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长期合同和关系合同
文/Morten Hviid

 LONG-TERM CONTRACTS AND RELATIONAL CONTRACTS

Abstract

 

This chapter discusses the literature on long-term contracts and relational

contracts. The central issues in the literature on long-term contracts are the

effects of renegotiation and what these contracts can accomplish over and above

a series of short-term contracts. The literature on relational contracts focuses

on how self-enforceable terms can be supported without the use of enforceable

contracts. Among the possible answers to this are repetition and norms.

JEL classification: C72, D82, K12

Keywords: Long-Term Contracts, Renegotiation Proofness, Relational

Contracts, Repeated Games, Norms

 

1. Introduction

 

For contracts of a non-trivial duration, contract law faces the dilemma of, on

the one hand, offering a means of commitment and, on the other, allowing for

sufficient flexibility to adjust to changes in the environment. ‘This tension

between the need to fix responsibilities at the outset and the need to readjust

them over time permeates the long-term contractual relationship’ (Baird, 1990,

p. 586). This tension is basic to both long-term and relational contracts.

 

This entry discussed two classes of contracts, long-term contracts and

relational contracts. Although closely related, neither is a subset of the other.

Completely state-contingent long-term contracts are clearly not relational.

Incomplete long-term contracts would in most cases be relational, although, as

pointed out by Eisenberg (1995), they need not be. As regards relational

contracts, ‘[t]wo features largely define what lawyers mean by a relational

contract: incompleteness and longevity. Relational contracts govern continuing

relations’ (Schwartz, 1992b, note 1, p. 271). However, as pointed out in Goetz

and Scott (1981) a relational contract need not be a long-term contract,

although in most cases it would be.

 

The two literatures appear to address different issues and hence will be

discussed separately below. The central issues in the literature on long-term

contracts seems to be the effects or renegotiation as well as what can be

accomplished by such contracts over and above what can be achieved by a

series of short-term contracts. The literature on relational contracts assume that

contract terms are not used and focus on how repeated interaction and social

norms can ensure that obligations between parties can become self-enforceable.

 

A. Long-Term Contracts

 

2. Long-Term Contracts: General

 

Summaries of the literature can be found in Bolton (1990), Hart (1987), Hart

and Holmstrom (1987) and most recently in Salanié (1997, chs 6 and 7). For

a recent survey focusing solely on labor contracts, see Malcolmson (1997).

 

Following Salanié (1997, p. 150), a dynamic (long-term) contract is

complete if ‘all variables that may have an impact on the conditions of the

contractual relationship during its whole duration have been taken into account

when negotiating and signing the contract’. This definition rules out any

unforeseen contingencies which may arise during the duration of the contract.

However, it does not rule out asymmetric information. If, for example, the

principal can never observe the effort of an agent, the contract cannot stipulate

a level of effort. According to the above definition, the contract is still complete

if no information of future relevance will become available later on in the life

of the contract. Some authors, such as Hart (1995) refer to this as a

comprehensive contract, because ‘there will never be a need for the parties to

revise or renegotiate the contract as the future unfolds’ (Hart, 1995, p. 22).

 

For an early demonstration that long-term complete contracts can enable

valuable commitment, see Grout (1984). In the case where complete contracts

can be written, full commitment is always valuable, since a contract with full

commitment can always mimic the outcome of any other contract with less

commitment by committing to the same actions as lead to the outcome for the

latter contract, see Salanié (1997, pp. 144-146).

 

Commitment to a contract can either be broken by a unilateral deviation,

namely breach, or multilateral deviation, namely renegotiation. In case of

breach, one party has access to the legal system to either enforce the contract

or to award damages. When using the legal system is costless, whether breach

is actually possible depends on the breach remedies used by the court. If the

remedy is specific performance, the contract can only be varied by mutual

consent. If, as is more commonly the case, the remedy is expectation damages,

one party can always decide to breach and pay the damages (see Chapter 4600

Contract Remedies: General).

 

In the case of a multilateral deviation where both parties want to vary the

contract term, it is in general not possible to hold the parties to the original

contract by legal means. ‘[B]oth parties’ commitments are only as strong as

their contracting partners’ desire to hold them to their original promises’ (Jolls,

1997, p. 203). Since commitment is valuable when complete contracts can be

written, losses may occur if renegotiation at any point during the life of the

contract cannot be prevented. Although Jolls (1997) does offer some

suggestions for enforcing terms which both parties would later agree to vary,

it would appear that renegotiation is difficult to rule out legally. This then leads

to a focus on contracts which are renegotiation proof (see Dewatripont, 1989

and Bolton, 1990).

