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working paper
department
of
economics
Reputation Effects and the Limits of Contracting:
A Study of ttie Indian Software Industry
Abhijit Banerjee
Esther Duflo
No. 99-14
July 1999
massachusetts
institute of
technology
50 memorial drive
Cambridge, mass. 02139
WORKING PAPER
DEPARTMENT
OF ECONOMICS
Reputation Effects and the Limits of Contracting:
A Study of the Indian Software Industry
Abhijit Banerjee
Esther Duflo
No. 99-14
July 1999
MASSACHUSEHS
INSTITUTE OF
TECHNOLOGY
50
MEMORIAL DRIVE
CAMBRIDGE, MASS. 02142
Reputation Effects and the Limits of Contracting:
A
Study of the Indian Software Industry
Abhijit V. Banerjee* and Esther Duflo^
First Draft:
November, 1998
-
This version June
11, 1999*
Abstract
This paper examines evidence of the role that reputation
outcomes.
We
We
plaj'S in
determining contractual
conduct an empirical analysis of the Indian customized software industry.
analyze a data set containing detailed information about 230 projects carried out by
125 software firms that
reputation matters.
varj'
Ex
we had previously
collected.
The evidence supports
ante contracts as well as the outcome after cx-post renegotiation
with firms' characteristics plausibly associated with reputation.
pattern
is
the view that
We
argue that this
not consistent with optimal risk sharing and propose a model of the industry
where reputation determines contractual outcomes, whose predictions are consistent with
several facts observed in the data.
We
argue that there
is
no obvious alternative explanation
to the patterns present in the data.
'Massachusetts Institute of Technology. Email: banerjce@mit.edu
*
Massachusetts Institute of Technology. Email: edufio@mit.cciu
*Wc thank Daron Acemoglu, PhiHppc Aghion, Roland Benabou, Mathias Dewatripont, David Gcncsove,
Jonathan Guryan, Oliver Hart, Doug
Jean Tirolc, and Richard Zcckhauscr
We
Miller, Dilip
Mookhcrjec, Ashok Rai,
for helpful conversations
Emmanuel
and Paul Joskow
for
encouragement and support.
acknowledge financial support from the the National Science Foundation, Alfred
Shultz Fund and the John D. and Catherine
professionals in India,
who
Mac Arthur
patiently answered our
Foundation.
many
We
Saez, Andrei Shleifer,
P.
Sloan Foundation, the
are especially grateful to the software
questions, and in particular to
Mr
N. R. Narayana
Murthy, from Infosys Technologies Limited, whose help and insights were crucial throughout this project.
1
Introduction
The
idea that there arc severe hinits to
what can be achieved througli contracting has had
an enormous impact on the way economists now
tliink
about
Correspondingly, there has been a growing emphasis on
firms, marl<ets
and governments.
of reputation as a
tlie role
way
of coun-
teracting the problems created by the hmitations of contracting.^ Wliile less often emphasized,
a view of the world which gives central importance to issues of contracting, reputation and
trust, also has
portantly,
it
important consequences
for the process of
growth and development. Most im-
suggests that the lack of a proper infrastructure for contract enforcement (which
makes contracting
less effective)
and the
important determinants of success
human
determinants such as
difficulty of building a secure reputation^ are potentially
in getting
out of poverty, along with the more conventional
and physical infrastructure.
capital
This paper attempts to quantitatively assess the importance of reputation and, by implication, the seriousness of the limits
software industry.
sired
way
on contracting
Customized software
is
in the context of the Indian
an obvious place to study such
end-product tends to be extremely complex and
the contract themselves do not fully understand
process. Therefore,
it
ahead of time
in a
In fact, typically the parties to
what they want
until well into the production
seems naive to expect that they could write a contract enforceable by the
courts that would fully cover
all
contingencies that could arise in the production process. More-
over, software production docs not require very
simply own a number of
PCs (which
much
are cheap
fixed capital: indeed
most firms nowadays
and getting cheaper). The
premises, access to a mainframe and links to a satellite, can
sibility of
effects since the de-
difficult to describe
that a third party (such as a court) would understand.
customized
all
be
rented."^
rest,
including
the
This limits the pos-
the reputation effects that interest us being confounded with the effects of deferential
access to capital or the lack of real competition.
The Indian
is
software industry
an industry which
is
is
suitable for such a study for a
hi Lidia, the
of reasons: First,
prejudice, or a history of
Murphy
bad performance,
government has actually invested
heavily,
(1997).
as
and by
emphasized by Tirolc (1996).
all
accounts
fruitfully, to
make
sure that firms
have the option of renting expensive fixed inputs (such as expensive computers, building space and equipment
satellite
it
quite large (employing 140,000 people with a turnover of $1.75 biUion in
'Sec for example Grcif (1994), Baker, Gibbons and
Stemming from
number
telecommunication) in virtual "Software Techonology Parks" (STPI, 1997).
for
1997-98) and growing fast (at an average annual growth rate of
Second,
its
large (over
main focus
is
on exports (more than
of
30%) and fast-growing share of the exports
industry's current focus
is
revenue comes from exports) and a
its
is
over the past six years).
customized software. Moreover, the
on expanding the export of customized software relative to
businesses on the grounds that this
1997).''
