Rev. Adm. (São Paulo) vol.52 número4

(1)

Revista

de

Administração

http://rausp.usp.br/ RevistadeAdministração52(2017)492–496

ThinkBox

Informal

contracting

between

and

within

firms

夽

Ricard

Gil

a,∗

,

Giorgio

Zanarone

b

a_Johns_Hopkins_Carey_Business_School,_Baltimore,_USA b_Colegio_{Universitario}_Estudios_Financieros_(CUNEF),_Madrid,_Spain

Abstract

Whileinformalcontractsarewidelyusedinmoderneconomies,limitedsystematicempiricalevidenceisavailabletoresearchersandpolicymakers. Thispaperaimstofillthegapbydiscussingaselectedsampleofempiricalworksthroughthelensofatheoreticalframeworkthatclarifiestherole ofinformalcontracts.Wealsohighlightunexploredresearchopportunitiesofferedbymorerecenttheoreticalmodelsthatinvestigatehowinformal contractsarebuiltovertime,howtheyaresubjecttopathdependency,andhowrelationalrentsarecreated,andareawaitingempiricalanalysis. ©2017DepartamentodeAdministração,FaculdadedeEconomia,AdministraçãoeContabilidadedaUniversidadedeSãoPaulo–FEA/USP. PublishedbyElsevierEditoraLtda.ThisisanopenaccessarticleundertheCCBYlicense(http://creativecommons.org/licenses/by/4.0/).

Keywords: Informalcontracts;Enforcement;Empiricalevidence;Testability

夽

ThisstudyreceivedfinancialsupportfromtheSpanishMinistryofthe Econ-omyandCompetitivenessthroughgrantECO2014-57131-R.

∗_{Corresponding}_author.

E-mail:[email protected](R.Gil).

Introduction

Theexistenceandpervasivenessofinformalcontracts—that is,contractsthatareenforcedbypartiesratherthancourts—has been extensively documentedin socialscience. Forinstance, managers often rely on “hand-shake” agreements to support theirdeals(Macaulay,1963);largecorporationssuchasGeneral Motors relyoninformal,internallyenforced routinesto man-agetheir workersandsuppliers(Helper&Henderson,2014); and long-distancetradersenter commercialcontracts evenin theabsenceofreliablecourtsbecausetheyareafraidofbeing ostracizedfromthemarket,asunderthemedievalLawMerchant (Milgrometal.,1990).

Inspiredbytheseandotherworks,arich theoretical litera-turehasemergedineconomics,investigatingtheconditionsthat makeinformalcontractsfeasible,theirdynamicpatterns,andthe wayformalcontractshelpsustainandenforceinformalonesby reducingtheparties’temptationtorenegeontheirpromises.This literatureissummarizedbyMacLeod(2007),andMalcomson (2013).However,thereisscarcesystematicevidenceonwhether existing economic theories correctly predict the determinants andconsequencesofinformalcontracting.Inthispaper,webuild onourrecentwork(Gil&Zanarone,2015,2016,2017)to illus-trateboththeaccomplishmentsandtheresearchopportunities forempiricalresearchersinthisfield.

https://doi.org/10.1016/j.rausp.2017.08.009

(2)

Following Gil and Zanarone (2015, 2017), we begin by summarizingthekeypredictionsreceivedfromeconomic mod-els of stationary informal contracts—that is, contracts that do not change over time—and discussing recent empirical works thatprovide evidenceon thesepredictions. In the sec-ondpartofthepaper,wesuggestdirectionsforfutureempirical research.Ononehand,thereareimportantuntestedpredictions ofstationaryinformalcontractingmodel,particularlythoseon the coexistence andinteraction between formaland informal contract.Onthe otherhand,therearenewtheoretical predic-tions that await careful empirical analysis. In particular, the morerecenteconomicmodels relax conventionalsimplifying assumptions—namely,symmetricinformationandtheabsence ofliquidityconstraints—andpredictthatfarfrombeing station-ary,optimalinformalcontractsmaygraduallyevolveovertime, andmaybesubjecttocyclesofcooperationandpath depend-ency.FollowingGilandZanarone(2016),weconcludethepaper bydiscussingsomestrategiesfortestingthepredictions gener-atedbythisnewtheoreticalfrontier.

