Contracts between firms are at the heart of economics. In a new paper, me and my co-author Rajkamal Iyer from MIT Sloan School of Management study how contracts between buyers and sellers are shaped by opportunistic behavior in inter-firm transactions. We exploit a novel database of 185 proprietary contracts signed between a large transportation company and her 89 suppliers.
We start with a static analysis of how contracts address moral-hazard problems, i.e., the concern of the buyer that a supplier provides insufficient effort, which can manifest itself in no performance at all, delayed deliveries or poor product quality. Such concerns are larger if a supplier’s products are ‘critical’ to the buyer. What do we mean with critical? We consider a supplier as critical if her misbehavior has a large negative impact on the buyer’s performance. We find in our paper that contracts with critical suppliers contain more clauses that address moral-hazard concerns, primarily through monitoring, and to a lesser degree also through incentives. Monitoring clauses include regular meetings to evaluate supplier performance, but also buyer intervention rights such as audits of supplier factories.
We then analyze holdup problems and test predictions derived from an important theory, the property rights theory (PRT). What are holdup problems? Suppose you are the buyer and you make an investment that caters to the products that are supplied by the supplier. Further, suppose that this investment is totally useless when you switch to an alternative supplier; economists call this a relationship-specific investment (RSI). You are now concerned that once you made this investment, the supplier behaves opportunistically by asking you for a higher price (this called a ‘holdup’). You are now in trouble and you will have to agree to her demands as switching suppliers is super costly for you. PRT shows that potential supplier opportunism distorts your incentives to invest initially, leading to underinvestment. Naturally, concerns about holdups are larger if RSI are bigger.
Why would you still invest? Well, because contracts may protect you against misbehavior. Specifically, PRT predicts that the allocation of control rights is an important contractual solution to holdup concerns. We test the specific prediction that a control rights allocation to the buyer is more likely if her RSI are larger. Measuring RSI is difficult, but we assume that if these investments are larger, then it takes more time and it is more costly to switch suppliers. Consistent with PRT, we find that the buyer’s holdup concerns are addressed in contracts, as suppliers are more likely to transfer intellectual property rights, a form of control rights, if supplier switching takes longer or is more costly.
The main advantage of our setting is that it allows us to study dynamic contracting. Here again we can test some theories that make interesting (and actually also opposing) predictions on how contracts should evolve. On the one hand, incomplete-contracting models predict that contracts with the same supplier become stricter over time, i.e., they should contain more clauses that address moral hazard. It is argued that contracting costs make it initially costly to specify a contract that addresses all future contingencies. However, as incentives and the production process are better understood, contracting costs decrease, allowing the buyer to write a more complete contract. This effect should be most pronounced if output observability and verifiability are initially low, as contracting costs are then particularly high. On the other hand, relational-contracting models imply that contracts can become more relaxed, as trust and reputational capital accumulate and substitute formal contracting.
We find that contracts with the same supplier become stricter over time. Repeat contracts contain, in particular, additional clauses that allocate monitoring rights to the buyer, but also clauses that allow the measurement and evaluation of supplier performance. Output verifiability matters significantly for contract dynamics, as the increase in contract strictness is driven by service contracts. As services are initially more difficult to observe and verify than goods, repeated contracting can help to specify better monitoring technologies and to reduce contractual incompleteness. Our evidence on contract dynamics is consistent with the view that contracting costs go down over time as the buyer learns how to address monitoring needs. In summary, the key finding of our dynamic analysis is that contracts become more complete over time.
Our findings indicate support for several theories, but also that contracts are multi-dimensional, covering different types of clauses that address both moral hazard and holdups. We therefore also study which clauses are substitutes or complements, and how different clauses within a broader set of terms interact. If you are interested in those results, please have a look at the paper.