Planning for Extending and Terminating Inter-Firm Relationships: Bringing Psychology into the Study of Contractual Governance

We combine insights from economics and psychology to understand how firms strategically plan to extend and terminate their contractual relationships. In many economic respects, provisions that allow a buyer to terminate a project early and those that allow a buyer to extend a project have much in common. Psychologically, however, including and exercising extendibility and early termination provisions have very different effects on how people view the relationship and thus can inform when each would be most effective at managing inter-firm transactions. Examining extendibility and early termination provisions in a sample of 388 contracts from the information technology services industry, we find that relationship and cognitive factors from psychology play a big role in when one type of clause would be preferred over another and when either type might suffice. These results suggest that managers can use contracts strategically to manage inter-firm relationships and not just as enforcement mechanisms to mitigate opportunism.