60%
54%
is
be
likely to
its
best bet for the near future
other
(NASSCOM,
Consequently, the limits of contracting are a major issue in this industry and one that
everyone
is
clearly concerned about. Finally, the fact that the contracts are typically across long
distances makes contracting
and, perhaps
more complicated
more importantly, because
Ijoth
by making monitoring somewhat harder
of the inherent difficulties of international litigation
(combined with the deficiencies of the Indian court system).
comes from interviews of 125 software companies
in India (Bangalore,
on the two
a total of
Prima
how
major software development centers
collected detailed data
and
the software buyer
-
supposed to pay
is
for all realized costs.
henceforth, the client
fraction of the contracts
-
is
very limited and the view
and the
client
quarter of the time and material contracts. There
is
post: the
pays
less
and
2.
Figure
'in the past, export of software services
1
-
is
-
henceforth, the firm
and material contracts
for all realized costs.
A
large
buyer docs not pay the entire
than the
full
amount
also a simple pattern in
contract that gets chosen and the sharing of the costs which
in Figures 1
In time
supposed to pay
do however get renegotiated ex
cost in almost half the fixed contracts
shown
initially
sample are either fixed-price contracts or
All contracts in our
important.
is
time and material contracts. In fixed-price contracts the software firm
gets a fixed price
on the company and
set).
the data supports both the view that contracting
is
use in this paper
the contract got renegotiated as the project evolved (wc have
236 contracts in our data
that reputation
The data we
they have completed, including what kinds of contracts were
last projects
facie,
in three
Wc
Hyderabad and Pune)^.
arranged between them and
is
its
in
about a
both the kind of
a result of the renegotiation.
It
shows the fraction of fixed-price projects as a function
was almost exclusively
on-site services (or "body-shopping"),
cf.
Hecks
(1996).
''In
We
each
city,
wc interviewed half of the firms who belong
selected the firms randomly, but
we oversampled the
refused to meet with us and answer the questionnaire.
CEO's
unavailability at the
moment we were
to the software technology park (all exporters do).
firms that are not fully-owned subsidiaries.
Some appointments
No
firm
could not be arranged due to the
interviewing, and these firms were replaced.
and Figure
of the foundation date of the software firm,
2
shows
tlie
share of overrun'' paid for
by the firm as a function of the age of the software firniJ Botli arc sharj^ly increasing with the
starting date of the firm. In particular, firms created in 1994 or after (half of the sample) Ijcar
a substantially larger share of the overrun than older firms
they bear
is
more sharply with age over
increasing
on average, and the share of overrun
this range.
Measured both
in
terms of the
ex ante contract and in terms of ex post outcome, young firms bear a larger share of the
'risk'
of each software project.
This
effect of
effect of
and have
age
perhaps the main empirical finding of the paper.
is
We
interpret this as an
reputation on the grounds that the firms that started in the industry a long time ago
sur\'ivcd arc
more
be the kinds of firms that clients can trust
likely to
-
the older firms
that cannot be trusted arc likely to have already gone out of business (since eventually people
would have got to know about them).
To provide
in Section 5
further support for our interpretation of the age effect as a reputation effect,
we show that
a similar pattern exists
when we use
other potential measures of
reputation such as whether there has been a previous transaction between the firm and the
client,
whether
it is
an internal project
term arrangement with the firm)^,
to
some extent
among
with a client
firms that
work
an internal
for
industry ^^hich explains
basic idea of the
know who was
why
model
reliable: reliable firms
'"The
is
that this
amount
is
is
between young and old firms disappears
we develop a simple model based on our observation
of the
and the
that in most cases by the end of the project the firm
it if
While
this
is
client
not contractible, firms and clients
they could commit to always follow a certain norm.
clearly there
can be other norms that
will also
work
- is
The
that of being
always try very hard to ensure that they do not exceed the cost overrun
when they
fail
typically not consistent with short-run profit maximization
of the project cost that goes
Because the number of firms per year
all
or has a long-
that different kinds of reputation are
that they had implicitly promised, and pay for any extra overrun
problem
owns the firm
reputation would have the observed effect on contractual outcomes.
could nevertheless benefit from
-
either
client.
responsible for cost overruns.
norm we emphasize here
who
we show
Further,
substitutes. For example, the difference
In sections 3 and 4 of the paper
The
etc.
(i.e.,
beyond the
in the
sample
these firms together.
''Wc will describe this type of structure below.
to
do
so.
The
by the firm or
initial prediction.
is
small for firms created before 1988, wc have grouped
the client, and can onty be sustained
convcntionall}',
value on
reliable
who
tlicir
We
reputation.
rest are not
them
look at equilibria where a certain fraction of firms and clients are
and investigate the implications of
what happens
buyers from unreliable
more
there should be
smaller, which
is
a
change
in the fraction of those
fixed-price contracts
if
of other predictions
from
this
who
we describe above.
are likely to be reliable
We
also argue that a
is
we cannot provide sharp enough evidence
The
objective of this paper
is
However our reputation-based story does
it
rules out
where there
Of
number
it
clear
is
to rule out alternative reputation models:
possible, for example, that the relevant reputation
reliability.
is
model are consistent with what we observe.
