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The Interaction Between Formal and Informal Contracts Giorgio Zanarone Colegio Universitario de Estudios Financieros, Madrid European.

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Presentation on theme: "The Interaction Between Formal and Informal Contracts Giorgio Zanarone Colegio Universitario de Estudios Financieros, Madrid European."— Presentation transcript:

1 The Interaction Between Formal and Informal Contracts Giorgio Zanarone Colegio Universitario de Estudios Financieros, Madrid European School of New Institutional Economics 2009

2 Outline 1.Introduction 2.Theoretical framework 3.Formal vs. informal contracts 4.Formal & informal contracts may be friends 5.Conclusions

3 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

4 Tradeoff b/w formal & informal contracts Formal contracts –Enforceable by institutional 3 rd 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

5 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 π P (d) & outside option π P A has benefit π A (d) & outside option π A To make contract on d enforceable, P spends –f(d) if enforcer = court –i(d) < f(d) if enforcer = P

6 2.2. Formal contract A feasible formal contract sets performance d & price p such that –PC P : π P (d)-f(d)-p π P p π P (d)-f(d)-π P –PC A : π A (d)+p π A p π A -π A (d) π A -π A (d) p π P (d)-f(d)-π P π P (d)+π A (d)-f(d) π P +π A The optimal contract d F maximizes the joint surplus π P (d)+π A (d)-f(d) s.t. π P (d)+π A (d)-f(d) π P +π A

7 2.3. Informal contract A feasible informal contract sets performance d & quasi-rent q such that –PC P : π P (d)-i(d)-q π P q π P (d)-i(d)-π P –PC A : π A (d)+q π A q π A -π A (d) –IC A : π A (d)+(1/r)[π A (d)+q] π A (d*)+(1/r)π A Note: d * = argmax π A (d) = Ds opportunistic action Setting q= π P (d)-i(d)-π P yields π P (d)+π A (d)-i(d) π P +π A +r[π A (d*)-π A (d)] The optimal contract d I maximizes π P (d)+π A (d)-i(d) s.t. π P (d)+π A (d)-i(d) π P +π A +r[π A (d*)-π A (d)]

8 3. Formal vs. informal contracts Informal contract will be used when –r low long-term relationship –i(d) low 2 nd party enforcement cheap –f(d) high court enforcement costly

9 Example (1): Long-term relationship Note: π A (d) = -cd π P (d)-cd-i(d) d Surplus π P (d)-cd-f(d)πP+πAπP+πA π P + π A +r L cd

10 (2) Short-term relationship d π P (d)-cd-f(d) Surplus π P + π A +r L cd π P (d)-cd-i(d) πP+πAπP+πA

11 (3) Cheap informal contracts d π P (d)-cd-f(d) Surplus π P + π A +rcd π P (d)-cd-i L (d) πP+πAπP+πA

12 (4) Costly informal contracts d π P (d)-cd-f(d) π P (d)-cd-i H (d) Surplus πP+πAπP+πA π P + π A +rcd

13 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

14 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 drillers effort, not on fair bargaining –Cheap informal contracts (i ) or closer relationship (r ) parties rely more on informal contract

15 Gil & Marion 09 Highway procurement in California –Contractors partially outsource to subcontractors Past interactions –Decrease contractors bid on given project –Increase contractors likelihood to bid –Increase contractors 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

16 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 managers effort –High wage & threat of termination compliance –Franchisee residual claimant smaller reneging temptation lower wage needed

17 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 As 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

18 4.2. Extension to double agency P wants A to do d A, and A wants P to do d P –P earns π P (d A,d P )-i P (d A )-(q P -q A ) –A earns π A (d A,d P )-i A (d P )+(q P -q A ) We can extend previous results: –The optimal informal contract maximizes Σ i [π i (d i,d j )-i i (d j )] s.t. Σ i [π i (d i,d j )-i i (d j )] Σ i π i +rΣ i [π i (d * i,d j )-π i (d i,d j )] –P & A will add formal provisions to minimize the aggregate reneging temptation & create quasi-rents

19 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

20 (cont.) Incentive contracts –Gibbons & Murphy JPE 92, Baker et al. QJE 94, Gibbons Man. Sc. 05

21 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 dealers gains from competing when other dealers do not compete

22 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

23 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) manufacturers (dealers) reneging temptation

24 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

25 Baker et al. QJE 02 U(pstream) produces a good, and repeatedly exchanges it w/ D(ownstream) –Ex: supply chains Integration reduces Us temptation to hold D up, but increases Ds temptation to hold U up –Holdup bad b/c it distorts Us 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

26 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

27 Example (1): integration optimal w/ large spillover d πP+πAπP+πA π P +π A +r[π S (d * S )-π S (d)] π P +π A +r[π I (d * I )-π I (d)]

28 Example (2): separation optimal w/ small spillover d π0π0 π P +π A +r[π S (d * S )-π S (d)] π P +π A +r[π I (d * I )-π I (d)]

29 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

30 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

31 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

32 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

33 Thank you

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