Testingforinformalcontractinginstationary environments

Thechoiceofenforcementregime

Afirstsetoftestableimplicationsfromtheliteratureregard thechoiceofenforcementregime—thatis,theextenttowhich contractingpartiesuseformalorinformal contractstogovern theirtransactions.Inparticular,becauseinformalcontractsare enforcedbytheparties’threatofterminatingalong-term collab-orativerelationship,theiruseispredictedtoincreasewhenthe partieshavealonghorizonand/orvaluefuturepayoffshighly, whentheiroutsideoptionsfollowingbreakdownofthe relation-shipare nottooattractive,andwhentheiropportunitycostof honoringinformalobligations,andhencetheirshort-run temp-tationtobreach,isnottoolarge.

Ideally, totest thesehypotheses we would need measures forthefollowingvariables.First,wewouldneedadependent variableindicatingwhetheraformalcontractexists.Second,we wouldneedexogenousmeasuresfortheparties’intertemporal discountrateandtheirpayoffsoutsidetherelationship.Finally, wewouldneedvariationintheagent’sopportunitycostof hon-oringaninformalagreement.Wediscussbelowtwoexamplesof empiricalworkstestingthissetofpredictions.Moreexamples, andamoretechnicaldiscussionoftheunderlyingeconometric challenges,canbefoundinGilandZanarone(2015).

First,Gillan,Hartzell,andParrino(2009)studythechoice betweenexplicit and implicitemployment agreements (EAs) forCEOsinS&P500firms.Theyfindthattheuseofexplicit EAs (measured by an indicator for whether the firm’s SEC filings report an explicit agreement) increases in the CEO’s perceived uncertaintyabout the firm’sfutureprospects (mea-suredbysalesvolatility,therateatwhichfirmsintheindustry changeownershipandcontrol,andanindicatorforwhetherthe CEOisnewtothefirm).Thisresultisconsistentwiththe pre-dictionbecause when the firm’sprospects are uncertain (the intertemporaldiscountrateishigh),promisingapurely

discre-tionarycompensationtotheCEOisnotcredible,becausethere’s ahighchancethattheCEO-firmrelationshipwillsoonend,and hencethecompensationpromisewillnotbehonored.

Second,Gil(2013)exploits adatasetof movieexhibition contractswhere22distributorsplacetheirmoviesonthescreens ofoneSpanishexhibitor.Theauthorhadaccesstointernal com-pany records detailing whether distributors and the exhibitor usedformalrevenue-sharingtermsornot.Thepapershowsthat moviesthat didwellduring theirUSrelease (which occursa few months earlier thanthe Spanish release) are more likely touseaformalcontractthanmoviesthatwerenotreleasedin theUS,or werereleasedbutdidnotperformwell.Thisresult isconsistentwiththepredictionbecause whenthe agreement is completely informal, the exhibitor, who collects revenues upfront,istemptedtorenege,themoresothelargerthemovie’s revenues. Tomitigatetheexhibitor’sreneginghazard,movies withhighexpectedrevenuesaregovernedbyformalcontracts, preventingtheexhibitorfromretainingthemovierevenues.

Contractsandoutcomesunderagivenenforcementregime

Asecondsetofpredictionsintheexistingliteratureregards theoptimalactionsandcontracttermswithinagiven enforce-mentregime(purelyformal,informal,oramixtureofformaland informal). Whenthe predictionsdiffer dependingon whether informal contractsareusedor not,theyallowustoindirectly testforthepresenceofinformalcontractsandtheirinteraction withformalones.

Corts andSingh (2004)study the choice betweenturnkey contracts (akintofixed-price) andday-ratecontracts (akinto cost-plus) in offshore oil drilling. Turnkey contracts provide drillerswithstrongerincentivestocutcoststhanday-rate con-tracts,butarealsomorerigid,andhencecostliertorenegotiate whenprojectspecificationsneedtobechanged.Usingasample of1476drillingprojects,andaninstrumentalvariableapproach tocontrolfortheendogenouschoiceofdrillers,CortsandSingh (2004)findthat,allelseequal,projectsarelesslikelytobe gov-ernedbyaturnkeycontractwhentheoilcompanyandthedriller haveworkedtogetherinthepast.1Theyinterpretthisresultas evidence that informal self-enforcing agreements and formal incentivecontracts(i.e.,turnkeycontracts)aresubstitutes,rather thancomplements.

