But the local knowledge problem that occasions their use and the flexibility they afford produces many more opportunities for third-degree opportunism than otherwise — many of which produce only counterfactual losses. In such cases if moral restraint is based solely on a reluctance to do harm, then moral restraint will be virtually non-existent.
That was David C. Rose in his book, “The Moral Foundations of Economic Behavior,” pp. 104-105. There are great insights throughout, highly recommended. Here is Rose on EconTalk discussing the book.
What Rose means by third-degree opportunism when a person takes advantage of a case where discretion is provided to them in a relational contract, such as an employer-employee relationship. I think that many R&D projects, even if they use formal contracts between separate organizations (e.g., defense acquisition), are also in many respects relational contracts. The principal is interested in achieving new things which cannot always be specified before-the-fact, and thus there is a large relational component to R&D contracts even if they are written very tightly. Cost-plus contracts and the ubiquity of engineering-change orders for fixed-price contracts are a reflection of this de facto relational nature. Here is David Rose again:
Relational contracts are contracts that lack specificity because the circumstances of the transaction involved are so unpredictable that flexibility is of paramount importance.
Usually, in these cases, the transaction costs of contracting is so high that the decision-maker prefers to internalize the resources (i.e., creating or expanding the boundaries of the organization). But through reputation and other aspects of trust, contracts may be agreed upon with the relational understanding that the supplier will not act opportunistically.
Now, I think we all agree that in those situations where the contractor can shirk or siphon off funds without the client knowing, that acting on these “golden opportunities” would be morally wrong just based on the principle of the matter. Incentives don’t count when the client isn’t monitoring the wrong-doing. And there’s often no identifiable harm done, particular when it is spread over hundreds of millions of taxpayers. If people aren’t told, they’d never have noticed.
But Rose extends the idea of principled moral-restraint into notions of duty. Say that while the contractor is performing a development project to the government’s specifications, it finds out that the specifications were poorly conceived and would result in very high operating and maintenance costs. Say the high maintenance procedures could be averted at no additional cost. If the customer/employer cannot trust that the contractor/employee will act upon these value-increasing options, once having recognized the opportunity costs, then the scope of relational contracting will be decreased and everyone’s welfare involved would also decrease.
In the case, the contractor must feel guilt for not having maximized the value of the customer. It’s managers must be duty-bound to act in the customer’s welfare. Only if the customer trusts the contractor in this way, will more discretion be provided to pursue innovation that cannot be adequately justified to laymen bureaucrats beforehand. However, by doing so, the contractor is giving up a lot of business in operations and maintenance because of better performance. The contractor is sacrificing its own welfare, because that could only have ever been possible to obtain by first breaching a moral prohibition, which is to maximize the client’s welfare.
In reality, the government used to have relational contracts before Robert McNamara, but after him only incentive-based rational management mattered. The government does not trust the contractors, and therefore, it does not provide much discretion. In fact, had the contractor actually pursued a design that led to lower maintenance costs, then it would have broken its contract requirements and incurred penalties if it couldn’t convince the government to amend the contract. So without trust stemming from duty-based moral restraint, the government losses any gains that it cannot precisely predict, and the contractor is forced to take major risks if it wants to act on local knowledge which can vastly increase government value.
What is interesting about David Rose’s use of counterfactual costs — or local knowledge that would benefit the customer/employer if acted upon — is that usually all it takes to be trustworthy is to not act on opportunism. Not stealing; not murdering; not shirking. But in this case, not acting on opportunism involves action of a different kind, and often more action than otherwise. Not only is the person changing the plan, but they’ll have to later convince the customer/employer that the change of plans was actually promoting his own value, and not an instance of opportunism itself.
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