 

One reason why there may be scope for renegotiation is that ex ante

efficiency may require ex post inefficiency. For example, in order to separate

out workers with different levels of unobservable productivity, the menu of

contracts offered to the workers will generally not imply that all types get their

first-best contract. However, once their type has been inferred from their choice

of contract, it is (ex post) efficient to renegotiate these contracts. Doing so may

make a renegotiated contract of a type A worker more attractive for a type B

worker than the contract which ex ante was designed for type B and the

original menu will no longer be fully separating. Thus removing the ex post

inefficiencies may remove the incentives which ensured that the contract was

ex ante efficient.

 

3. Renegotiation

 

As pointed out among others by Bolton (1990, p. 304) ‘[i]t turns out that the

role of and issues raised by renegotiation are somewhat different when the

contracting problem is set in an environment of asymmetric information as

opposed to an environment of symmetric but unverifiable information.’ The

difference between the two cases relates to whether some ex post inefficiencies

remain when renegotiation is possible.

 

Asymmetric Information

For the case of adverse selection, the value of commitment is very clear.

Consider a dynamic contract between a principal and an agent, where initially

the productivity of the agent is not known to the principal. In any separating

equilibrium, the productivity of the agent will be known to the principal after

the first period. For the ‘bad’ type of agent, separation involves a distortion

leading to a lower utility in every period of the contract than would be the case

if his true type was known. If the true type is really the bad type, the distortion

can be removed after the first period when the agent’s type is known for sure.

Hence if renegotiation is possible, it will take place - the contract is not robust

against renegotiation. Moreover, since both parties want to renegotiate, it is

difficult to see how the legal system can prevent this happening. Papers such

as Dewatripont (1989) turn the focus on contracts which are

renegotiation-proof, that is, contracts where there is never an incentive to

renegotiation. With comprehensive contracting this is possible, because any

incentive to renegotiate later could have been foreseen at the time of agreeing

the original contract. As is shown in Dewatripont (1989), Hart and Tirole

(1988), Laffont and Tirole (1987, 1990) the possibility of renegotiation slows

down the speed of revelation. Essentially this is caused by a trade-off between

speedy revelation and the damaging incentive to renegotiate.

 

Moral Hazard

For the case of moral hazard, the literature is less well developed. Fudenberg

and Tirole (1990) consider a principal-agent model where there is a gap in time

between the agent taking a hidden action and the outcome of this being known.

If the principal can infer the agent’s action before the outcome is known, a

renegotiation which perfectly insures the agent is optimal. However, if the

agent realizes this, the incentive structure of the original contract is blunted. As

in the case of adverse selection, information revelation has to be slowed down.

In the moral hazard case this is achieved by the agent randomizing over its

choice of action. The essential lesson from this model is that if renegotiation

is possible after effort has been chosen, then the principal cannot make the

agent choose the optimal effort for sure. Hence renegotiation again leads to an

efficiency loss. Related papers in this area are Chiappori et al. (1994) and Ma

(1991).

 

Symmetric but Unverifiable Information

Consider a contract on future trade between two parties. Because the

information and hence the state of nature is unverifiable by a third party, a

contract cannot be conditioned on this state. However, because information is

symmetric, any negotiation of the sharing of the surplus in such a state will,

given the symmetry of information, be efficient. Problems arise because the ex

post sharing of the surplus need not be ex ante efficient. Contracts which are

proof against renegotiation can still improve upon an allocation without any

long-term contract by designing the environment of the renegotiation in the

unverifiable state. Hart and Moore (1988) show how the ex ante contract can

be constructed to affect the bargaining power of the two parties ex post.

However, this literature is not as yet well developed, but other papers in this

area are Aghion, Dewatripont and Rey, (1990) and Bolton (1990).

 

4. Unforeseen Contingencies

 

Because unforeseen contingencies may arise during the life of the contractual

relationship, there is a need to fill in the consequent gap between obligations.

Gap filling in general is discussed in Chapter 4000 (Contract Law).