While we do provide some evidence supporting the broad premises of our model,
that
basic
true of time and material contracts. Therefore
is
the share of buyers
consistent with the evidence
is
The
that fixed-price contracts arc best for protecting reliable
while the reverse
sellers
some
to put
arc reliable (interpreted as a change in the average reputation of the firms).
trade-off that governs
more
the firms and chcnts arc cither innately reliable or,
the particular equilibrium that they arc playing induces
if
and the
if
is
for
not to distinguish
rule out
many
it
honesty or for a different form of
among
different kinds of reputation.
alternative explanations. In particular
models where there are no agency problems as well as models of agency problems
is
no learning about the firm's type.
course, this
is all
conditional on establishing that
data when we impose the reputation model on
what we arc picking up here
is
the effect of
it.
6,
are in fact correctly interpreting the
In other words,
some other
with these measures of reputation. In Section
we
it still
variable which
we consider some
remains possible that
happens to be correlated
They
of these explanations.
broadly in two classes.
fall
First, there
is
a class of alternative explanations which rule out agency problems: the differ-
ences in the contracts
is
then explained cither by differences in risk-sharing or by differences in
the production technology available to the firm. Against this view,
implausible that the contractual variations that
The
basic point
is
that in our data set, firms are usually
young firms are especially small.
of the risk
we observe
It is
(57% on average) and why
we
first
argue that
it is
very
are a result of optimal risk-sharing.
much smaller than
therefore very hard to understand
especially the smallest
why
their clients
firms bear so
and
much
and youngest firms bear the most.^
In response to the view that there arc differences in the production technology (essentially that
''There arc of course other determinants of the sharing of the risk.
We
discuss these issues in section
6.
young firms arc more incompetent) wc point out that the natural
should be to lower the price the j'oung firms gets paid rather than
they can
lisk that
ferences in
to
make them
Moreover the evidence docs not support
afl'ord.
ill
competence between the firms
is
of a
such incompetence
effect of
bear a
lot
view that the
tlie
of
dif-
magnitude that can explain the differences
in
the contracts. For example, \vc present in Figure 3 the average overrun as a function of firm's
foundation date.
pay
If
the high shares of overrun paid by young firms were a
we should
for higher overrun,
seems
to
be
class of
competing theories posits that there are agency problems but no learning
with the evidence on the effects of sources of
this conflicts
reputation other than age. These and related issues are discussed at
firms.
a final piece of evidence,
is
recognized and
we emphasize the
some length
and
at the industry level as well as
by individual
For example, the National Association of Software Services Companies
(NASSCOM)
The main element they
is
emphasized repeatedly
stress
in the process of acquiring
it
is
the
number
of Indian firms that have
is
a
way
association provides technical consulting to any
The Indian government
level, efforts to
This paper
ISO 9000
1997).
certification or are
for firms to establish
member who wants
provides financial incentives for firms
who
a reputation).
to get
acquire
it.
ISO
The
certification.
At the individual
develop a reputation arc also obvious.^"
a part of a small but growing
is
contractual choice. ^^
to this work.
(NASSCOM,
(ISO-certified firms have proven that their software development
processes follow approved routines, which
is
in Section 6.
fact that the necessity to build reputation
directory of the Indian Software industry has a large section on "quality"
more
make them
see average overrun falling with age. If anything, the opposite
about the firm: we point out that
trust
to
true.
The second
As
way
Among
They examine
number
of papers that study the empirics of
recent papers Crocker and Reynolds (1993)
is
most
closely related
the determinants of the choice between fixed-price contracts and
flexible contracts in U.S. Air Force engine
procurement. In their view, the key trade-off
the following: fixed-price contracts protect the government against ex post opportunism (in
particular
it
makes
'"20% of the firms
in
it
useless for the contractors to claim higher costs) but they require the
our sample already have ISO certification.
"Monteverde and Tcece
(19S2),
early papers on this subject.
specific investments
13%
arc in the process of getting
These papers
differ
from ours
in
studying settings where there arc huge relationship-
and very long term relationships arc the norm and where the key trade-off
of contract (or control)
and
it.
Masten and Crocker (1985), Joskow (1987) and Pittman (1991) arc important
flexibility.
is
between tightness
an exhaustive
ability to draft
costly.
Time and material
room
the
list
is
and
if
contractor.-'^ Contracts will tend to
by the
for opportunistic Ijehavior
short),
them easy
the contractor
is
to draft
more
(if
likely to
the engine
well
is
known
be fixed-price
if
or the production
and two contractors confirms these
Their work shares therefore a central intuition with ours: the reputation of the
predictions.
contractor does matter for the choice of contracts. ^'^
is
possible, but
behave opportunistically. Their empirical
analysis of a panel of 44 contracts between the government
it
is
contracts do not require a truly complete agreement ex ante, but open
the nature of the engine makes
cycle
of requirements (a complete contract), which
that the contract will be fixed-price
The
.
