The Interaction Between Formal and Informal Contracts Giorgio Zanarone Colegio Universitario de Estudios Financieros, Madrid gzanarone@cunef.edu European.
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The Interaction Between Formal and Informal Contracts
Giorgio ZanaroneColegio Universitario de Estudios Financieros, Madrid
gzanarone@cunef.edu
European School of New Institutional Economics 2009
Outline
1. Introduction
2. Theoretical framework
3. Formal vs. informal contracts
4. Formal & informal contracts may be friends
5. Conclusions
1. When is a contract enforceable?
• When the enforcer– Understands its terms– Can verify breach– Is able/willing to enforce
• Affected by quality of law & courts. These are mostly ignored here, but see McLeod JEL ’07
• Parties must sink costs to make a contract enforceable
Tradeoff b/w formal & informal contracts
• Formal contracts– Enforceable by institutional 3rd parties (courts,
arbitrators)• Strong anti-breach remedies • High costs of making contract enforceable
• Informal contracts– Enforceable by the parties and/or by the
market• Weaker anti-breach remedies• Lower costs of making contract enforceable
2. An illustrative model
• P wants A to provide non-standard performance d– P=employer, A=employee, d=effort– P=employee, A=employer, d=bonus
• P has benefit πP(d) & outside option πP
• A has benefit πA(d) & outside option πA
• To make contract on d enforceable, P spends– f(d) if enforcer = court– i(d) < f(d) if enforcer = P
2.2. Formal contract
• A feasible formal contract sets performance d & price p such that– PCP: πP(d)-f(d)-p ≥ πP p ≤ πP(d)-f(d)-πP – PCA: πA(d)+p ≥ πA p ≥ πA-πA(d)
πA-πA(d) ≤ p ≤ πP(d)-f(d)-πP πP(d)+πA(d)-f(d) ≥ πP+πA
• The optimal contract dF maximizes the joint surplus πP(d)+πA(d)-f(d) s.t. πP(d)+πA(d)-f(d) ≥ πP+πA
2.3. Informal contract• A feasible informal contract sets performance d &
quasi-rent q such that– PCP: πP(d)-i(d)-q ≥ πP q ≤ πP(d)-i(d)-πP – PCA: πA(d)+q ≥ πA q ≥ πA-πA(d)– ICA: πA(d)+(1/r)[πA(d)+q] ≥ πA(d*)+(1/r)πA
• Note: d* = argmax πA(d) = D’s opportunistic action
• Setting q= πP(d)-i(d)-πP yields πP(d)+πA(d)-i(d) ≥ πP+πA+r[πA(d*)-πA(d)]
• The optimal contract dI maximizes πP(d)+πA(d)-i(d) s.t. πP(d)+πA(d)-i(d) ≥ πP+πA+r[πA(d*)-πA(d)]
3. Formal vs. informal contracts
• Informal contract will be used when– r low long-term relationship– i(d) low 2nd party enforcement cheap– f(d) high court enforcement costly
Example (1): Long-term relationship
Note: πA(d) = -cd
πP(d)-cd-i(d)
d
Surplus
πP(d)-cd-f(d)πP+πA
πP+ πA+rLcd
(2) Short-term relationship
d
πP(d)-cd-f(d)
Surplus πP+ πA+rLcd
πP(d)-cd-i(d)πP+πA
(3) Cheap informal contracts
d
πP(d)-cd-f(d)
SurplusπP+ πA+rcd
πP(d)-cd-iL(d)πP+πA
(4) Costly informal contracts
d
πP(d)-cd-f(d)
πP(d)-cd-iH(d)
Surplus
πP+πA
πP+ πA+rcd
3.2. Examples & evidence
• Outsourcing– Corts & Singh JLEO ’04, Kalnins & Mayer
JLEO ’04, Corts ’07, Camuffo et al. SMJ ’07, Shi & Susarla ’08, Gil & Marion ’09
• Delegation in firms– Baker et al. JLEO ’99, Foss Org Sc ’03
• Efficiency wages & quality assurance– Klein & Leffler JPE ’81, Shapiro & Stiglitz
AER ‘84, Krueger QJE ’91
Corts & Singh JLEO ’04
• Contracts b/w Oil & gas explorators and contracted drillers– Fixed price: strong incentives & strong holdup risks– Cost +: weak incentives & weak holdup risks
• Past interactions “cost +” contracts today• Effect greater for exploratory wells
– Note: in expl. wells costs predictable & effort important holdup (incentive) problems less (more) severe
• Interpretation– Informal contract on driller’s effort, not on fair bargaining– Cheap informal contracts (i ↓) or closer relationship (r ↓)
parties rely more on informal contract
Gil & Marion ‘09
• Highway procurement in California– Contractors partially outsource to subcontractors
• Past interactions– Decrease contractor’s bid on given project– Increase contractor’s likelihood to bid– Increase contractor’s likelihood to chose given
subcontractor• Significant only if future interactions expected• Interpretation
– Parties rely heavily on informal contracts– Cheap informal contracts (i ↓) and closer relationship (r ↓)
parties rely more on informal contract
Krueger QJE ‘91
• Franchised & integrated fast-foods• Managers earn 9% more in integrated
restaurants• Trade unions week in fast-food industry• Explanation: efficiency wage
– Informal contract on manager’s effort– High wage & threat of termination compliance– Franchisee residual claimant smaller reneging
temptation lower wage needed
4. Formal & informal contracts may be friends
• P & A will add to the informal contract “cheap” provisions that– Constrain A to provide standard performance
d, reducing her temptation to r[π(d)-π(d)]– Change A’s payoff function, reducing her
temptation to r[π(d*)-π(d)]– Create the quasi rent q when upfront
payments are too costly
• These provisions may be suboptimal in a purely formal contract
4.2. Extension to double agency
• P wants A to do dA, and A wants P to do dP
– P earns πP(dA,dP)-iP(dA)-(qP-qA)– A earns πA(dA,dP)-iA(dP)+(qP-qA)
• We can extend previous results:– The optimal informal contract maximizes
Σi[πi(di,dj)-ii(dj)] s.t. Σi[πi(di,dj)-ii(dj)] ≥ Σiπi+rΣi[πi(d*
i,dj)-πi(di,dj)]– P & A will add formal provisions to minimize
the aggregate reneging temptation & create quasi-rents
4.2. Examples & evidence
• Vertical restraints & decision rights– Klein & Murphy JLE ’88, Klein JCF ’95 & Rev
Econ Ind ‘00, Arruñada et al. JLEO ’01, Lafontaine & Raynaud ’02, Baker et al. ’09, Zanarone JLE ’09, Zanarone ’09b
• Firm boundaries– Garvey JEBO ’95, Halonen Econ Journ ’02,
Baker et al. QJE ’02, Zanarone ’09c
(cont.)