Zanarone (2009) studies how vertical restraints in Italian car dealership contracts changed after a2002 EU regulation prohibited manufacturers to assign dealers to exclusive ter-ritories. Among other results, he finds that, while contracts beforethelegalchangemostlyreliedonquantityfloorsto con-tain dealers’ double marginalization, contracts after the legal changecontainedamixofbothquantityfloorsandprice ceil-ings. Zanarone (2009) shows that this result is inconsistent withpurelyformaldealershipcontracts,butconsistentwiththe interactionofformalandinformalprovisions.Ifdealership con-tracts were purely formal,retail pricesshould decrease once

1 _Similar_results_are_obtained_by_Kalnins_and_Mayer₍₂₀₀₄₎_in_a_study_of_IT

(3)

intra-brand competition is liberalized. Hence, price ceilings should be less necessary after the legal change. In contrast, if manufacturers and dealers informally agreed to maintain exclusiveterritoriesintheshadowofthelaw,includingformal priceceilingswouldbe optimalbecausepriceceilings reduce thedealers’short-rungainsfromsellingoutsidetheirterritory, andhencetheir temptationtobreachthe informal exclusivity agreement.

GilandMarion(2013)testfor whethertheexpected dura-tion of relationships between contractors and subcontractors improvestheirabilitytobidcompetitivelyforprocurement con-tracts. Relying on data for 10 years of Caltrans (California Department of Transportation) auctions, they use the num-ber and value of projects auctioned over the next calendar yearasameasureofthefuturevalueofrelationshipsbetween contractors and subcontractors. Their results show that the higher the potential future value of a relationship, the lower the posted bids, even after holding constant the number of past interactions between contractors and subcontractors. This result is consistent with the idea that a longer time horizon improves the performance of informal collaborative relationships.

Macchiavello and Morjaria (2015) have access to an environment—the relationships between rose exporters in Kenyaandtheirinternationalclients—wherecontractsarenever governed byformal provisions.Moreover,theyhavedetailed dataontheinternationalspotmarketauctionpricesforroses. Foraninformalexporter-clientagreementtobeself-enforcing, theexpectedfuturevalueoftheirrelationshipmustbeatleast as largeas the pricethe exporterforgoes when honoringthe agreement instead of selling on the spot market. Consistent withtheideathattheseinformalenforcementconstraintis bind-ing,MacchiavelloandMorjaria(2015)showthatfollowingan unexpectedonepercent changeinthe spotmarketprice,the quantityofrosesinexporter-clientagreementsisalsoreduced byonepercent,sothattheagreementremainsself-enforcing. The idea that measures of the present gains from breaching an informal agreement (the reneging temptation) provide a lower bound for the future value of the relationship is fur-therexploitedbytworecentempiricalpapers—Gil,Kim,and Zanarone(2017),whostudyrelationaladaptationintheUS air-line industry, andMacchiavello andMiquel-Florensa (2017), whostudythe relativeperformanceofinformal contractsand vertically integrated supply chains in the Costa Rica coffee industry.

Finally, Barron et al. (2016) explores how movie distrib-utors and exhibitorsinformally adjustrevenue sharing terms inmovie exhibition contracts,and finds that adjustments are not contracted formally—that is, realized revenue sharing systematically differs from the terms in the formal revenue-sharing agreements. They argue that such adjustments occur informally to save on contracting and negotiation costs, and to affect the allocation of movies to screens. In particu-lar, Barron et al.(2016) showsthat renegotiations of pricing contracts are related to decisions about whether to continue show a movie and, if so, whether to show it in prime time.

Futurework

Untestedpredictionsfromstandardinformalcontracting models

Having reached this point, we can address where this literature islackingthe most.Thereislittle evidenceonhow thecost/qualityofformalcontractsaffectstheuse/performance of informal ones. When the parties’ fallback option fol-lowing breakdown of an informal relationship is to keep trading underarm’s-lengthformalcontracting—asopposedto termination—this effect, and hence the extent to which for-mal and informal contracts are complements or substitutes, is ambiguous(e.g., Klein,2000; Baker,Gibbons, &Murphy, 1994).Ontheonehand,anincreaseinthecost(decreaseinthe quality)offormalcontractsmakesithardertousesuchcontracts toreducetheparties’short-termgainsfrombreach,thusmaking informalagreementshardertoenforce.Ontheotherhand,poorer formalcontractsreducetheparties’fallbackoptionafter breach-ingthe informalagreement,therebyincreasing theirincentive tocooperate.

