The Economics of Relational Contracts: Supporting Empirical Evidence

1. The Economics of Relational Contracts:Supporting Empirical Evidence Ricard Gil UC – Santa Cruz (visiting LSE Management) rgil@ucsc.edu European School of New Institutional Economics 2011

2. Outline • Introduction • Theoretical framework • Formal vs. informal contracts • Testable implications • Empirical challenges and evidence

3. 1. When is a contract enforceable? When parties Understand its terms Can verify breach Are able/willing to enforce Third party (law & courts) can verify and enforce contractual agreement May be costly to make a contract enforceable

4. Tradeoff b/w formal & informal contracts Formal contracts Enforceable by institutional 3rd parties (courts, arbitrators) Strong anti-breach remedies Costly to include ex-post adjustment High costs of making contract enforceable Informal contracts Enforceable by the parties and/or market Weaker anti-breach remedies Less costly to include ex-post adjustment Lower costs of making contract enforceable

5. 2. An illustrative model • P wants A to provide non-standard performance d • P=employer, A=employee, d=effort • 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

6. 2.1. 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

7. 2.2. Informal contract • A feasible informal contract sets performance d, upfront payment w & bonus b such that • PCP: πP(d)-i(d)-w-b ≥ πP • PCA: πA(d)+w+b ≥ πA • ICP: -b+(1/r)[πP(d)-i(d)-w-b] ≥ (1/r)πP • ICA:πA(d)+b+(1/r)[πA(d)+w+b] ≥ πA(d*)+(1/r)πA • Note: d* = argmaxπA(d) = A’s opportunistic action • Setting b & w so that ICA & PCA bindyieldsπP(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)]

8. 2.3. Formal & informal contracts may be friends • Complements or substitutes? • P & A will add to the informal contract “cheap” provisions that • Constrain A to provide standard performance d, or change A’s payoff function, reducing her temptation to r[π(d**)-π(d)] • Create the quasi rent w+b when monetary payments are not practical • These may be suboptimal in a purely formal contract • Key understanding how the use of formal and/or informal contracting affects the value of fallback option

9. 3. Formal vs. informal contracts Informal contract is optimal whenever πP(dF)+πA(dF)-f(dF) < πP(d’)+πA(d’)-i(d’) Informal contract will be used when πP(dF)-f(dF)-p < πP(d’)-i(d’)-w-b r low  long-term relationship i(d) low  2nd party enforcement cheap f(d) high  court enforcement costly

10. 3.1. Informal contracts Self-enforcing contracts as long as ICP: -b+(1/r)[πP(d)-i(d)-w-b] ≥ (1/r)πP ICA:πA(d)+b+(1/r)[πA(d)+w+b] ≥ πA(d*)+(1/r)πA Empirical literature focuses on instances for which IC constraints may not bind

11. 4. Methodological summary: How to assess informal contracts? Look for links b/w contract design, outcomes & long-term relationships Variation in past and future interactions Look for relationships w/o a formal contract

12. 4.1. Examples Through Evidence Outsourcing: Corts & Singh JLEO ’04, Gil & Marion ’10 Macchiavello & Morjaria ’11 Social Networks: Gil & Hartmann JLEO ’11 Jackson & Schneider ’11 Interplay of Formal & Informal Contracts Gil ’11

13. 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

14. [Formal vs. informal contracts] Informal contract is optimal whenever πP(dF)+πA(dF)-f(dF) < πP(d’)+πA(d’)-i(d’) Informal contract will be used when πP(dF)-f(dF)-p < πP(d’)-i(d’)-w-b r low  long-term relationship i(d) low  2nd party enforcement cheap f(d) high  court enforcement costly

15. The Role of Repeated Interactions, Self-Enforcing Agreements and Relational [Sub]Contracting:Evidence from California Highway Procurement AuctionsRicard Gil and Justin MarionUC - Santa Cruz How valuable are supplier relationships? Dependence on continuation value of relationship? Auctions for California Department of Transportation (Caltrans) highway construction projects Universe of 5,120 contracts, May 1996 – December 2005 Winning and losing bids (26,125 total): 1,735 bidders and 2,900 subs All project characteristics and address of contractor and subcontractor Follow prime contractor and subcontractor interactions over time Model: Unobservable quality, hold-up temptation Relational contract lowers cost of employing a subcontractor Key contribution: estimate how these effects depend on continuation value of relationship