The more reputed a
central difference
is
firm
is,
the less likely
that fLxcd-pricc contracts
are not associated with any ex post cost for the contractor, since fixed-price contracts are "truly
complete agreements".
contract
is
In contrast,
we recognize the
fact that in the software industry the
never complete. Fixed-price contracts need not be more precisely drafted than time
and material contracts. Overrun happens
between containing opportunism by the
Lafontaine and
Shaw
(1996)
is
in
both types of contracts. The central trade-off
client
and opportunism by the
another paper that looks at the
is
firm.
efi'cct
on
of a firm's age
contracts (in the context of franchising) and finds that the franchiser's age has no effect on the
However
contract.
as they point out, by changing the franchise contract over time a franchiser
runs the risk of hurting
its
early franchisees
(who are locked
into one contract while their
competitors get a different contract that perhaps allows them to be more aggressive). Because
of this cross-contract externality, contracts
may
not change very
market over time becomes more knowledgeable about the
The
rest of the
paper
is
organized as follows:
much
over time, even
if
the
franchiser.-''*
In Section
2,
we
describe the institutional
'^Bajari and Tadclis (1999) emphasize a related trade-off in the private sector building industry (in a model
where there arc no unobserved difference among contractors). Time and material contracts give the contractor
little
incentive to control the costs, but do not require complete drafts. Fixed price contracts give the contractor
strong incentives to control cost, but require more precise design to avoid costly bargainig
during the completion of the project.
contract
is
The time
scale
and the complexity of the project
if
changes arc needed
will
determine which
chosen.
''in their paper, they
measure the reputation by the number of
litigation conflicts that the contractors
had
in
the past.
'""This
paper
is
also related to papers such as
Barron and limbeck (1984), Shcpard (1993) and Genesovc
(1993) which test the implications of theories based on aymmetric information in industrial contexts (but not the
implications for the choice of the contract).
more
settings in
The model
software.
and present a number of basic
detail
presented in Section 3 and
is
facts
its
about the production of customized
predictions about
how reputation shapes
the contractual forms as well as the ex post outcome arc described in Section
In Section
4.
5,
we
provide evidence which, in our view, clearly supports the implications of this model. In Section
6,
we
discuss alternative explanations of the pattern observed in the data. Section 7 concludes.
and Basic Facts
Institutions
2
We
begin
Ijy
describing the sequence of events leading to the off-shore production of a piece of
The
software.'^
when
project begins
the client sends a request for proposal to one or more firms.
interested firm studies the request (this costs the firm 1.25% of the total project cost for
Each
among
the median external project^*^), and submits a proposal, which includes,
proposed mode of payment and an estimate of how much the
chooses a firm, and the firm and the client agree on a contract.
client
mode
estimate of effort needed to complete the project, a
and
etc.)
client
would have
The
The
of specifications.
starts.
The
-
first
-
corresponding to
that will be reached
phase
For the median project,
it
takes
10%
project effort to complete this phase. ^^ At the end of this part of the project,
of deliverables
it
is
would cost
When
this
of the
a specified milestone
happens the
request changes.
''Tabic
1
client
The
is
'For
the writing
work
is
is
client
the lower level design, coding and testing of the software.
reached, the firm sends the deliverable to the client.
statistics
client
what the
clarified.
it
mentioned
does not
own
in this
Each time
has been delivered (by signing
firms also send regular status reports to the clients (a
shows the descriptive
of the total
usually clearer to both the client and the firm and the schedule
can either acknowledge that
"'Those projects where the
which
is
sometimes amended or
The second phase
is
firm, in collaboration with the user at the client's end, writes the set
of functions that the software will execute.
wants and what
The
of payment, financial details (price,
phases of the software development process or to modules of the software
completing the project). The work then
to pay.
contract specifics an
a projected schedule for deliverables (which arc specific milestones
in the course of
other things, a
little less
off) or
than once
paragraph.
the firm or does not effectively control the part of the firm
working towards the completion of the project (see below).
some
projects, specifications writing
and subsequent work arc decoupled. One firm - or the
- writes the specifications, and another firm completes the project.
client itself
a
In terms of project
is
clients up-to-date aljout the jH-ogress of the project.
week on average), keeping the
outcomes our main focus
the difference between the
amount
estimate.
entire chapter
A
be on overrun: overrun
in industry
of effort actuallj' needed to complete the project
estimated effort given in the contract.
mean by an
will
It is
therefore important to be clear about
parlance
and the
what firms
standard textbook on software management (Pressman (1997), has an
on estimation. He describes the process as
follows:
'The project planner begins with a bounded statement of software scope and from
this
statement attempts to decompose software into problem functions that can each
be estimated individually. Line of Code or function points (the estimation variable)
then estimated
is
component
for
may
each function. Alternatively, the planner
choose another
such as classes or objects, changes or business processes im-
for sizing,
pacted. Baseline productivity metrics
line of
(i.e.,
code per person- month or function
point per person months) are then applied to the appropriate estimation variable and
cost or effort for the function
an overall estimate
Our
is
(Pressman (1997))
for the entire project.'
interpretation of this and other material in this
what we have learned from industry sources)
how much
effort will
is
is
correct
therefore clearly not
will actually take.
book (which
that the estimate
is
is
also consistent with
is
the firm's best guess about
be needed to complete the project, assuming that the firm's current under-
standing of the project
estimate
combined to produce
derived. Function estimates are
This
is
and that
meant
the firm adheres to its
own
to be an unbiased estimate of
important because
it
tells
productivity
how much
norms}^ The
effort the project
us that overrun represents the extent of
deviation from the firm's initial plan of action.
