The Structure of Costs and the Duration of Supplier Relationships∗

The duration of a supply relationship depends on two types of costs: (i) the transaction cost of switching suppliers and (ii) the cost of being matched to an inefficient supplier when the relationship lasts too long. I develop a model of optimal contract duration that captures this tradeoff, and I provide conditions that identify the underlying cost structure. Latent transaction costs are identified even when the exact supplier selection mechanism is unknown. For a typical procurement good, I estimate the model and find that transaction costs are a significant portion of total costs. I conduct two counterfactual exercises. In the first, I estimate the effects of changing the maximum allowable contract duration, which is a common contracting friction. In the second, I evaluate the impact of reducing transaction costs. This second counterfactual illustrates why quantifying transaction costs is important for accurate welfare analysis. ∗I am thankful for the advice and guidance of my advisors, Ali Hortaçsu, Brent Hickman, Casey Mulligan, and Chad Syverson, and for the helpful comments and suggestions of Stephane Bonhomme. I also thank seminar and conference participants at the University of Chicago’s Applications of Economics workshop, the Industrial Organization working group, Applied Microeconomics working group, the CEPR-JIE conference, and the Econometric Society World Congress. †Department of Economics, University of Chicago ([email protected]). Website: http://home.uchicago.edu/mackay/