Contracting Practices and Learning to Contract

ESNIE 2004

Nicholas ArgyresBoston University

What kinds of things do we know about the economics of contract structure from empirical studies?

Contract duration

Joskow (1985, 1987): Greater relationship-specific investments associated with longer contracts in coal.

Masten/Crocker (1985, 1988): Performance incentives facilitate longer-term contracting in natural gas.

Pirrong (1993): Longer contracts used to avoid temporal, contractual specificities in ocean shipping.

Payment Terms, Incompleteness

Leffler and Rucker (1991): Payment terms reflect measurement costs in timber harvesting.

Crocker and Reynolds (1993): Greater incompleteness chosen to manage technological uncertainty, longer time horizons.

Equity, Control rights

Pisano (1989), Oxley (1997): Equity alliances more common when R&D is exchanged.

Lerner and Merges (1998): Allocation of intellectual property rights reflects bargaining power as much as marginal contributions in biotechnology.

Assertion

We know much less about how contract structures evolve over time, either: Between two partners Across an industry

Are “optimal” contract structures discovered quickly?

Determinants of Contract Evolution

Well understood: Changes in nature of contractual

hazards Regulatory changes (e.g., natural gas)

Less well understood Shifts in bargaining power (e.g.,

Lerner/Merges) Learning to contract

Why few studies of learning to contract?

Equilibrium theories Cross-sectional studies on old

industries with stable contract structures: Coal Natural gas Petroleum coke Timber harvesting Lobstering

The Evolution of a Contractual Relationship Seller: Small U.S. software developer Buyer: large Japanese

computer/electronics firm Series of short term contracts over 9

years 100% customized software

Four Types of Changes in Contract Changes

Enhancing communication Clarifying responsibilities &

expectations Contingency planning Format changes

Enhancing Communication

Changes to the contract must be in writing (SOW #3) Conflicting requests from HW personnel.

Changes to the contract must be reported in a timely manner (#6) Response to delays caused by #3 change.

Problem reporting process added (#8) #3 change didn’t eliminate conflicting

requests Single point of contact at Softstar (#9)

Clarifying Responsibilities and Expectations

Softstar receives full hardware spec’s (#6) HW had tried to push spec development onto

Sofstar Addition of Softstar deliverables section (#7)

Ensures HW release notes, info about source codes, etc.

Project schedule to be negotiated immediately after contract is signed (#7) To address conflicts over deadlines.

Project schedule to be negotiated into contract (#8) Attention deficit after contract signed.

Clarifying Responsibilities and Expectations (cont’d)

Delivery schedule for hardware platforms from HW Inc. added (#8)

Quality assurance/test procedure added (#9)

Features to be included in each release are added (#10) Conflict: HW wants more content in alpha, beta,

versions, Softstar wants more staggering. Equipment and materials required section

of the contract gets much more detailed (#10)

Planning for Contingencies

Addition of risks/concerns section to the contract (#5) HW complains about delays; Softstar cites

technical problems Clause added: hardware problems,

requested changes lead to re-negotiation of the contract and schedule (#8) Conflicts over definition of “minor” change

request Engineering change process added (#9)

Provides guidelines for price, schedule updating

Planning for Contingencies (cont’d)

Section dealing with how to adjust to changes in industry standards added (#10)

Modifying the Format

System architecture section added (#3)

Revision history section added (#5) Table of contents added (#6) System architecture section

expands to include much more product detail (#6)

Learning to Contract Problems encountered previous

projects/contract were incorporated into future contracts.

Contingencies had to be experienced before they were addressed in contracts – few anticipated. Even after contingencies experienced, several

remedies initially failed, and revision required At no point was effort made to

systematically identify/contract against future possible disturbances.

Nature of Learning

Learning tended to be slow, incremental, backward looking. Problemistic search (Cyert & March)

No evidence of learning from contracts with other parties, or from industry associations, etc.

Governance and Communication

Learning was largely in directions consistent with TCE: Many new contract terms aim to help

prevent/resolve disputes stemming fromself-interestedness, if not outright opportunism

Communication effects of contracts also important.

Figure 1Project Size and SOW (Contract) Length

0

5

10

15

20

25

30

35

40

45

1 2 3 4 5 6 7 8 9 10 11

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

SOW Pages - TechnicalContent

SOW Pages - AdminProcesses

Total SOW Pages

Estimated Project Cost

Softstar and HW Inc. Relationship

Alternative Explanations

Did detailed contracts reflect efforts to increase safeguards as asset specificity increased? Association between project cost and no. of

administrative pages only begins at SOW #7 Also: can’t ignore interview data

Increased contract length also not due to technical communication requirements only: Administrative pages grew faster than technical

pages

Alternative Explanations (cont’d)

Did parties trust each other less over time and thus require longer contracts? Opposite of suggestion by Gulati 1995, Doz

1996 No evidence of diminishing trust:

Softstar employees, including the project manager in charge of the relationship, report an increase in trust over time

Because documentation in contracts helped avoid “unrealistic expectations”

Contracts as Knowledge Repositories

Contracts can play key role in codifying knowledge about how to collaborate: Such codification may assist in development

of collaborative capability (e.g., Zollo & Winter 2002; Kale Dyer & Singh 2002)

“Contracting routines” can support the kinds of knowledge-sharing routines in alliances emphasized by Dyer & Singh 1998.

Beyond the Flexible Framework

Lewelyn, Macneil emphasized contracts as “flexible frameworks” for adaptation “iron rules” vs. “yielding rules”

When contracts serve as knowledge repositories, rules themselves are added or transformed over time.

Key conditions for repository role Contracts most likely to play

knowledge repository role when: Technical change is rapid Tight compatibility requirements

between buyer/supplier technologies Lawyers are in background

Effects of contracts on trust Some argue for negative effect

(e.g., Macauley 1963; Larson 1992; Uzzi 1997) Especially as relationship continues

(Ring & Van de Ven 1994; Gulati 1995) Others argue for positive effect

(e.g., Sitkin 1995; Lorenz 1999; Poppo & Zenger 2002)

Empirical evidence evidence exists to support both sides.

E.g., negative effect: Malhotra & Murnighan (2002) E.g., positive effect: Poppo & Zenger 2002

Implications for trust debate

In our case, effect was positive. Trust enhanced by:

Better understanding of roles and responsibilities in contracts

“Learning together” atmosphere that developed in contracting process

Implications for TCE In high tech industries, contracting

behavior may not be as forward-looking as theory assumes – contracts slowly evolve toward efficient structure.

Contract design capabilities could vary across firms and become a source of competitive advantage.

Such capabilities could act as a “shift parameter” in TCE calculus: Strong capability -> outsource transactions at

lower threshold level of asset specificity.

2nd Paper We identify several dimensions

along which learning to contract occurs: Dispute Resolution Assigning Roles and Responsibilities Communication Allocating Decision/Control Rights Contingency Planning

2nd paper (cont’d)

Claim: Learning to contract involves achieving better trade-offs, along each dimension, between: Level of contract detail Use of template vs. Customized contract

Claim: Contract design capabilities inhere primarily in lawyers or managers/engineers depending on key dimension.