This also
tells
us that overruns ought to be quite
client are typically not very clear at the very
himself.
Moreover the
client
may
common:
first,
because the needs of the
beginning of a relationship
-
even to the
client
not put enough effort into understanding and explaining what
he wants. Not surprisingly then, the firm often does not understand what the client really wants.
When,
to be
in the course of the project, the
made and
needs of the client eventually become
these are costly. Second, the
amount of time and
"In other words, the presumption behind the estimate
wants and that the firm implements the project at
its
is
level of productivity.
changes have
needed to design and
that the firm has understood perfectly
normal
8
effort
clear,
what the
client
code a piece of software
evaluate ex ante, even
difficult to
is
when the
set of functions
well-
is
defined (both for the client and for the firm), and will depend on the type of technology Ijeing
used, the ability
staff
and the
and the experience of the
clearest of goals there
is
and one would expect that some projects
to
maximum
74%
will
firms try their hardest to control costs
24%
of the initial estimate,
overrun in the sample
of the overrun
is
is
to.
initial
negative overrun, and the
Both firms and
by the
changes cause
48%
in
client.
mean overrun
themselves
is
34%, and the
of the overrun on average).
ambiguity in the specifications
clients are, of course,
from being wasteful
The average overrun
varies a lot (its standard deviation
8%
(the most frequent one being the loss of the project
to delays occasioned
it
250%). According to the firms, overruns are due mostly to
client (these
due to
and
did not understand what the client really wanted),
13%
and
and delays
end up costing much more than they ought
of the projects are completed with a positive overrun.
changes required by the
20%
all
arises
shows evidence from our interviews confirming that overruns arc indeed common:
1
turns out that
amounts
some unexpected problem
also the risk that
delays or destroys the project. Finally, not
Table
two companies. Third, with the best of
staff of the
(in so
(i.e.,
manager
Very few projects
(less
in the
where the firm
to cases
due to internal
is
Another
difficulties in the firm
middle of the way) and
than 5%) are completed with a
clearly not zero.
is
aware of the possibility of
much
as they could have
overruns.^'-'
Overruns, apart
been avoided by both parties
being more diligent), lead to delays which are costly^" and are a potential source of conflict
between the
client
and the firm
Vertical integration
(conflicts arise
when each
and contracts arc two ways of limiting the waste due
foreign companies have set
up 100% owned
subsidiaries in India.'^^
export oriented, and carry out work for their mother
clients as well.
'
side blames the other for the overrun).
A number
to overrun.
Many
These subsidiaries are 100%
company and
in
some
cases, for other
of Indian software firms have also entered into arrangements under
For example, the template of a firm's contract specifies that "the effort estimates provided for the conversion
and testing phases of
this project
have been provided by the software firm on a best estimate
basis. If the
scope
of the effort changes as a result of discussions during the detailed design phase, the software firm will analyze the
impact of changes on the project and
may
present revised schedules and costs. Changes in schedules and costs
resulting from such changes will be reflected by an
'"Delays, while rarer than overrun, are far from
and
in
25%
amendment
uncommon
to this contract."
in our sample: there are delays in
of the cases where there was an overrun.
'•"Including AT.S;T,
IBM,
Microsoft,
INTEL, ORACLE,
Fujitsu and Motorola.
19%
of the cases,
which the firm dedicates a part of
This
client.
is
what
an "Off-shore Software Development Center" (OSDC). The
called
is
employees, office space, and computers to a single foreign
its
sends a steady fraction of his software development needs to the firm, and
of the facilities devoted to him. This
making use
OSDC
becomes virtually a unit of the
and the
interests of the firm
there
much
is
we
Since
is
less
(i.e.,
fixed-price contracts, a fixed price
is
These contracts are by
far the
Under mixed contracts the
The
and while there may be overrun,
entire product
is
is
fixed for the specification phase only at the beginning of the
is
fixed only
when
specifications are written
A
striking fact
is
that there appears to be no "intermediate"
contracts where the client and the firm agree on sharing the costs.
While these contracts predict extreme outcomes
This
is
this.
It
evident from Table
2,
all
may be more
may
be happy to do whatever
Or
their variants: in
is
terms of cost-sharing, we actually do not
for
by the firm and the
or nothing of the overrun for the three types of contracts.
overrun
of the cases) while firms with time
For example, the client
in
^"^
which shows the fraction of overrun paid
in fixed-price contracts, the actual
""Indeed there
For example, there arc no
turns out that a large fraction of contracts get renegotiated ex post.
proportion of firms that pay
46%
paid for on a time and
paid for on a time and material basis. These contracts are the least frequent
contracts belong to one of these three categories. ^"^
always observe
is
and
not necessarily the case. Under time and material contracts, the
external contracts (15%).
all
nor for
agreed upon up-front, before the specification analysis.
