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