Renegotiation may be valuable as one would expect the contracting parties to

be able to fill the gap at a lower cost than a third party, partly because the

contracting parties can be assumed to have better information. As in the case

of symmetric but unverifiable information, long-term contracts may allow the

parties to at least partly design the environment under which the (re)negotiation

takes place.

 

In terms of modeling unforeseen contingencies, there is not as yet an agreed

approach. What is clear is that at least for contract issues, simply treating

unforeseen contingencies as events which occur with probability zero is not

generally appropriate. If the contingency occurs with probability zero, the

expected cost of not providing for it in a long-term contract is also zero, and

hence the more flexible short-term contract would not appear to offer any

advantage due to any unforeseen contingencies. For a survey of the state of the

art as well as a discussion of incomplete contracts, see Dekel, Lipman and

Rustichini (1998).

 

The theory of residual control rights, developed in Grossman and Hart

(1986) and Hart and Moore (1990), see also Hart (1995), offers one way in

which we can approach the problem of modeling unforeseen contingencies.

Residual control rights determine who has the right to decide on how a

particular asset should be used whenever an unforeseen contingency occurs.

Thus even if the actual event cannot be described, rules for who fills in the gap

for a particular class of events can be described (see also Kreps, 1990).

In general, in the case of unforeseen contingencies, the ability to renegotiate

or put differently, contractual flexibility, may be efficiency enhancing rather

than an added constraint.

 

5. Short-Term vs. Long-Term Contracts

 

With asymmetric information, the possibility of renegotiation slows down

info2mation revelation. This is equally true in the case where only a series of

one-period (or spot) contracts can be signed, an effect known as the ratchet

effect (see Freixas, Guesnerie and Tirole, 1985). What are then the fundamental

differences between short-term and long-term contracts?

 

The literature suggests that the performance of long-term contracts may

differ from a series of short-term contracts for a number of reasons. The

(transaction) costs of negotiating and policing one long-term contract may be

lower than negotiating a series of short-term contracts. Long-term contracts

may enable income smoothing if this is not available via credit markets. If

regenotiation can be avoided, they also offer better commitment. Informational

asymmetry may also favor long-term contracts. For a general discussion, see

Hart and Holmstrom (1987).

 

It is fairly obvious that differences in transaction costs may lead to

differences in the performance of long-term and short-term contracts. Not only

may the actual costs of writing the contracts be different, but if renegotiation

is costly, the commitment aspect of long-term contracts may also be

strengthened. This area does not appear to be well developed but see Dye

(1985).

 

In a principal-agent model of asymmetric information Malcomson and

Spinnewyn (1988) show that, in the absence of renegotiation, long-term

contracts can improve on short-term contracts only if they commit either the

principal or agent to a payoff in some future circumstance which is lower than

what could be obtained from a short-term contract negotiated if that

circumstance occurs. Thus the long-term contract has to have some

commitment value in order to be preferred to a series of short-term contracts.

Similar results are obtained in Allen (1985).

 

In the special case where the contracting parties have perfect information,

Crawford (1988) shows that short-term contracting distorts investment

decisions only when the efficient plan involves mainly sunk cost investment

and the relationship plays a consumption smoothing role. In this case the main

role for long-term contracts is to serve as a substitute for an efficient credit

market.

 

In a pure moral hazard principal-agent model, Chiappori et al. (1994)

demonstrate that two conditions are necessary in order that there is no

difference between what can be achieved by an optimal long-term contract and

a series of spot contracts. Firstly, the long-term optimum must be renegotiation

proof. This reduces the commitment value of a long-term contract. However,

this is not sufficient. In addition, the spot contracts should provide efficient

consumption smoothing. When the agent does not have access to credit

markets, spot contracting does not allow for consumption smoothing and hence

spot contracts cannot implement the long-term contract. However, if the agent

has access to credit markets and the principal can monitor this, we do get spot

implementation, a result also found in Fudenberg, Holmstrom and Milgrom

(1990), Malcomson and Spinnewyn (1988) and Rey and Salanié (1990). The

case where the agent has access to capital markets but where the access cannot

be monitored is more complicated because the spot contract may involve more

smoothing that the renegotiation-proof long-term contract.

 

If consumption smoothing is a strong reason for preferring long-term

contracts over short-term contracts, one might expect that in labor markets, the

lower the wage, the more likely would be long-term employment contracts.