Typically in such cases the requirement analysis
is
OSDC
observe the following types of external contracts: Under
price for the complete project
known.
contracts:
In such cases the
most frequent: 58% of external contracts are fixed-price contracts.
price
material basis, though this
among
works regularly.
contracts that are performed neither within
We
is
it
type of vertical integration: the
are interested in contracts rather than vertical integration our focus in this paper
the mother companies of the firm).
more
whom
responsible for
is
^^
the overrun should be wasteful.
mainly on external contracts
process.
in effect a
client are clearly better aligned
why
reason
client for
is
client
is
often shared between the client
and the firm
and material contracts sometimes pay
overrun in such cases than
in
Even
for
overrun
(in
(in
general precisely because overrun entails less waste.
not need to be very precise about what he wants since he knows that the firm will
asked of
it.
some cases property
Such contracts arc observed, albeit
rarely,
rights in the
among
product substitutes
for
cash payments.
the procurement contracts for airplane engines studied by
Crocker and Reynolds (1993).
10
22%
of the cases).
However
is
it
from the figures
also clear
Table 2 that the
in
initial
contract
has an clear influence on which party bears the risk of the project: in fixed-price contracts, firms
bear on average
15.5%
of the overrun, while they bear on average
63%
time and material contracts.
in
51.5%
in
mixed contracts and
Since fLxed-pricc contracts dominate our sample, this
evidence also implies that firms bear a lion's share of the overrun (57% on average for external
76%
projects,
for the
median external
somewhat
clients, this is at least
project). Since firms arc typically
a firm faces a fixed-price contract
has the option of walking off the job.
done, but
may
it
will also avoid the
may have some
it
If it
for the pervasiveness of renegotiation.
docs,
there
is
arbitrage court (even though in
generally,
Finally, firms
is
no project
in
where the
extremely
make some
and therefore we ought
and
clients
CEO
may
is
by internal
who was
responsible for
difficulties.
what
is
'it
was our
at least
it
(3)), or
is
We
with the
client).
More
for
case: as
In
is
of their
own making,
had a number of conversations
and we paid
fault
responsible for the overrun.
it'.
We
also
have some
mentioned above, we asked
what
follows,
we assume that
described as changes due to ambiguities and overrun caused
entirely
client
due to the
due partly to both (column
regression of the share of overrun paid
all
conflict
renegotiation.
reliable.
sometimes the
Changes required by the
by the firm when the overrun
some
to expect
are taken to be caused by the client's responsibility.
In
is
concessions in order to avoid
voluntarily pay for any overrun that
of the firm told us
firms questions about
OLS
cff"cct
and going to court
inefficient
some occasions the firm reports a
indirect evidence that this
(column
has already
it
our sample where the firm and the client went to
because they care about their reputation for being
the firm
usually
from our conversations with industry people we have the impression that people go
to court very rarely
more
it
overrun and, at least at early stages of the job, the second
very costly. Firms and clients will therefore prefer to
fact,
paid for work that
even
First,
bargaining power because
will not get
it
dominate. Second, the court system in India
going to court. In
smaller than their
surprising.
There arc several potential explanations
when
much
(2)).
and delays coming from the
client's side
Table 3 shows the share of overrun paid
client
(column
In column (4),
(1)), entirely
we
due to the firm
present the coefficient of an
by the firm on the share of overrun which
it
caused.
types of contracts, firms always pay more of the overruns entirely caused by their
mistakes compared to the overrun entirely due to the
share of overrun paid by the firm
lies
client.
Moreover, in
all
cases but one, the
inbetween these two numbers when the overrun
11
own
is
partly
caused by each
side.
OLS
Furthermore, the
regressions indicate that, regardless of the initial
contract, the larger the fraction of the overrun that a firm has caused, the larger
has to pay
(if
a firm causes
percent more of
one additional percent of the overrun,
it
share
tlie
it
bears approximately 0.20
it).
In the next section
we present a model
of the industry which
is
based on the picture that
emerges from the above discussion. The main elements we wish to capture
in our
model arc the
following:
^to-
the high levels of overrun,
•
• the fact that
both sides arc responsible
for overrun,
• the use of simple ex ante contracts,
• the fact that the contracts get renegotiated ex post,
the fact that the ex ante contract continues to influence the renegotiated outcome,
•
• the fact that firms
and
clients care aljout their reputation for
voluntarily pay for overrun that
A
3
Model
is
of their
being reliable and will often
own making.
of the Software Industry
The model we propose
in this section
is
an attempt to capture
in as simple
a way as possible
what, on the basis of our experience in the industry, we see as the fundamental structures and
conflicts in the Indian
predicted by the model
in the data.
customized software industry.
will,
as
wc
shall sec,
contracting outcomes that will be
match up reasonably
However, one could come up with other models, or at
models, which also explain the data.
5.
The
In the end, however,
it
Wc
will discuss
some
well with
least
what
is
observed
combinations of other
alternative explanations in Section
remains plausible that elements of these other models could also be
a part of any comprehensive story of the software industry in combination, perhaps, with the
story
we
tell.
