1. RELATIONAL CONTRACTS IN ECONOMICS Emmanuel RAYNAUD INRA SADAPT & Centre ATOM (U. Paris I) ESNIE Workshop 2004

2. OUTLINE 1. What are relational contracts? A short overview of literature 1. What are relational contracts? A short overview of literature 2. Introducing relational contracts in contract theories: relational contract as repeated games 2. Introducing relational contracts in contract theories: relational contract as repeated games 3. Interactions between relational and formal contracts: complements or substitutes? 3. Interactions between relational and formal contracts: complements or substitutes?

3. 1. What is relational contracting? No universally accepted definition within and between fields (economics, law & eco) «A contract that specifies only the general terms and objectives of a relationship and specifies mechanisms for decision making and dispute resolution» (Milgrom & Roberts, 1992) «A contract that specifies only the general terms and objectives of a relationship and specifies mechanisms for decision making and dispute resolution» (Milgrom & Roberts, 1992) «Contract that do not try to take account of all future contingencies but are nevertheless long-term arrangements in which past, present and expected future personal relations among the contractual parties matter» (Furubotn & Richter, 1998). «Contract that do not try to take account of all future contingencies but are nevertheless long-term arrangements in which past, present and expected future personal relations among the contractual parties matter» (Furubotn & Richter, 1998). «Informal agreements and unwritten codes of conduct that powerfully affect the behavior of individuals” (Baker, Gibbons & Murphy, 2002) «Informal agreements and unwritten codes of conduct that powerfully affect the behavior of individuals” (Baker, Gibbons & Murphy, 2002)

4. 1. Relational contracts in Law Relational Contract: Contract as a general framework (Goldberg, Macneil, et al. ….) the whole range of obligations cannot be defined ex ante  for complex transactions, formal contract is just a part of the relation that governs transactions Relation (relational «contract») formal contract

5. 1. Relational contracts in Economics Transaction cost economics Transaction cost economics Contractual arrangement at the core of HYBRID governance structures (Williamson, 1996) RL is an incomplete formal contract  contract as a framework to structure ex post adaptations  design a contract that encourages adjustments (FLEXIBILITY) but at the same time prevents opportunism.

6. 1. Relational contracts in Economics Principal / Agent theory (simple model) Principal / Agent theory (simple model)  Only verifiable variables include in the contract and enforced by court  Only verifiable variables include in the contract and enforced by court  Irrelevance of relational arrangements, no need to ex post adaptation  In equilibrium, court has no role to play  In equilibrium, court has no role to play Incomplete contracts à la Grossman & Hart Incomplete contracts à la Grossman & Hart Importance of the allocation of ownership for ex ante investment incentives Costless ex post bargaining process  irrelevance of relational aspects

7. 1. Relational contracts in Economics How to integrate relational arrangement in (formal) contract theory? How to integrate relational arrangement in (formal) contract theory? Include in the initial contract both verifiable and observable variables (by both parties) verifiable variables  court enforced observable variables  “self-enforced” Integrating relational aspect in formal modeling  integrating new enforcement devices in models and combination of different enforcement mechanisms

8. 2. Relational contracting and formal models A. Introducing relational contracts in standard Principal-Agent models and in incomplete contracts models A. Introducing relational contracts in standard Principal-Agent models and in incomplete contracts models Relational contract as a REPEATED INTERACTIONS among agents OUTLINE

9. 2. Relational contracting and formal models Relational contract as a repeated game Relational contract as a repeated game Repeated game is an ordinary game reiterated many times A relational contract is « self-enforced » if the expected value of the future relationship must be sufficiently large that neither party wishes to renege A relational contract is « self-enforced » if the expected value of the future relationship must be sufficiently large that neither party wishes to renege Self-enforcement  subgame perfect equilibrium

10. 2A. Relational contracts and Principal / Agent models Relational incentive contracts (Levin, 2003) Relational incentive contracts (Levin, 2003) Goal of the paper: introduce relational aspects in standard PA Main model assumptions  Relational contract combines court-enforced provisions («wage») and self-enforced discretionary payment  RC expand the range of incentive instruments (temporal dimension) but also add an additional constraint (SEC)  Performance measures are non verifiable

11. 2.A Relational contracts and Principal / Agent models Two cases for the design of optimal contract (o.c)  Common monitoring (performance measures are commonly observed) O.C = if output is above a cut-off point then maximum rewards, else minimum reward  Private monitoring (subjective assessments)  Private monitoring (subjective assessments) same O.C except : if bad output then no reward (i.e. termination)

12. 2B. Relational contracts and incomplete contract models Baker, Gibbons, Murphy (2002) Baker, Gibbons, Murphy (2002) Goal of the paper: introduce relational contracting in a Grossman-Hart like model Standard G&H model: One-shot game model Main result: allocate the asset ownership to the agent whose investment has the biggest marginal impact on total surplus Repeated G&H model: Does repetition of the initial game alter the main result?