This does not seem to be the case in reality. For this reason, Fudenberg,

Holmstrom and Milgrom (1990) assume away any imperfect capital market

influences and focus on problems caused by asymmetric information. They

consider long-term contracts that cannot be renegotiated and set out the

circumstances under which these have a value above a series of spot contracts

or a contract which is renegotiation proof. Due to the asymmetric information,

two types of adverse selection, which imply a value to the commitment of a

long-term contract, can arise. The first case arises if the preferences of the

principal and the agent over future contingent outcomes are not common

knowledge. As was noted above, if more information about the agent becomes

available over time, there may be scope for renegotiation. The second case

arises when the outcome on some date $t$ conveys information on actions

taken by the agent prior to that date. At date $t$, the principal, on the basis of

this new information, may wish to punish or reward the agent for the past

actions. However this is not possible if there is not a binding long-term

contract. One of the main contributions of this paper is to make precise when

there would be a benefit to ruling out renegotiation.

 

The existing literature has demonstrated that even if renegotiation cannot

be ruled out, long-term contracts may still dominate a series of short-term

contracts. At the same time, the benefit of long-term contracts would be much

enhanced if renegotiation could be at least limited.

 

6. Empirics

 

Despite the huge problems of getting data, a substantial number of empirical

studies have considered long-term contracts. A general survey and evaluation

can found in Lyons (1996). An incomplete list of empirical case studies of

long-term contracts include among others: Chisholm (1993) (the movie

industry), Crocker and Lyon (1994), Crocker and Masten (1988, 1991) and

Masten and Crocker (1985) (the design and duration of long-term contractual

relationships for natural gas), Galassi (1992) (share contracts in early

Renaissance Tuscany), Goldberg (1985a) (aluminium), Goldberg and Erickson

(1987) (petroleum coke), Joskow (1985a, 1988, 1990) (contacts between

electricity generators and coal suppliers), Lafontaine (1992) (franchising),

Lyons (1994) (small subcontractors making specific inputs for customers in the

engineering industry), Palay (1984) (rail freight).

 

B. Relational Contracts

 

7. Relational Contracts: General

 

The relational move appears to grow out of the empirical work by Macaulay

(1963) with the origin of the term relational contract usually traced to MacNeil

(1974). Given the impact of this work, it is surprising how few replications

have been carried out to date. The best known of these is Beale and Dugdale

(1975), but see also Kenworthy, Macaulay and Rogers (1996) and Esser (1996).

The lack of replication is a concern because the modest sample sizes in these

studies imply that the results are not generally statistically significant. For

example, Macaulay’s sample was 68 businessmen and lawyers representing 43

companies and 6 law firms whereas Beale and Dugdale’s sample was 33

individuals in 19 firms of engineering manufacturers. Although in both cases

the authors are careful to point out the potential weaknesses of their data,

studies which rely on their results for motivation are less careful to point this

out.

 

The main empirical observation of relevance to the relational contract

literature was that firms within the same industry tended to resort to neither

contract terms nor contract law to settle disputes about obligations. Although

persuasive, neither Macaulay (1963) nor Beale and Dugdale (1975, p. 47) offer

any tests of statistical significance. Beale and Dugdale (1975, p. 47) do offer an

insight into when the result did not hold, namely when firms in the sample

were transacting with ‘outsiders’. ‘Firms frequently stated that they would take

much greater care when contracting with relatively unknown parties, especially

those outside the engineering trade’ (Beale and Dugdale, 1975, p. 47). From

these studies it would appear that contracts have little relevance where the

parties ‘knew’ each other.

 

To aid a discussion of the contribution of relational contract scholarship, a

clear definition of what is a relational contract would be helpful. However,

although several have to date been offered, most of which are discussed in

Eisenberg (1995), none appear to be universally accepted. Goetz and Scott

(1981) argue that what makes a contract relational is that there are states of the

world where obligations cannot ex ante be defined. ‘A contract is relational to

the extent that the parties are incapable of reducing important terms of the

arrangement to well-defined obligations. Such definitive obligations may be

impractical because of the inability to identify uncertain future conditions or

because of inability to characterize complex adaptations adequately even when

the contingencies themselves can be identified in advance’ (Goetz and Scott,

1981, p. 1091). The central role for the relationship between the contracting

parties for the duration of the contract would appear to be the manner in which

a gap is filled.