In this sense, the model
The premise
main
of the
model
is
is
meant
to
be
illustrative rather
than
definitive.
that software projects arc prone to cost overruns and that the
conflicts arc over the apportioning of these cost overruns.
Overruns can happen
for
two
reasons. First, the chcnt could have been insufficiently diligent in deUneating his requirements
12
or he could have
made
realize that this
is
As a
a mistake.
not what he wants and
The
issue
also
happen because the firm was
is
whether the
client will
demands changes. The
possibility that each side will
and
specifically the courts,
this
is
be willing to compensate
it
either lazy or unlucky in the
come from
Since the overrun could
cither side,
blame the other
for
when
firm
if it is
is,
a
product he might
to
adequately compensated.
enough. Second, overruns could
way
there
is
it
carried out the project.
an overrun, there
This need not be a problem
it.
happy
of course,
if
can observe who was really responsible. Our assumption
is
a real
outsiders,
will Ije that
not possible in most cases.
This
is
clearly
something of
a caricature of reality: firms
systems to ensure that
it
of defining deliverables
and having the
Once
on
a client signs off
up
clear, ex post,
is
who was
to that point the firm
presumably ascribable to the
is
had done what
and
blame
to
client sign off
a deliverable, he
scope for future disagreements.
is
comes up with
firm
the changes - since they arc Parcto improving - but only
make
least
when the
result,
clients clearly
it
set
up
any overrun. The procedure
for
on each deliverable
is
committed
to a large extent
do try to
one such system.
to
admit that
was supposed to do. This clearly
at
limits the
Nevertheless, there seem to be lots of disagreements and this
fact that
even after
many
milestones have been reached, there
remains substantial ambiguity about what exactly needs to be done.
Disagreements, Overrun and Contracts
3.1
We
The
capture the possibility of this kind of disagreement as follows.
(F) to build a piece of software that will be worth
on both sides throughout, so this
costs). In
is
V to the client
money
best thought of as a
a world where the client can describe the product
it
However we assume that
=
(C) wants the firm
(we will assume risk-neutrality
payoff and the costs as
money
wants perfectly and the firm also
understands this description perfectly, the project should cost y
adopt the normalization that y
client
(i.e.,
the estimate
is y).
We
0.
in every project the actual cost will
be positive,
i.e.,
there will be
overrun: the client's description of the project will always be incomplete and the firm will never
understand
it
perfectly. Total overrun will thus
and overrun caused by the
client (yc)-
Assume
be the sum of overrun caused by the firm (y^
that
firm.
13
all
overrun
is
initially
paid for the by the
The amounts
yp and yc, arc determined,
of the overrun,
by the firm and the chcnt in describing and understanding the project.
that firms face a choice between a high level of yp, yp^ and a low level,
faces a choice
between yc and
overrun
may be
-
this
cfTort
S])ccifically
put
because controlling overrun takes
wc assume
Likewise, the client
y£_.
it
because the firm (or the
effort or
has generated (say the firm
lying about
is
client)
its costs).
The
extra private benefits to the client and the firm of a high level of overrun arc, respectively,
and Bp. Assume that yc—
in
Ceteris paribus, both firms and clients prefer high levels of
yc_-
gets to keep a part of the overrun
by the
respectively,
yc> Be and yp— yF> Bp
so that
always
it is
efficient to
Bq
minimize
overrun.
However, we
assume that both yc and yp arc known only to the firm and
will
+
third parties such as the courts only observe total overrun {yc
all
yp)?''^
Moreover, we restrict
contracts to being linear and in addition require that they do not involve throwing
money. In other words, we only consider contracts where the
P+ (1 — s){yp +yc)
borne by the firm
-
(s
where
G
P
[0,1])
a prc-spccificd fixed
is
client
payment and
s
is
the share of the overrun
and material
and the contract with
contract).'^'' It will
s
=
=
1
else.
Of
(corresponding
(which corresponds roughly to a time
be key to our analysis that neither of these contracts obviously
dominates the other. The fundamental trade-off comes from the
is
anybody
to
particular interest to us will be two extreme contracts: the contract with s
to a fixed-pricc contract)
away any
pays the firm an amount
and neither party makes any payments
-
its client:
fact that s
is
one number that
being used to give incentives to both parties: a high s will give good incentives to the firm
but not to the
client,
while a low s contract does the reverse. As a result,
be possible to implement the
first bcst.^'^
To complete the description
contract.
will typically not
it
of the contracting process
Our reading of the industry practice
is
we need
that the contract
is
to say
who
usually proposed by the
^'In other words, the fact that, say, two people were assigned to the project for 14 weeks
what they were actually doing
"''The correspondence
realized costs rather
is
-
proposes the
is
verifiable
but not
they could have been really working on a different project for most of that time.
not exact because a time and material contract typically pays a
than a fixed payoff.
markup on the
Similar results hold for that case but the exposition
is
somewhat
more cumbersome.