13. 2B. Relational contracts and incomplete contract models Main model assumptions  Model with two agents and one asset  Moral hazard on action and non contractibility of outcomes  Relational contract: promise to pay a bonus that depends on outcomes  enforcement of the promise Results  The (best) implementable relational contract depends on integration decision  The (best) implementable relational contract depends on integration decision WHY? The size of the incentive to renege on a promise depends on who owns the asset

14. 3. The interactions between relational and formal contracts Relational and formal contracts: what interactions? What are the interactions between alternative enforcement devices?  Complements or substitutes?

15. 3. The interactions between relational and formal contracts Rationale for complementarities Rationale for complementarities  Joint use of formal and informal contracts provides more efficient outcomes than the use of either arrangement in isolation  (Incomplete) formal contracts facilitate the self- enforcement of relational agreements (Klein, 1996) Court-enforceable terms affect the «self-enforcing» range of contractual relations by reducing the short term incentive for opportunistic behavior

16. 3. The interactions between relational and formal contracts The example of franchising (Lafontaine and Raynaud, 2002) The example of franchising (Lafontaine and Raynaud, 2002)  2 types of incentive mechanisms for franchisees are identified in the literature: - residual claimancy (residual profit) - self enforcement (ongoing rents)  Alternative devices to provide incentive in the literature (substitutes instruments)  Empirically, coexistence of both mechanisms

17. 3. The interactions between relational and formal contracts A solution to the puzzle: complementarity between both mechanisms  Residual claims give franchisee strong incentive to maximize his own profit sometimes at the expense of the chain (cheating on brand name reputation)  restrictions on franchisee behavior  reduction on “potential” franchisee profit  Rents as a «compensation» for the missing opportunities lost due to the court-enforced restrictions  Rents as a «compensation» for the missing opportunities lost due to the court-enforced restrictions  Residual claims give the incentive to put forth effort and ongoing rents give incentive to maintain the value of the brand

18. 3. The interactions between relational and formal contracts Rationale for substituabilities Rationale for substituabilities  Formal contracts may damage exchange performance by undermining relational governance (Macaulay, 1963)  Formal contract may signal distrust  If one party trusts the other there is little need for contractually specifying actions  Trust reduces transaction costs by «replacing contracts with handshakes»  Trust reduces transaction costs by «replacing contracts with handshakes»

19. 3. The interactions between relational and formal contracts Empirical assessment Empirical assessment  Corts and Singh (2004) in the US offshore drilling industry  Corts and Singh (2004) in the US offshore drilling industry  Poppo and Zenger (2002) in the US information services outsourcing industry

20. 3. The interactions between relational and formal contracts  Corts and Singh (2004) What is the effect of repeated interactions on the choice of contract form? (here high vs low-powered incentive contracts)  how relationships affect both the incentives and the contracting costs associated with the two contracts (Bajari & Tadelis, 2001)  Relationships and high-powered incentive contracts are complements / substitutes depending on the relative effects of relationships on incentives pb / contracting costs (ex ante & ex post)

21. 3. The interactions between relational and formal contracts - If repeated relations affect more incentive than contracting costs, then parties will choose a C+ contract  high powered contract and relations are substitute. - If repeated relations affect more contracting costs than incentives, parties will choose a FP contract  high powered incentive contracts and relations are complements

22. 3. The interactions between relational and formal contracts  Empirical measure of the frequency of interactions: Number of project particular parties have worked on together in the previous six months.  Empirical results: substitutability between relationships and formal contract in this particular industry

23. 3. The interactions between relational and formal contracts  Poppo and Zenger (2002) Test of the interaction between contractual complexity and relational governance  Increase in contractual complexity will increase / decrease the level of relational governance  Increase in relational governance will enhance / discourage the use of complex contracts

24. 3. The interactions between relational and formal contracts  Relational governance: several indicators based on questionnaire items to assess the intensity and duration of the relation Degree of collaborativness, level of trust, ….  Contractual complexity= completeness several indicators: +/- customized contract, +/- legal work involved, length of the contract (in pages) several indicators: +/- customized contract, +/- legal work involved, length of the contract (in pages)

25. 3. The interactions between relational and formal contracts Empirical estimation procedures: system of simultaneous equations because several endogenous variables + interaction terms of these variables in performance estimation Empirical result: relational governance positively affects contractual complexity and vice versa.

26. Conclusion Relational contract is still a fuzzy concept in economics (relational, norms, trust, …..) Relational contract is still a fuzzy concept in economics (relational, norms, trust, …..) A relational contract must be self-enforced A relational contract must be self-enforced Designing an (efficient) relational contract means selecting and supporting a particular equilibrium of a repeated game Designing an (efficient) relational contract means selecting and supporting a particular equilibrium of a repeated game Formal and informal agreements can be complements or substitutes depending on the context Formal and informal agreements can be complements or substitutes depending on the context When do contract act as a substitute or as a complement?