Relational Contracts and the Value of Loyalty

3349 Firms routinely rely on the goodwill of their trading partners. In developed economies, ongoing relationships complement formal contracts in mitigating holdup and facilitating transactions (Stewart Macaulay 1963). In developing economies, where contracts enjoy little legal protection, long-term relationships are even more critical for trade (John McMillan and Christopher Woodruff 1999). The major cost of maintaining a relationship is that, when there are many potential suppliers, it can reduce the scope of trade. The purpose of this paper is to make this trade-off precise. We consider a firm (principal) that would like to trade with different suppliers (agents) over time under the threat of holdup. We derive the optimal relational contract, show that it induces loyalty, and characterize the resulting distortions. The model enables us to make predictions as to when a firm will switch suppliers, and how these switches depend on the length of the relationship, the number of suppliers, and the shocks to the economy. The following examples illustrate the practical importance of loyalty in overcoming the holdup problem. In 1984, the US government started awarding $200 billion worth of contracts through “full and open competition,” either in the form of sealed bids or competitive negotiations. In order to reduce corruption, the evaluation panel was instructed to ignore subjective information, such as prior performance. Steven Kelman (1990) examines computer procurement, showing that the government was considerably less loyal than private firms (awarding 58 percent of contracts to the incumbent versus 78 percent), and that it was more likely to use the cheapest bidder (65 percent versus 41 percent). As a result, he finds that government contractors overpromised more than private contractors, leading managers to be 50 percent more dissatisfied and to be involved in more formal disputes. The government contracts rated particularly badly on “keeping promises” and “sticking to the contracted delivery schedule,” with vendors holding up the government by withdrawing key personnel, providing poor advice and few creative ideas. He concludes that “Lacking the ability to recoup transaction specific investments through the assurance of repeat business, [government] vendors fail to make investments that require conscious effort and expenditure of resources” (Kelman 1990, p. 72). Relational Contracts and the Value of Loyalty