• Incentive contracts– Gibbons & Murphy JPE ’92, Baker et al. QJE
’94, Gibbons Man. Sc. ‘05
Zanarone JLE ‘09
• Automobile franchise contracts• After law prohibits exclusive territories,
manufacturers impose price ceilings• Puzzle: free competition
price ceiling redundant• Proposed interpretation
– Informal contract on non-competition– Ceiling reduces dealer’s gains from competing
when other dealers do not compete
Klein & Murphy JLE ‘88
• Contract b/w Coors & beer distributors• Coors used resale price maintenance (RPM)• Quality observed after sale traditional efficiency
reasons for RPM inapplicable• Proposed interpretation
– Informal contract on quality– RPM creates a monopolistic quasi-rent
• Question: why RPM & not monetary payment?
– Coors detects low quality & expropriates quasi-rent through termination
Zanarone ’09b
• Decision rights in automobile franchise contracts• Decision rights shared ex ante, manufacturers
dictate decisions ex post• Proposed interpretation
– Formal contract ≠ observed behavior informal contract matters
– Informal contract: manufacturer dictates, dealer implements
– Decision right increases (decreases) manufacturer’s (dealer’s) reneging temptation
Arruñada et al. JLEO ’01
• More decision rights to– Car manufacturers in larger networks– Car manufacturers in older networks
• Interpretation (consistent w/ Zanarone ’09b)– Large network freeriding dealer more tempted– Old network reputation manufacturer less
tempted– Decision rights allocated to minimize aggregate
reneging temptation
Baker et al. QJE ’02
• U(pstream) produces a good, and repeatedly exchanges it w/ D(ownstream)– Ex: supply chains
• Integration reduces U’s temptation to hold D up, but increases D’s temptation to hold U up– Holdup bad b/c it distorts U’s ex ante incentives
• Implications– Varying supply prices U tempted to hold D up under
separation integration– Strong incentives needed D tempted not to pay U
under integration separation
Zanarone ’09c
• D provides performance to U– Ex: commercial distribution, trucking
• Efficient performance > performance that maximizes downstream profits
• Informal contract on performance: D obeys (fiat)• Separation D residual claimant D more (less)
tempted to renege on high (low) performance• Implications
– Greater (informal) fiat under integration– Spillovers from D to U integration– Closer relationship b/w U & D integration
Example (1): integration optimal w/ large spillover
d
€
πP+πA
πP+πA+r[πS(d*S)-πS(d)]
πP+πA+r[πI(d*I)-πI(d)]
Example (2): separation optimal w/ small spillover
d
€
π0
πP+πA+r[πS(d*S)-πS(d)]
πP+πA+r[πI(d*I)-πI(d)]
4.4. Extensions: Endogenous outside options
• After breach, parties may revert to purely formal contract
• Good formal contracts may backfire– Greater fall-back option less informal
contracts feasible• Baker et al. QJE ’94, Bernheim & Whinston AER ’98,
McLeod JEL ‘07
Informal contracts & the law
• Should courts enforce incomplete contracts?– Yes, b/c parties delegate completion to courts
• Hadfield Stan. Law Rev. ‘90
– No, b/c parties want private enforcement• Klein AER ‘80
– Not when the parties signal they want courts out • Scott Col. Law Rev. ’03
4.5. Methodological summary: How to assess informal contracts?
• Look for links b/w contract design, outcomes & long-term relationships– Ex: Past & future interactions
• Look for relationships w/o a formal contract
• Look for seemingly inefficient formal contracts
• Look for outcomes inconsistent w/ observed formal contracts
5. Conclusions
• Informal contracts appealing when– Formal contracts costly to write, monitor & enforce– Parties know each other well– Parties have a future together
• Formal contracts complement informal ones by– Minimizing reneging temptations– (Maybe) creating sources of quasi-rents
• Interaction b/w formal & informal contracts explains puzzles
Thank you
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