 

MacNeil, in a series of papers (MacNeil, 1974, 1978, 1981a, 1987a),

highlights the importance of two principles of behaviour: solidarity and

reciprocity. ‘Getting something back for something given neatly releases, or at

least reduces, the tension in a creature desiring to be both selfish and social at

the same time; and solidarity - a belief in being able to depend on another -

permits the projection of reciprocity through time’ (MacNeil, 1987a, pp.

274-275). The importance of these have been tested in Kaufmann and Stern

(1988), who study how firms react to breach by a trading partner. They

demonstrate how firms are initially very forgiving in order to maintain the

relationship, but that once they judge that the partner has acted

opportunistically, their attitude changes dramatically. For a discussion of this

and other empirical work on relational contracts, see Lyons (1996, pp. 45-49).

 

Relational contract theory can be seen as an attempt to generate a model

able to explain when transacting parties do not resort to contracts and by what

means they ensure that each party fulfils their obligations. The theory focuses

on the relationship between the ‘contracting’ parties and posits that this leads

to cooperation and to implicit obligations being self-enforcing. In the extreme,

no formal contract is needed to ensure that all gains from a particular

transaction are realized. The theory rests on repeated interaction within a

particular well-defined group together with a set of norms governing the

behaviour of the group members. Whereas the literature on long-term contracts

focuses on the problems which arise because of incompleteness and the

potential for renegotiation, the theory of relational contracts focuses on the

relationship between the contracting parties which ensures that opportunistic

behaviour does not arise. Unless we assume that individuals are naturally

cooperative, the next step is to determine how cooperation might emerge

anyway.

 

8. Endogenous Cooperation

 

One way to understand the observations in Macaulay (1963), as well the

attempts to define a relational contract, is as follows. If having the reputation

of either keeping to a contract term, or modifying or bargaining to fill a gap in

good faith, is sufficiently important (or valuable), the law is not needed to

enforce this term. Reputation is valuable either when interacting with the same

individual on several occasions or when interacting sequentially with several

individuals. In a relational contract, the parties rely on each other to behave in

a cooperative manner for the duration of the contract, rather than exploiting

any opportunity which may come along. ‘Parties who enter contracts desire

coordinated, and hence cooperative, actions on the part of their contracting

opposites. Therefore, the principal measure of the success of our contract law

is whether it in fact induces cooperation’ (Baird, 1990, p. 584).

 

The remainder of this section considers briefly how and when cooperation

can occur endogenously among, to follow MacNeil, creatures desiring to be

both selfish and social at the same time. The discussion makes clear how norms

can play an important role in this theory.

 

The Folk Theorem and Repeated Games

Repeated games consider the possibility of achieving cooperation through

self-enforcing (possibly tacit) agreements. These are discussed more extensively

in Chapter 0550 (Game Theory Applied to Law), see also Baird, Gertner and

Picker (1995) and Hirshleifer (1994). Consider a game where the

non-cooperative Nash equilibrium is Pareto dominated by another outcome.

This is, for example, the case in the Prisoner’s Dilemma, or in a game where

A must decide whether or not to lend B money and B must subsequently decide

whether or not to pay A back. If the parties could write a binding contract, they

could clearly implement a better outcome for both. If that is not the case, any

(tacit) agreement to cooperate must be self-enforceable.

 

Repeated interaction may enable cooperation, because of the potential for

a current deviation to be punished in the future. For this to work, four

conditions must be met. Any deviation must be observable and it must be

punishable. This punishment must be credible so that it is clear that when

required the punishment will be carried out, and the parties must be patient in

the sense that the future matters to them.

 

The folk theorem for repeated games, loosely speaking, states that if the

players are sufficiently patient and the game is repeated for a sufficient number

of periods, the players can cooperate to obtain a better outcome than the

non-cooperative Nash equilibrium of the one-period game. Put differently, the

short-term gain from deviation is more than offset by the present discounted

value of the future punishment. The folk theorem generalizes to many different

settings. Cases where there are uncertainty, informational asymmetries,

differences in the identity of the players, overlapping generations of players and

random matching between players can all give rise to folk theorem-type

outcomes. Thus, for example, the repeated interaction does not have to be

between the same two individuals over time.