The closest suggestive empirical evidence is Johnson, McMillan, andWoodruff (2002).They find that in European countriesfromtheformerSovietblock,tradecreditincreased when courts were believed to reliably enforce formal con-tracts. However, thisrelationshipwas weakerwhen suppliers were locked into abilateral monopolyrelationship with cus-tomers and, therefore,werelikely tokeep dealingwiththem underarm’s-lengthformalcontractingfollowingabreakdown in the informal relationship. While the evidence in Johnson etal.(2002)issuggestive,itislimitedbyobviousmeasurement and endogeneity problems. Thus, identifying an appropriate experimentalsettingtothoroughlyassesshowtheavailability of formalcontracts affects informal agreements constitutesa clearopportunityforfutureresearch.Suchresearchmayexploit exogenous changes in contract law that affect the feasibility of termination—asopposedtoarm’s-lengthcontracting—asa fallback option,suchas terminationlaws infranchising (e.g., Brickley,Dark,&Weisbach,1991).Sincecourtqualityandthe regulationofcontractterminationhavebeenfoundtovaryacross countriesandindustriesandwithincountries,thetestweare sug-gestingmayexploitvariationacrosscountries,withinacountry overtime,orevenwithinacountryandyearbutacrossdifferent industries.

Testingthenewmodelsofinformalcontracting

(4)

selectioninsupplychains.Toillustratehowonecouldattempt totestthesemodels,andgiventhattheirpredictionsvarywidely and hence are hard to summarize, we briefly discuss Halac (2012)asarepresentativeexample,andoffersomeideasonhow totestherpredictionsinthehopethatinterestedresearchersmay useourdiscussionasastartingpointtopushtheempirical fron-tierfurther.Weprovide amoredetaileddiscussion ofhow to testthenewmodelsofinformalcontractinginGilandZanarone (2016).

Inaprincipal-agentmodel wherethe agentdoesnotknow howmuchtheprincipalvaluesherfuturerelationshipwithhim, akey result inHalac (2012)is that both the initialincentive contract, and its evolution in the course of the relationship, importantly changes depending on whether the principal or the agent has bargaining power. More precisely, her frame-workpredictsthatatthebeginningofacontractualrelationship, bonusesinaninformalincentivecontractshouldbehigher, rel-ative to thoseinan optimal formal contract, when the agent hasastrongpriorbeliefthat theprincipalvaluesthe relation-ship,andhence isable tocommit. Second, the likelihood of defaultsoninformalbonusesbytheprincipal shouldincrease in the agent’s prior belief when the principal has bargain-ing power, but not when the agent has bargaining power, as in the latter case ex ante screening ensures that there are nodefaultsinequilibrium. Finally,informalbonuspayments, andthe probabilityof default,shouldbeincreasing overtime whentheprincipal(theinformedparty)hasbargainingpower, andnon-increasing over timewhen the agent has bargaining power.

Totestthesepredictions,wewouldneedatleastfour vari-ables: (i) the incentive bonus offered at the beginning of an informal principal-agent relationship; (ii) the evolution of informallycontractedbonuspaymentsinthecourseofthe rela-tionship;(iii) the allocationof bargainingpower betweenthe principal (a company, a manager, a buyer) and the agent (a CEO, a worker, a seller); and (iv) the agent’s prior beliefs regardingthe principal’s type(low or highcommitment type inthemodel).Assaidbefore,collectingdataonwhether incen-tivepaymentsareformalorinformalischallengingbutpossible (Gillanetal., 2009;Gil,2013).The agent’sbeliefs aboutthe type of the principal can be assessed by looking at whether the agent has someknowledge of the principal’s history and reputation—perhapsthroughpublicrankingssuchasFortune’s “BestCompaniestoWorkFor”index—or hasspecific exper-tisetojudgetheprincipal’stype—forinstance,becausehehas beenanemployeeorfrequentbusinesspartneroftheprincipal inthepast.Finally,variablesthatmeasurethebargainingpower oftheagentwouldbethedegreeofunionizationoflaborforce inacompanyorlocation,andwhethertheprincipalisa monop-sonist(e.g., sole employer for allworkers) inthe local labor market.

Conclusion

In this paper we have discussed how furtherevidence on informal contracting can be produced. Overall, we find that theexistingevidenceisbroadlyconsistentwiththetheoretical

predictionsfromeconomicmodelsofinformalcontracting.At thesametime,wenoticethattheempiricalresearchoninformal contractshassubstantialroomtogrowandpresentsplentyof opportunities.Wehavehopefullyprovedthispointbyshowing howcurrenttestsofthetheoreticalpredictionscanbeimproved, andwhichtypesofpredictions areleftuntested.Wehopeour paper will foster future research that will test and feed our understandingofinformalcontractsandoftheirinteractionwith formalones.

Conflictsofinterest

Theauthorsdeclarenoconflictsofinterest.

