Theoretical aspects of contracting 2018 Taylor Francis Contract

Theoretical aspects of contracting © 2018 Taylor & Francis

Contract Legally enforceable agreement Opportunity to invoke (state) dispute resolution mechanisms and coercive power to enforce promises Contract design contract enforcement © 2018 Taylor & Francis

Role of contracts Specify commitment Constrain opportunism Reduce uncertainty, transfer risk Goal alignment and incentives Reduce transaction costs - Ex ante negotiations - Ex post conflict resolution © 2018 Taylor & Francis

Contract problems Information asymmetry Moral hazard (ex post) Adverse selection (ex ante) Opportunism* * For example withholding information © 2018 Taylor & Francis

Two economic theory streams Agency theory study the contract Objective: goal alignment and risk distribution Transaction cost theory study the transaction Objective: minimisation of transaction costs The contracting parties want to obtain control so as to be able to achieve their goals and reduce their costs © 2018 Taylor & Francis

Some basic agency theory Interests of the principal Interests of the agent Bounded rationality Risk aversion Opportunism Incentives Asymmetric information Control Goal alignment? © 2018 Taylor & Francis

Then, some basic transaction cost theory Asset specificity + Governance through legal contracts* - Opportunism** + Uncertainty * Originally: hierarchy vs market ** Self-interest seeking with guile © 2018 Taylor & Francis

How formal & detailed should a contract be? What are the factors impacting on contract formalisation/specification? When does contract formalisation and specification pay off? © 2018 Taylor & Francis

Costs and benefits of loose vs rigid contract terms More detailed contract terms Keeping contracts open • Enables managers to – Set goals – Clarify expectations – Reduce misunderstandings – Reduce counter-party opportunism • Requires expenditures in – Searching for information – Projecting scenarios – Identifying feasible contingencies – Negotiating acceptable solutions • Enables parties to make valueenhancing adjustments • Is likely to foster trust between parties because parties do not hold each other to precise terms of the contract • May lead to opportunism because counter-party can exploit unspecified loopholes that lead to wasteful renegotiations and hold-ups © 2018 Taylor & Francis

Governing relationships 1. Relational contracting Informal governance through credible commitments 2. Legal contracting Formal governance through (written) contracts So the question then is: What factors favour legal/relational contracting? © 2018 Taylor & Francis

Legal contracting - Choice of law - “Private laws” = contracts - Guideline to working relationship - Litigation/arbitration + + Control Relational norms - Common worldview - Common goals - Benevolence - Reciprocity - Flexibility - Loyalty - Trust © 2018 Taylor & Francis + - Goal alignment Opportunism Uncertainty factors - Cultural differences - Economic volatility - Legal/political uncertainty Control of operations through relational norms and contracts

Contract formalisation and effectiveness Relationship factors - Dependence on agent - Relationship length Product/market factors - Market volatility - Product standardisation Exporter factors - Exporter host market experience - Export ratio Based on Aulakh and Genctürk 2008 Contract formalisation Performance Economic uncertainty difficult to anticipate demand/competition, prices, inflation, exchange rates calls for contractual flexibility Legal uncertainty difficult to anticipate outcomes of Host country uncertainty litigation calls for relational contracting and - Economic uncertainty trust building activities - Legal uncertainty © 2018 Taylor & Francis

Impact of culture Legal contracting ? Relational contracting Uncertainty avoidance © 2018 Taylor & Francis

Impact of culture ? Legal contracting Relational contracting © 2018 Taylor & Francis Collectivism Individualism

Contract formalisation and specification ? Performance Difficult to anticipate demand/ competition, prices, inflation, exchange rates calls for contractual flexibility Host country uncertainty - Economic uncertainty - Legal uncertainty - Cultural dimensions Difficult to anticipate outcomes of litigation calls for relational contracting and trust-building activities Uncertainty avoidance relational contracting? Individualism formal contracting? Power distance formal contracting? Masculinity formal contracting? Long-termism relational contracting? © 2018 Taylor & Francis

Contract specificity and transaction costs Buyer lock-in Transaction complexity + + Contracts more specific than predicted + Ex post transaction costs + Ex ante contract drafting costs Contract specificity Performance ambiguity - Contracts less specific than predicted Mooi and Ghosh 2010 © 2018 Taylor & Francis -

Ex ante stage Transaction stages model Activities/Issues Governance costs 1. Partner selection/ contract negotiation How to create and claim values? 1. Direct contracting/search costs - Performance evaluation (screening/selection) - Safeguarding (legal/contingencies search) - Adaptation (communication/negotiation) 2. Opportunity costs of foregone transactions 2. Value creation Difficult to observe transaction specific costs Direct monitoring costs due to performance evaluation problems 3. Realising the state of the world Ex post stage 4. Value claiming Observing what happened in stage 2 Outcome not as anticipated need for adaptation Renegotiation to appropriate rents Refusal of partner to adapt 5. Receiving payoffs Direct enforcement/adaptation costs -Renegotiation, haggling, coordination, communication, conflict resolution Depend on decisions made in earlier stages © 2018 Taylor & Francis Based on Gibbons 2005

Contract design The party with the “upper hand” should be left at least as well off maximising the joint gain as taking any other feasible action. Incentive scheme © 2018 Taylor & Francis

Exporter experience Leg al Relational Trust na o i t l la Mutual adaptation Re Governance mode: relational or legal al g e R 2 0. 85* L Control & role specification Relational or legal governance of partners? Based on Deligonul and Cavusgil 2006 © 2018 Taylor & Francis * Nagelkerke R 2

Some basic premises Control through relationships Performance/ goal alignment Control through legal contracts © 2018 Taylor & Francis

Incentives to attain goals and risk distribution Commission (depends on outcome) Agent’s risk Salary (fixed) Principal’s risk Goal attainment “Balanced risk” © 2018 Taylor & Francis

Relationship- vs transaction-oriented exporter–middleman relations Transaction oriented Relationship oriented None Yes Geographic exclusivity No certainty for middleman Opportunities to expand (for middleman) Limited uncertainty for middleman Limited opportunities to expand (for middleman) Level of incentives High Low Goal alignment through (short-term) sales volume Other levers of goal alignment more important (social/investment) with a view to achieve long-term results Commission Salary Risks at middleman level Exporter investment in longterm relations exporter risk Type of incentive Short/medium-term perspective Flexibility needed Information exchange? Clan control less prevalent? Opportunism contained by risk of losing agency? Source: Unpublished research project, BI Norwegian School of Management Long-term perspective Social relations warranted Asset specificity? Clan control more prevalent? Opportunism contained by social relations (and clan control)? © 2018 Taylor & Francis

Drivers of relationship quality under different incentive schemes Standardised beta values Source: Unpublished research project, BI Norwegian School of Management Geographic exclusivity Level of incentives Type of incentive None Yes High Low Clan control . 45 a . 43 a . 53 a . 30 a . 46 a Process control -. 15 -. 26 c -. 24 -. 11 -. 24 c Outcome control . 23 . 01 . 08 -. 11 -. 05 -. 17 Social relations . 12 . 31 a . 19 . 34 b . 17 . 36 b Investment in relations -. 15 . 11 -. 03 . 29 c . 03 Information exchange . 05 . 10 . 17 . 07 . 16 . 03 Flexibility . 32 b . 08 . 24 c -. 07 . 28 b -. 02 F-value 6, 776 a 11, 066 a 6, 379 a 8, 347 a 2, 312 a R 2 Adj. . 419 . 484 . 473 . 394 . 532 a: p<=. 01; b: p<=. 05; c: p<=. 10 6, 750 a. 467 Commission Salary © 2018 Taylor & Francis