 

In order to cooperate, the parties have to ‘agree’ on two issues: which

cooperative outcome should be support and which punishment should be used

in case of a deviation. Although this agreement could be tacit, when we are

talking about contractual relationships it is more natural to think of this as an

explicit agreement. Not only are there typically many outcomes which could be

supported, but each outcome may also be supportable by many different forms

of punishment. Of the latter, the best known are Tit-for-Tat (each player in this

period does what the other player did in the last period), the (Grim) Trigger

Strategy (deviation is followed by non-cooperation in all future periods) and

Stick and Carrot (severe punishment followed by forgiveness). Because there

are many different potential punishments, norms may pay a crucial role in

selecting which path is used. This is particularly important where the

cooperation is between many different individuals over time. If A is willing to

cooperate with or trust B because B cooperated with many other individuals in

the past it is important that A understands if and when B is being punished. For

more on this see Chapter 0780 (Non-legal Sanctions). Thus the theory would

predict that cooperation is more likely between fairly homogeneous groups.

 

There are cases where repetition does not admit cooperation. The most

notable case is when the number of periods over which the game is played is

finite and known, where the equilibrium of the one-period game is unique and

where the exact characteristics of the players are known to all players. In the

last period defection will occur because there is no future in which to punish

this. But then cooperation in the penultimate period cannot be supported by a

combination of a credible promise of cooperation in the last period combined

with a threat of defection in the last period as a punishment. Much is made of

this in Jolls (1997). However, if just one of the three conditions is violated,

cooperation may emerge. If there is an uncertainty about whether this period

is the last, then there is still a potential future and hence a future punishment

to worry about if a player decides to deviate. If the stage game has multiple

equilibria, cooperation may be possible because a credible threat consisting of

the ‘worst’ equilibrium can be issued. If there is some small chance that one of

the players is not a rational economic actor at all, but is an irrational type who

will cooperate regardless, the rational type may prefer to maintain a reputation

for being irrational.

 

Some of the punishments which supports cooperative outcomes harm both

the guilty and the innocent. In such cases, the innocent has an incentive to

accept any request for forgiveness, which would destabilize the cooperative

agreement as deviations from cooperation are not punished. Although there is

no formal contract, this problem is one of renegotiation resembling that

encountered in long-term contracts. A social norm entailing punishment for

cheaters would clearly support cooperation. On the other hand, a social norm

of forgiveness would not.

 

Relational Contracts and Repeated Games

Scott (1987b) represents an early, if incomplete, attempt to model long-term

contracts as a repeated game. Unfortunately the paper does not fully utilize the

then available theory on repeated games. Scott recognises that cooperation may

arise without any contracts at all and points out that legal rules can affect both

the formation of the contract (‘the initial risk allocation’) and later adjustments

to the contract, but argue that the greater effect is on the initial risk allocation.

This effect comes via implied terms and express invocations. Scott highlights

the importance of norms, in particular the norm of ‘reciprocity’. The analysis

is summarized as follows:

 

Contracting parties use a mix of legal and extralegal mechanisms, as well as

patterned and individualized responses, to ameliorate the information and

enforcement deficits that threaten emergent patterns of cooperation. Nevertheless,

contractual breakdowns are inevitable. Patterns of cooperation in contractual

relationships are inherently unstable, especially where one party is threatened with

substantial losses (or tempted with substantial gains). Where necessary adjustments

are of lesser magnitude, however, social norms aimed at introducing long-term

cooperation will often prompt adjustment, and legal rules provide appropriately

remote, but harsh, deterrents and incentives. (Scott, 1987b, p. 2049)

 

Other attempts to model relational contracts using repeated games are found in

Baird (1990), Baird, Gertner and Picker (1995), Campbell and Harris (1993),

Hviid (1996, 1998) and, for an example of the use of experimental methods,

Hackett (1994).

