Relational Contracts: Bringing Dynamics Into the Model

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Lecture 8

• Relational Contracts Bringing Dynamics Into the
  Model

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Idea

• Business dealings are riddled with relational
  contracts. Supply chains often involve long-run,
  hand-in-glove supplier relationships through
  which parties reach accommodations when
  unforeseen or uncontracted-for events occur
• Relational contracts help circumvent difficulties
  in formal contracting

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Difficulty

• Allows parties to utilize their detailed
  knowledge of their specific situation and to
  adapt to new information as it becomes available
• Problem it must be self-enforcing, i.e. the
  value of future relationship must be sufficiently
  large that neither party wishes to renege (get
  out of the relationship)

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Key Finding

• Integration affects the parties temptation to
  renege on a relational contract
• In a given environment, a relational contract
  could be feasible under integration but not under
  non integration
• Therefore integration could be a way to create
  the conditions for the feasibility of a
  relational contract

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Assumptions

• Ownership of the asset conveys ownership of the
  good produced with the asset
• There is an alternative use to the good
• Actions are not observable, outcomes are not
  contractible

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Relational Contracts Can Help

• The downstream party can promise to pay the
  upstream party a bonus if she produces a good of
  high value
• This promise is based on noncontractible outcomes
• It provides incentives only if it is
  self-enforcing, i.e. the short run value of
  reneging is lower than the long run value of the
  relationship

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Integration Can Help

• Having the right type of ownership can make a
  given promise self-enforcing
• Under integration, if the downstream party
  reneges on the bonus, he still owns the good
• Under nonintegration, he still has to buy it from
  the upstream party
• Nonintegration provides more recourse (bargaining
  power) to the upstream party if the downstream
  party misbehaves

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• However, nonintegration also creates incentives
  for the upstream firm to increase the value of
  the good in its alternative use, in order to
  improve her bargaining position with the
  downstream party
• Therefore, integration affects the parties
  temptations to renege on a relational contract,
  and hence affects the best relational contract
  the parties can sustain

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New Explanation for Fisher-GM

• GM acquired Body because it wanted the relational
  contract with Fisher to be self-enforcing
• Fisher (most probably) or GM might have had
  incentives to renege on the relational contract
  under nonintegration

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New Explanation for Crown-Pepsi

• Pepsi did not acquire Crown because the
  relational contract it had with Crown would not
  have been self-enforcing under integration, but
  well under nonintegration
• Pepsi (most probably) or Crown might have had
  incentives to renege on the relational contract
  under integration