Contracting in the Shadow of the Future: Bilateral Reputation and Relational Controls in Inter-Firm Transactions

Abstract

Inter-firm contracting involves balancing the costs of ex ante incentives to reduce moral hazard with ex post hold up and adaptation costs. This tradeoff is complicated when there is potential for deliberate obfuscation by the vendor, which cannot be detected through the client’s traditional control mechanisms. In the presence of deliberate obfuscation relatively flexible, incomplete contracts (such as cost-plus contracts) can reduce ex post hold up and adaptation costs. However, moral hazard problems of cost-plus contracts may be severe enough to offset the benefits from their lower adaptation costs leaving contracting parties with few feasible options. Under these circumstances, relational controls based on observable but unverifiable information can help contracting parties reach consensus. We use archival data of contracts that have potential for deliberate obfuscation and examine if the formal contract form is influenced by two types of relational controls. These relational controls include the possibility of a future horizon, and bilateral reputation capital for cost containment. We predict that the likelihood of a cost-plus contract is increasing in contracting parties’ possibility of a future horizon, and vendor bilateral reputation for cost containment. We empirically test predictions using textual analysis of 149 SEC material contracts averaging $49.1 million in value, supplemented with hand-collected trade and industry data. Results using recursive, simultaneous, bivariate probit estimations with instruments for endogeneity corrections support our predictions. JEL Codes: D23, D86, L14, M41

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Cite this paper

@inproceedings{Susarla2016ContractingIT, title={Contracting in the Shadow of the Future: Bilateral Reputation and Relational Controls in Inter-Firm Transactions}, author={Anjana Susarla and Ranjani Krishnan and Bob Gibbons and Ricard Gil and Bob Kaplan and Jacques Lawarree}, year={2016} }