 

One insight from the theory of repeated games is that successful cooperation

does not necessarily involve observing either deviations or punishments. This

does not reduce the importance of the punishment because it is what keeps

opportunism in check. Contract law potentially affects the available

punishments, their severity and the gains from deviation. Hadfield (1990) notes

that in franchise contracts courts consistently fill gaps to the benefit of one side

of the contract (the franchisor). This may severely hamper the ability of the

franchisor to credibly promise to act in good faith. Contract terms also affect

the ability to punish. The severity of the punishment can be increased by

leaving the contract more incomplete than necessary (see Bernheim and

Whinston, 1998; Hviid, 1998). Other examples are terms implying expensive

third-party arbitration, rights to terminate the contract (for example,

franchises), or demands of performance under the contract. All these terms can

make non-cooperative behaviour potentially costly. Thus contract law and

contract terms may matter even in relational contracts which are substantially

relying on self-enforceable agreements and where the law is not seen to be used.

 

Repetition may not in itself be sufficient to ensure cooperation. In some

cases this depends on the available institutions. An interesting combination of

repeated games and institutional design as a means to overcome incentives for

short-term opportunistic behaviour is found in Greif, Milgrom and Weingast,

(1994). They model the emergence of merchant guilds in the late medieval

period as a response to the incentives of the ruler of a trade centre to

opportunistically appropriate rents from some of the traders. In their model

repetition as such is insufficient to ensure cooperative behaviour by a ruler

because the ruler can abuse individual traders, whose threat of punishing the

ruler by staying away from the centre is non-credible if most of the other

relevant traders do not know about the abuse and hence continue to use the

trading centre. Strong merchant guilds can credibly initiate a collective

punishment (a boycott for a given period) by coordinating the actions of its

members. One relevant lesson for relational contract theory is that institutions

may still matter. Moreover, the institution of the guild had an effect even if a

boycott was never observed in the same way that legal institutions may have an

effect even if they are never seen to be active.

Finally, what might on the face of it appear to be a mixture of relational and

 

written contracts has been considered in Klein (1996), who argues that court

enforcement and private enforcement need not be alternative contract

enforcement mechanisms, but may be complements. The former may on its own

generate too much rigidity, making it possible for one party to ‘hold-up’ the

other when conditions change radically (one has to think of such radical

changes as being insufficient to excuse performance, but radical enough that

they were not covered by the original contract). The latter generates too much

flexibility.

 

The idea of Klein (1996) is that private enforcement creates a range of

self-enforcement. So long as the change to the environment does not place the

gains from a hold-up outside what can be negated by private punishment, the

hold-up will not occur. Court-enforceable contract terms can be used to change

this range, either by extending it, by shifting it, or by affecting the probability

distribution over the value of a hold-up. It is in this way that court and private

enforcement becomes complementary.

 

It is worth noting that unless the definition of a relational contract is

weakened, it does not seem that the framework in Klein (1996) provides an

economic justification for relational contracts since the contract terms which

have been agreed must be enforced, that is, there is nothing relational about

that part of the contract. Moreover, if the courts fail to enforce the terms of a

contract literally, then this may paradoxically create more scope for hold-ups.

 

9. Concluding Remarks

 

The impact of the relational contract theory on the economic literature on

incomplete long-term contracts as well as mainstream law appears to date to

have been relatively modest. This may partly be because ‘it is impossible to

locate, in the relational-contract literature, a definition that adequately

distinguishes relational and non-relational contracts in a legally operational

way - that is, in a way that carves out a set of special well-specified contracts

for treatment under special well-specified rules’ (Eisenberg, 1995, p. 291; see

also Craswell and Schwartz, 1994, p. 199). If this is not the case, there appears

little point to making the distinction and given the lack of a common jargon

between economics and law, it is not clear what would be achieved by

relabelling contracts. The main contribution of the relational contract theory so

far would appear to be to highlight the potential importance of the relationship

between the contracting parties and the social groups to which these belong,

including the importance of norms and non-legal sanctions.

 

However, the success or failure of transacting does not solely depend on the

relationship between the contracting parties, because contracts also play a

significant role. A fruitful way to look at contracts would be as a combination

of legally enforceable and self-enforceable obligations. This recognises that

whereas some obligations need to be self-enforceable because third parties

cannot verify the facts giving rise to a particular obligation, others need to be

self-enforceable because of the (transactions) space costs of using the legal

system. Moreover, in order to cope with unforeseen contingencies, the parties

may either rely on each other to handle the new situation in good faith, or, by

using the contract to allocate residual control rights, place the onus on a

particular party. The paper by Klein (1996) is a promising step in that

direction, offering the possibility of a more balanced view between incomplete

contract theory and relational contract theory.

 


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