Presented by – Amit Darekar Complementarity and Evolution of Contractual Provision An Empirical Study of IT Services Contracts Nicholas S. Argyres Janet Bercovitz Kyle J. Mayer Presented by – Amit Darekar

Introduction Literature on managing outsourcing relationships  Structure of agreement is important to determine performance of relationship The gap  How contracts are actually designed? How structures of contracts evolved? Reason? Heavy emphasis in literature on role of “Trust” in inter-organizational relationships Literature on alliances and interfirm relations  sophisticated contracts are important, especially in high technology industry The empirical economic literature  Determinants of contract structure Gap?  Co-evolutionary patterns in contract structures and mechanisms of learning to contract Determinants of contract structure – contract duration, payment terms, intellectual property rights, and equity participation

Research Objective and Question Understand nature of contractual learning process by investigating the relationships among different elements of contract design and their coevolution over time. 2 categories of contractual provisions Task description Contingency planning Research Question How learning processes are reflected in systematic relationships between contingency planning and task description contractual provisions?

Theory contd… Transaction Cost Economics (of contract design) Actors have bounded rationality  cant foresee all future contingencies  incomplete contracts Contracts may contain key characteristics – degree of bilateral dependency Degree of protection to property rights to assets deployed in relationship (Bilateral dependency)↑ + (Legal protection)↓  Contracts will contain additional “safeguards” against opportunism Safeguards – Exchange of contractual hostages(Williamson, 1985) – e.g. equity participation (Pisano, 1989) More complete contracts Contingency planning clauses – relatively generic OR more specific More detailed specification of tasks Trade-off for degree of completeness of contract Identifying additional contingencies & incorporating in contract is costly due to bounded rationality  but leaves flexibility Highly incomplete contracts  opportunism Safeguards – can be incorporated in agreement in several different ways.

Theory contd… Learning and Complements – Does various types of contractual provisions act as complements OR substitutes for each other? Agency Theory Task definition and contingency planning are alternative mechanisms for monitoring and controlling behavior  they are substitutes. Organizational Theory Firm’s incentive arrangements tend to be highly complementary Empirical Economics Because contracts are similar to organization as they are mechanisms for organizing and governing business activity, they are complementary. Recent research in organizational complementarities show that relationship betn features of org structure & activities only discoverable by its members || to “Learning Processes” (Mayer & Argyres, 2004) Agency Theory  By developing more detailed task descriptions, a supplier is better controlled. Alternatively, more detailed task description  limit severity of any –ve consequences of opportunism. So, more detailed task description  reduce value of additional contingency planning. Similarly, more contingencies identified ex ante & detailed procedures are established to deal with them  detailed task description is unnecessary. Hence “Task description” and “Contingency Planning” are substitutes for each other Organizational theory  Holmstrong and Milgrom (1991) showed that when organizational members carry out multiple tasks, their incentives must be aligned or else inefficient allocation of efforts will result.

Hypotheses H1 – Contingency planning and task description have reciprocal positive effects on one another, suggesting that they act as complements in complex, high-technology contracts H2A – Prior experience with contingency planning is associated with more detailed task description in subsequent contracts between the same firms H2B – More detailed task description in prior contracts is positively associated with contingency planning in subsequent contracts between the same firms H3A – As an exchange relationship between two parties continues, the parties will be more likely to include contingency planning clauses in their contracts with each other H3B – As an exchange relationship between two parties continues, the parties will include more detailed task description in their contracts with each other H1 – The authors suggest that learning about contingency planning may tend to spill over to learning about task description, and vice versa, and that this creates a relationship of complementarity that dominates any substitution effect between the two contract provisions. More efforts on identifying and providing for contingencies  more opportunities are revealed to clarify the tasks to avoid these contingencies. Conversely, more efforts to clarify roles and responsibilities  potential problematic contingencies are more likely to be identified and marginal cost to include them in contract falls. H2A – prior experience is used to identify and elaborate problematic tasks with the same partners H2B – vice versa of H2A H3A – Partner specific learning. They learn about idiosyncrasies of each other and use it to include contingencies planning. H3B – vice versa of H3A

Data Single firm, code-named “Compustar”, data. Firm engaged in high technology activities and is from “emerging industry” Period – 1986 to 1998. Population – All the contracts with Compustar’s 141 partners for the given period Samples – 405 (25% of population) randomly chosen based on first letter of partner’s name. Final sample = 386 after removing missing data contracts “Emerging Industry” – perfect setting to study “Learning Effects” which this study has hypothesized

DV / IV / CV DV IV CV Task description Contingency planning Relationship history CV Interdependence Proprietary Measurement cost Mainframe Innovation Fixed fee Dollar value Programming Time CV1 – Control for holdups. CV2 – Proprietary technologies. CV3 – To assess difficulty to verify quality of tech. CV4 – Degree of uncertainty. CV5 – Degree of innovation required for project. CV6 – Incentive structure for contract. CV7 – Total money value for project. CV8 – Need for programming. CV9 – Time trend

Method Probit Regression OLS i Indicates index of the contract Task Description – Likert scale, hence continuous variable. Effect of Contingency planning on Task Description in an OLS regression would be endogenous. So used two-stage least square in STATA to test it. Results showed that it is exogenous Contingency Planning is Dichotomous variable. So used Probit regression. Effect of task description on contingency planning in regression would be endogenous. So used Smith-Blundell test it. Results showed it is endogenous. To correct it, used “Predicted value of task description” from a regression on all the exogenous variables. i Indicates index of the contract

Results contd..

Results

Discussion Contingency planning and task description act as complements likely to be result of learning spillovers The firms in the sample were learning to contract such that contingency planning become prevalent over time Contingency planning was more likely to be included in partners with longer relationships history For the specific case of Compustar, task description become less detailed over time Result 2 & 3 are quite contradictory to “Theories of Contract Evolution” 4. Possibly due to – Compustar’s reputation for honest dealing become strong in its clients, OR Compustar realized that some types of details are unnecessary,

Conclusion Implications of research Limitations Investigating the determinants of each term in contract in isolation could be misleading Examining contract designs assuming that they are equilibrium outcomes can be misleading to parties in contract Limitations The problem of limitations on generalizability of the results