16. Measurement One way to measure relationship: use prior interactions between firms and suppliers (Corts and Singh, 2004) Continuation value? Past interactions may indicate future interactions Identification problems Prior relationships have value in relationship-specific productivity (Miller, 2008) Current cost correlated with measure of relational capital Suppose measure future supplier relationship Future interactions potentially depend on success of relationship Cannot separately identify continuation value from current costs Our measure of continuation value: Future Caltrans contracts in same geographic area  Arrival rate of projects exogenous to relationship-specific productivity

17. Institutional details Caltrans awards road construction and repair contracts through sealed-bid first-price auctions Potential bidders are notified through newsletter Bidders prequalified according to their characteristics and history Caltrans engineers provides a list of items required Each bid must include list of subcontractors Each subcontractor included certified for her task List if greater than $10K or (0.5% of total) Constraints: Affirmative action, specialty items, caps Ex-post changes not unusual (Bajari, Houghton and Tadelis (2007)) due to unforeseen contingencies Project work flow important

18. Predictions A contractor will bid lower for a given project when outsourcing to a given subcontractor the lower the coordination costs and the larger the value of future interactions with this subcontractor Not here … A contractor will be more likely to participate in an auction for a given project the lower the coordination costs and the larger the value of future interactions with her potential subcontractors in the area A contractor will be more likely to choose a subcontractor for a given project the lower the coordination costs and the larger the value of future interactions with that subcontractor How to test these in the data? Past interactions proxy for coordination costs Use contracts in a district within one year in the future to proxy for continuation value

20. Specification Regress project outcome bid on stock of past interactions Rik and consider interaction with future opportunities Oik in project district Yik= β0 + β1log(1+Rik)+ β2log(1+Rik)log(1+Oik) + β3log(1+Oik) + +BXik + ρi + uik Define stock of relationships Rik for firm i in project k All past relationships with listed subcontractors Define future opportunities: Number of contracts occurring in project district within next year Volume of contracts occurring in project district within next year Consider those left after current project completion Past subcontractor interactions on winning bids correlated with experience, backlog → introduce these variables as covariates

22. Interpretation of Results • Stock of relationships are negatively correlated with posted bids • Posted bids are negatively correlated with value of future contracts • Interaction of stock of relationships and value of future of contracts are negatively correlated with posted bids • Direct correlation between posted bids and stock of relationships becomes statistically insignificant • Stock of relationship matters when future business are at stake • An increase in one std dev in stock of relationships (+1.228) • - 0.89% with one std dev below median of future contract volume • + 1.9% with one std dev above median of future contract volume • Average winning bid of 3.17 m … savings of between 28K and 60K

23. [Informal contracts] Self-enforcing contracts as long as ICP: -b+(1/r)[πP(d)-i(d)-w-b] ≥ (1/r)πP ICA:πA(d)+b+(1/r)[πA(d)+w+b] ≥ πA(d*)+(1/r)πA

24. The Value of Relationships:Evidence from a Supply Shock to Kenya Rose Exporters Rocco Macchiavello & AmeetMorjaria Warwick University, Harvard Kennedy School With incomplete contracts parties rely on long term relationships to facilitate trade. Theoretical literature has developed many different models – few empirical papers. In the context of Kenya rose exports, this paper: 1. computes value of the relationship, 2. uses a shock to distinguish different models

25. Data Exports of Roses from Kenya provide an ideal setting: 1. Transactions recorded in Customs data: all exports of flowers from Kenya 09/2004 - 08/2009 2. Use spot market price to compute future rents 3. Short-run shock: post-election violence in January 2008 4. Firm survey designed and conducted by authors through 2 hour face-to-face interviews in Kenya during summer 2008 5. Other sources to complement information

26. Two Export Channels Spot Market (Dutch Auctions) in the Netherlands - Firms have accounts and can export flowers anytime, - No contractual obligation, price determined through bidding, - Quality and Payments enforced by the Auctions. Direct Relationshipswith foreign buyers - no formal contract enforcement available - sellers value stable orders and prices, buyers value reliability. Parties work out an informal “marketing plan” at the beginning of the season - save on transport and intermediation

27. Industry • Flowers are one of main exports from Kenya – the second largest exporter of flowers in the World • Industry counts about a hundred large, vertically integrated, exporting firms. All flowers are exported • Seasonal Industry 4. Two export channels: Dutch Auctions and Direct Relationships with Foreign Buyers: - identical logistic & transport, but different incentives

