Theoretical aspects of contracting © 2018 Taylor & Francis

Contract Legally enforceable agreement Opportunity to invoke (state) dispute resolution mechanisms and coercive power to enforce promises Contract designcontract enforcement © 2018 Taylor & Francis

Role of contracts Specify commitment Constrain opportunism Reduce uncertainty, transfer risk Goal alignment and incentives Reduce transaction costs Ex ante  negotiations Ex post  conflict resolution © 2018 Taylor & Francis

Contract problems Moral hazard (ex post) Adverse selection (ex ante) Information asymmetry Moral hazard (ex post) Adverse selection (ex ante) Opportunism* * For example withholding information © 2018 Taylor & Francis

Two economic theory streams Agency theorystudy the contract Objective: goal alignment and risk distribution Transaction cost theorystudy the transaction Objective: minimisation of transaction costs The contracting parties want to obtain control so as to be able to achieve their goals and reduce their costs © 2018 Taylor & Francis

Some basic agency theory Interests of the principal Interests of the agent Bounded rationality Risk aversion Opportunism Incentives Asymmetric information Control Goal alignment? © 2018 Taylor & Francis

Then, some basic transaction cost theory Asset specificity + Governance through legal contracts* Opportunism** - + Uncertainty * Originally: hierarchy vs market ** Self-interest seeking with guile © 2018 Taylor & Francis

How formal & detailed should a contract be? What are the factors impacting on contract formalisation/specification? When does contract formalisation and specification pay off? © 2018 Taylor & Francis

Costs and benefits of loose vs rigid contract terms More detailed contract terms Keeping contracts open Enables managers to Set goals Clarify expectations Reduce misunderstandings Reduce counter-party opportunism Requires expenditures in Searching for information Projecting scenarios Identifying feasible contingencies Negotiating acceptable solutions Enables parties to make value-enhancing adjustments Is likely to foster trust between parties because parties do not hold each other to precise terms of the contract May lead to opportunism because counter-party can exploit unspecified loopholes that lead to wasteful renegotiations and hold-ups © 2018 Taylor & Francis

Governing relationships 1. Relational contracting Informal governance through credible commitments 2. Legal contracting Formal governance through (written) contracts So the question then is: What factors favour legal/relational contracting? © 2018 Taylor & Francis

Control of operations through relational norms and contracts Legal contracting Choice of law “Private laws” = contracts Guideline to working relationship Litigation/arbitration Goal alignment + + Control - Relational norms Common worldview Common goals Benevolence Reciprocity Flexibility Loyalty Trust Oppor- tunism + Uncertainty factors Cultural differences Economic volatility Legal/political uncertainty Control of operations through relational norms and contracts © 2018 Taylor & Francis

Contract formalisation and effectiveness Relationship factors - Dependence on agent - Relationship length Relationship factors - Dependence on agent - Relationship length Product/market factors - Market volatility - Product standardisation Contract formalisation Performance Economic uncertainty difficult to anticipate demand/competition, prices, inflation, exchange rates  calls for contractual flexibility Legal uncertainty difficult to anticipate outcomes of litigation  calls for relational contracting and trust building activities Exporter factors - Exporter host market experience - Export ratio Host country uncertainty - Economic uncertainty - Legal uncertainty Based on Aulakh and Genctürk 2008 © 2018 Taylor & Francis

? Impact of culture Legal contracting Relational contracting Uncertainty avoidance © 2018 Taylor & Francis

? Impact of culture Legal contracting Relational contracting Individualism Collectivism Relational contracting © 2018 Taylor & Francis

? Contract Performance formalisation and specification Difficult to anticipate demand/ competition, prices, inflation, exchange rates calls for contractual flexibility Host country uncertainty Economic uncertainty Legal uncertainty Cultural dimensions Difficult to anticipate outcomes of litigation  calls for relational contracting and trust-building activities Uncertainty avoidance  relational contracting? Individualism  formal contracting? Power distance  formal contracting? Masculinity  formal contracting? Long-termism relational contracting? © 2018 Taylor & Francis

Contract specificity and transaction costs Contracts more specific than predicted - Buyer lock-in + Ex post transaction costs + Transaction complexity + Contract specificity Ex ante contract drafting costs - + Performance ambiguity Contracts less specific than predicted - Mooi and Ghosh 2010 © 2018 Taylor & Francis

Transaction stages model Activities/Issues Governance costs 1. Partner selection/ contract negotiation How to create and claim values? 1. Direct contracting/search costs - Performance evaluation (screening/selection) - Safeguarding (legal/contingencies search) - Adaptation (communication/negotiation) 2. Opportunity costs of foregone transactions Ex ante stage 2. Value creation Difficult to observe transaction specific costs Direct monitoring costs due to performance evaluation problems Observing what happened in stage 2 3. Realising the state of the world Outcome not as anticipated need for adaptation 4. Value claiming Renegotiation to appropriate rents Direct enforcement/adaptation costs Renegotiation, haggling, coordination, communication, conflict resolution Refusal of partner to adapt Ex post stage Depend on decisions made in earlier stages 5. Receiving payoffs © 2018 Taylor & Francis Based on Gibbons 2005

Incentive scheme Contract design The party with the “upper hand” should be left at least as well off maximising the joint gain as taking any other feasible action. Incentive scheme © 2018 Taylor & Francis

Relational or legal governance of partners? Exporter experience Legal Governance mode: relational or legal Trust Relational Relational Mutual adaptation R2 0.85* Legal Control & role specification Relational or legal governance of partners? Based on Deligonul and Cavusgil 2006 © 2018 Taylor & Francis * Nagelkerke R2

Some basic premises Control through relationships Performance/ goal alignment Control through legal contracts © 2018 Taylor & Francis

Incentives to attain goals and risk distribution  Commission (depends on outcome) Agent’s risk  Salary (fixed) Principal’s risk  Goal attainment “Balanced risk” © 2018 Taylor & Francis

Relationship- vs transaction-oriented exporter–middleman relations Relationship oriented None No certainty for middleman Opportunities to expand (for middleman) Yes Limited uncertainty for middleman Limited opportunities to expand (for middleman) Geographic exclusivity High Goal alignment through (short-term) sales volume Low Other levers of goal alignment more important (social/investment) with a view to achieve long-term results Level of incentives Commission Risks at middleman level Salary Exporter investment in long-term relations exporter risk Type of incentive Short/medium-term perspective Flexibility needed Information exchange? Clan control less prevalent? Opportunism contained by risk of losing agency? Long-term perspective Social relations warranted Asset specificity? Clan control more prevalent? Opportunism contained by social relations (and clan control)? Source: Unpublished research project, BI Norwegian School of Management © 2018 Taylor & Francis

Geographic exclusivity Drivers of relationship quality under different incentive schemes Standardised beta values Source: Unpublished research project, BI Norwegian School of Management Geographic exclusivity Level of incentives Type of incentive None Yes High Low Commission Salary Clan control Process control Outcome control Social relations Investment in relations Information exchange Flexibility F-value R2 Adj. .45a -.15 .23 .12 .05 .32b 6,776a .419 .43a -.15 .01 .31a .11 .10 .08 11,066a .484 .43a -.26c .08 .19 -.03 .17 .24c 6,379a .473 .53a -.24 -.11 .34b .29c .07 -.07 6,750a .467 .30a -.11 -.05 .17 .03 .16 .28b 8,347a .394 .46a -.24c -.17 .36b .03 -.02 2,312a .532 a: p<=.01; b: p<=.05; c: p<=.10 © 2018 Taylor & Francis