References

Baker,G.,Gibbons,R.,&Murphy,K.J.(1994).Subjectiveperformance meas-uresinoptimalincentivecontracts.QuarterlyJournalofEconomics,109, 1125–1156.

Barron,D.,Gibbons,R.,Gil,R.,&Murphy,K.J.(2016).Relationaladaptation underreelauthority.Mimeograph.

Board,S.(2011).Relationalcontractsandthevalueofloyalty.American Eco-nomicReview,101,3349–3367.

Brickley,J.,Dark,F.,&Weisbach,M.(1991).Theeconomiceffectoffranchise terminationlaw.JournalofLawandEconomics,34,101–132.

Corts,K.,&Singh,J.(2004).Theeffectofrepeatedinteractiononcontract choice:Evidencefromoffshoredrilling.JournalofLaw,Economicsand Organization,20,230–260.

Fuchs,W.(2007).Contractingwithrepeatedmoralhazardandprivate evalua-tions.AmericanEconomicReview,97,1432–1448.

Gil,R.(2013).Theinterplayofformalandrelationalcontracts:Evidencefrom movies.JournalofLaw,EconomicsandOrganization,29,681–710. Gil,R.,&Marion,J.(2013).Self-enforcingagreementsandrelationalcontracts:

EvidencefromCaliforniahighwayprocurement.JournalofLaw,Economics andOrganization,29,239–277.

Gil,R.,&Zanarone,G.(2016).Newfrontiersintheempiricalresearchon informalcontracting.JournalofInstitutionalandTheoreticalEconomics, 172(June(2)),390–407.

Gil, R.,&Zanarone,G.(2015).Onthedeterminants andconsequencesof informalcontracting..AvailableatSSRN:http://ssrn.com/abstract=2560520 Gil,R.,&Zanarone,G.(2017).Formalandinformalcontracting:Theoryand evidence.AnnualReviewofLawandSocialScience,13(inpress,volume publicationdateNovember2017).

Gil,R.,Kim,M.,&Zanarone,G.(2017).Thevalueofrelationaladaptation inoutsourcing:Evidencefromthe2008shockto theUSAirline Indus-try.HitotsubashiInstituteofAdvancedStudy.DiscussionpaperseriesNo. HIAS-E-32.

Gillan,S.,Hartzell, J.,& Parrino,R. (2009).Explicitversus implicit con-tracts:EvidencefromCEOemploymentagreements.JournalofFinance, 64,1629–1655.

Halac,M.(2012).Relationalcontractsandthevalueofrelationships.American EconomicReview,102,750–779.

Helper,S.,&Henderson,R.(2014).Managementpractices,relationalcontracts, andthedeclineofgeneralmotors.JournalofEconomicPerspectives,28, 49–72.

Johnson,S.,McMillan,J.,&Woodruff,C.(2002).Courtsandrelational con-tracts.JournalofLaw,Economics,andOrganization,18,221–277. Kalnins,A.,&Mayer,K.J.(2004).Relationshipsandhybridcontracts:An

analy-sisofcontractchoiceininformationtechnology.JournalofLaw,Economics, andOrganization,20,207–229.

Klein,B.(2000).Theroleofincompletecontractsinself-enforcingrelationships. RevueD’ÉconomieIndustrielle,92,67–80.

(5)

Macaulay,S.(1963).Non-contractualrelationsinbusiness:Apreliminarystudy. AmericanSociologicalReview,28,1–19.

Macchiavello,R.,&Miquel-Florensa,P.(2017).Verticalintegrationand rela-tionalcontracts:EvidencefromtheCostaRicacoffeechain.Universityof Warwick(WorkingPaper).

Macchiavello,R.,&Morjaria,A.(2015).Thevalueofrelationships:Evidence fromasupplyshocktoKenyanroseexports.AmericanEconomicReview, 105,2911–2945.

MacLeod,B.(2003).Optimalcontractingwithsubjectiveevaluation.American EconomicReview,93,216–240.

MacLeod,B.(2007).Reputations,relationships,andcontractenforcement. Jour-nalofEconomicLiterature,45,595–628.

Malcomson, J.(2013). Relationalincentive contracts. InR. Gibbons,&J. Roberts (Eds.), The handbook of organizational economics. Princeton: PrincetonUniversityPress.

Milgrom,P.,North,D.,&Weingast,B.(1990).Theroleofinstitutionsinthe revivaloftrade:Themedievallawmerchant.EconomicsandPolitics,2, 1–23.