Buyer-supplier contracting: contract choice and ex post negotiation costs.

Structuring partnerships to facilitate long-term, productive relationships is a central concern of researchers in strategy, marketing, law, and economics (Dyer, 1997; Heide and John, 1990; Macneil, 1978; Williamson, 1985, 1991). According to a number of researchers, "the most challenging aspect of developing and maintaining long-term exchange relationships" (Cracker and Masten, 1991: 70) is how to develop efficient (i.e., least costly) contracts to effectively govern exchange (Macneil, 1978; Williamson, 1985, 1991). Formal contracts enable parties in an exchange to coordinate their actions and limit potential opportunistic behaviors (Dahlstrom and Nygaard, 1999; Goldberg and Erickson, 1987). Yet the initial drafting and subsequent maintenance of these contracts can be costly. Depending on the type of contract used, these "transaction costs' can include both the ex ante costs of initially establishing the contract, and the ex post costs of periodically renegotiating and adjusting existing contracts (Cracker a nd Masten, 1991; Williamson, 1985). A critical question to be answered then is "How do transactors manage the process of contract selection and maintenance?" Indeed, while the factors influencing the type of contract chosen and the ensuing costs associated with this choice are seen as critically important to the long-term viability of an exchange, very few empirical studies have examined actual contracting practices and their performance implications.

This article seeks to address this shortcoming in the literature by investigating the process of contract selection and the performance implications related to how those contracts are managed. By doing so, we seek to provide valuable insights into the contracting process that may allow firms to realize the potential gains from their exchange relationship (Williamson, 1996). In addition to the aforementioned contribution, we also seek to directly investigate the costs of contracting. While theoretical predictions provide valuable insights into the nature of contracting, empirical investigation is necessary to evaluate the normative implications of those theories (Dyer, 1997; Williamson, 1996). However, most previous studies have failed to conduct this empirical examination of the cost of transacting.

This study seeks to address this gap in the literature. By doing so, we respond to calls for research that directly measures transaction costs (Rindfleisch and Heide, 1997). It should also be noted that while various types of transaction costs such as negotiating and monitoring costs are incurred during exchanges, we focus solely on the negotiating costs that are incurred to revise incomplete contracts (Williamson, 1985). While the negotiation costs of revising contracts can include a wide variety of costs including travel and computer expenses Dobler et al. (1990) argue that the majority of negotiation costs are labor-related. Thus, we use an approach similar to the one suggested by Anderson and Weitz (1992) and empirically measure the labor costs associated with the renegotiation of incomplete contracts between original equipment manufacturers (OEMs) and their component suppliers.

Thus, we have two main objectives in this paper. First, we develop and empirically test a model of the determinants of contract choice. This model draws on economic and legal theories suggesting that the appropriate type of contract may depend on certain transactional and relational attributes (Crocker and Reynolds, 1993; Williamson, 1985). Second, we examine how exchange partners can effectively manage the costs of adjusting and maintaining incomplete contracts after they have been established. Literature in marketing, social contracting and relational exchange theory suggests that certain behavioral characteristics (i.e., relational norms) may play an important role in contract management (Artz and Brush, 2000; Lusch and Brown, 1996; Macneil, 1980).

In the next section, we discuss the concept of contract completeness. The following section develops hypotheses concerning contract choice and ex post negotiating costs. The methods section describes our data collection, measures, and data analysis and is followed by the results section. The discussion section presents research and managerial implications, suggestion for future research, and limitations of the study.

CONTRACTING

A review of the theoretical and managerial literature in economics, sociology, strategy, and marketing, combined with in-depth field interviews with purchasing personnel responsible for developing contracts, revealed several distinct contract types used in interorganizational exchanges. These contracts can be differentiated based on their degree of completeness.

Contract completeness is the degree to which the obligations of the exchange (e.g., price, quality, delivery, other terms and conditions) are outlined upfront. A totally complete contract is one in which all duties of all parties are completely prescribed for the duration of the contract (Crocker and Masten, 1991). Conversely, a totally incomplete contract places no a priori restrictions on the terms under which subsequent trade may occur (Crocker and Reynolds, 1993). In practice, contracts rarely exhibit the characteristics of purely complete or incomplete contracts. Even in relatively complete contracts, some terms and specifications are left to future determination. Likewise, even very incomplete contracts must specify some terms and conditions upfront to make exchange feasible. Thus, intermediate degrees of contractual completeness are the norm and contract completeness is a relative term.

In relatively complete contracts, the majority of each party's responsibilities and performance expectations are explicitly specified in the document (Lusch and Brown, 1996; Macaulay, 1963). This reduces the potential for opportunistic behavior by transactors after an agreement is reached because terms of the contract are not renegotiable (Dahlstrom and Nygaard, 1999). Since relatively complete contracts attempt to clearly define nearly all terms of the exchange for the life of the contract, specific terms are less likely to be violated (Dyer, 1997). However, while relatively complete contracts may provide protection, it is often difficult to identify all possible contingencies and negotiate mutually acceptable responses. Thus, relatively complete contracts often result in considerable ex ante negotiating costs.

In contrast, relatively incomplete contracts do not attempt to spell out the complete set of terms and conditions for the entire contract term at the time the contract is established. Rather, they seek to define a general process for periodic mutual adjustments of contract items such as price and/or quantity (Goetz and Scott, 1981). Since incomplete contracts do not attempt to stipulate a response to all possible contingencies, they are considerably simpler and less costly to draft than complete agreements (Crocker and Reynolds, 1993). Moreover, incomplete contracts are intended to provide the partners with flexibility to adapt to changing conditions. However, exchange partners using incomplete contracts face greater potential opportunism, or what Williamson defines as "self-interest seeking with guile" (1979: 234), after the initial agreement is reached. In addition, they may require costly ex post bargaining as the parties attempt to periodically negotiate adjustments to the contract (Crocker and Masten, 19 91).

Given the differences between relatively complete and relatively incomplete contracts, transactors face a trade-off between greater safety and predictability (and higher ex ante negotiating costs) offered by more complete agreements, and greater flexibility (and higher risk of opportunism and ex post negotiating costs) offered by less complete contracts (Tirole, 1986). What then are the factors that determine which type of contract is ultimately chosen? We explore this question in the following section.

THEORY AND HYPOTHESES

Contract Choice

A primary contribution of transaction cost economics (TOE) is its insights into the conditions that determine the appropriate structure to govern exchange (Williamson, 1996).

Thus, TCE provides valuable guidance in identifying factors that may influence the type of contract chosen for an exchange. Here, we examine the role of three such factors: environmental uncertainty, transaction-specific assets, and the potential for opportunism.

The first of these, environmental uncertainty, is defined as the inability to predict changes in factors surrounding an exchange (Walker and Weber, 1987). Creating relatively complete contracts may be fairly straightforward in simple environments. The task becomes more daunting as the parties become less confident about future conditions or the variables of concern are less quantifiable (Sutcliffe and Zaheer, 1998). As Goetz and Scott state, contracts "... tend to be less complete where the parties are incapable of reducing important terms of the arrangement to well-defined obligations" (1981: 1094).