28. Seasonality in Prices

29. Outline Violence New Season Pre-Violence History Baseline Sample: August 04 August 07 Dec 07 Jan / 24-30th / 08 August 08 Dec 08 Future Outcomes in the Relationship Test 3 Future Rents [lower bound ] based on IC constraint Test 1 Response to Shock Test 2

30. The Ethnic Violence: Timing and Geography 1. Following contested presidential elections at the end of 2007 2. Two spikes: - December 31st – January 4th - January 24-30th 3. The violence did not affect all of Kenya

31. The Geography of Ethnic Violence The Ethnic Violence did not concern all parts of Kenya where flower firms are located

32. The Economics of Ethnic Violence The violence caused exports to drop mainly because of missing workers (see Ksoll et al. (2010))

33. Outline Violence New Season Pre-Violence History Baseline Sample: August 04 August 07 Dec 07 Jan / 24-30th / 08 August 08 Dec 08 Future Rents [lower bound ] based on IC constraint Test 1

34. Relationship Value: Different Samples

35. Test 1: Relationship Value and Relationship Age

36. Outline Violence New Season Pre-Violence History Baseline Sample: August 04 August 07 Dec 07 Jan / 24-30th / 08 August 08 Dec 08 Response to Shock Test 2

37. Response to the Shock: Construction Counterfactual: how many flower would have been sold in a relationship had the violence not occurred ? There is a lot of regularity in shipments within relationships: Shipments week t predict 85% of variation in shipments in week t + 1 ⇒ Firm’s Response in a Relationship: R = Shipments During Violence / Predicted Shipments

38. Test 2: Response to Shock and Relationship Value

39. Outline Violence New Season Pre-Violence History Baseline Sample: August 04 August 07 Dec 07 Jan / 24-30th / 08 August 08 Dec 08 Future Outcomes in the Relationship Test 3

40. Test 3: Relationship’s Survival and Response to Shock

41. Summary Test 1: Corr ( Relationship Value , History ) >> 0 Test 2: Corr ( Response to Shock , Relationship Value) >> 0 Test 3: Corr ( Future Outcomes , Response to Shock) >> 0 Firms value acquiring and maintaining a reputation for being reliable suppliers

42. [Informal contracts] Self-enforcing contracts as long as ICP: -b+(1/r)[πP(d)-i(d)-w-b] ≥ (1/r)πP ICA:πA(d)+b+(1/r)[πA(d)+w+b] ≥ πA(d*)+(1/r)πA

43. On Social Networks T T+1 T+2 T+3 T+4 … Principal1 Agent Principal2 Principal3

44. On Social Networks T T+1 T+2 T+3 T+4 … Principal1 Agent Principal2 Principal3

45. Airing Your Dirty Laundry:Vertical Integration, Reputational Capital and Social NetworksRicard Gil and Wes HartmannUC – Santa Cruz, Stanford GSB • Are firms in social networks more willing to outsource (i.e. less likely to vertically integrate)? • What does the relationship between social networks and vertical integration suggest about the determinants of the boundaries of the firm?

46. Why Laundry Services and Koreatown? • Each store makes 2 “make-or-buy decisions”: • Laundry and Dry Cleaning • Over 80 cleaners within a 2 mile radius of many addresses in Los Angeles • Useful institutional details for identifying the determinants of the boundaries of the firm • 2000+ Korean cleaners in southern CA indicate the likely presence of a network

47. Positive Relationship Reputations with workers lower the costs of “managed coordination” Reputations with creditors lower the capital costs of integrating Negative Relationship Reputations with suppliers lower the costs of “using the market” Poor access to formal credit in SN decreases ability to integrate Framework Predictions for Relationship Between SN and VI

48. Definition of the Social Network • Members: • Koreans in Koreatown • Non-members: • Koreans elsewhere • Non-Koreans in Koreatown or elsewhere • Communication and therefore reputation (within laundry industry and society members) should be enhanced in Koreatown

50. Data Description • Data from laundry service stores. • 173 stores surveyed. • 138 stores answered. • 4 areas in LA: • Korea Town (30+18) • China Town/Downtown (30). • Century City (30) • Santa Monica (30). • Tract level demographic information.