-'"'This
basic tension
is
very general.
we
have chosen here, can be relaxed
if
impossibility of implementing the
first
Our
restriction to linear contracts, while vital in the discrete case
arc prepared to go to the
best in that case
is
14
model where overrun
varies continuously:
a consequence of the results in Holmstrom (1982).
we
the
firm. W^c will
hold
if
make
we allowed the
3.2
Norms
When
the
outcome
first
maintained assumption, noting however that similar results would
this our
client to
propose the contract.
best cannot be achieved by contractual means,
the behavior of the firms and the clients
if
is
at least partly
assume that there are two types of firms and two types of
one type of
client observes
a
norm
of being reliable,
possible to improve on the
it is
clients.
norm-governed. Specifically
Of
these,
one type of firm and
by which we mean that they always pay
for
any overrun that they themselves have generated, as long as the other side does the same. In
particular, they will
pay
for the
that the other side pays for
However,
to
tr}'
if
When
if
the contract stipulates
words they do not necessarily maximize current
in other
the other side docs not act reliably they do not act reliably either
maximize current
maximize
it -
overrun that they have generated, even
profits.
Assume by
contrast, unreliable firms
and
clients
-
profits.
they simply
always act to
their current profits.
a firm
and
a client are
matched, they do not directly observe each other's types.
Rather they assign probabilities to the other party being
know about them. The
reliable,
on the basis of what they
probability that the firm puts on the client's being reliable, 6c, and
the probability that the client puts on the firm's being likewise. Op, therefore summarize their
respective reputations.
and
We
will return to the question of
how
these reputations are sustained
their evolution later in this section.
Contracts for Protection
3.3
In this setting, since the reliable firms and clients arc going to be sclf-rcgulated, the function
of the contract
versa.
The
is
to protect reliable clients against
contract protects because
it
provides a fall-back option
unreliable. If a firm, for example, generates a large
it
opportunism by unreliable firms and vice
amount
when
of overrun
the other party
and
can be taken to court and forced to pay at least the share of the overrun
refuses to
it
is
pay
being
for
it,
has contracted to
bear.
However
as
we have already argued
in Section 2,
we expect
these contracts to be renegotiated.
We assume that the renegotiated outcome is a sharing of the overrun which is potentially different
15
from what
when
in the contract
is
tliere is a dispute,
would also
cxjject that
and
is
represented by the share of the overrun paid for by the firm
s*{s,9c,9p).
more reputed
natural to assume that s*
will
increasing in
is
We
s.
more bargaining power and therefore pay
parties will have
example, the court
less (because, for
It is
pay more attention to
their plaints but also because
other determinants of bargaining power such as creditworthiness tend to be correlated with
reputation),
above by
s*
i.e.,
<
>
^f-
and
^- <
0.
Assume
also that s*
is
bounded below by «!_>
and
1.^^
Firm Behavior
3.4
Reliable firms and clients always pay for any overrun that they generate.
always choose a low
level of
overrun
-
yp
for the firm
and yc
follows that they
It
for the client.
At the end of the
contracting period they observe the overrun generated by the other party and also whether or not
they agree to pay for
is
it.
If
a dispute: then the firm
the other party refuses to pay for the overrun
and the
client
end up splitting the overrun
reliably
reliable firms
and
respects
and choose yp and
to go to the dispute
(i.e.,
to
pay
for all of
outcome otherwise); and
it
pay
to
outcome otherwise;
for all of
to choose
it
in the ratio s*/(l
They have
Unreliable firms want to maximize their short run earnings.
mimic the
yp
or
yp and
—
four options:
yp but
to act reliably in
and
all
made by
contract, as well as
unreliable firms and clients will
to
other
to go to the dispute
to go directly to the dispute outcome.
Unreliable clients also want to maximize short run earnings and face a similar trade-off.
actual choice
s*).
as long as the client behaves
as long as the chent behaves reliably
to choose cither
has generated there
it
depend on the
s that is
The
written into the
on what they expect the other side to do. The following proposition gives
conditions under which unreliable firms and chents indeed are unreliable
of overrun
and then get into a dispute:
Claim
1
The unique
and yc
= yc ""^
equilibriuTn behavior of unreliable firms
and
i.e.,
choose a high level
clients is to choose
yp
=
yp
go the dispute outcome subsequently, as long as the two following conditions
hold:
Given that
\vc
have assumed risk ncutrahty, the natural interpretation for s*
of the overrun borne by the firm in the event of a dispute.
The
that
it is
the expected share
actual share will presumably vary according to
exact circumstances of the negotiation process, and, on occassion,
16
is
may
turn out to be
1
or
0.
(i)s*{ijF-yF)
(a)
< Bf and
yp and yc
1
(
< Be
-s^) (yc -yc)
dose
are both sufficiently
to 0.
for there to
These conditions arc not necessary
be an equihbrium with unrehable behavior
but they have the advantage of being easy to interpret.
that even
if it
The
were possible to give incentives separately on
induced to make their
yp-
first
condition essentially says
and yc, neither party could be
best choice purely on the basis of those incentives
first
most extreme contracts
in our setting renegotiation rules out the
(s*
=
-
simply because
=
or s*
1).
The
second condition illustrates an additional source of incentives that arises Ijccause of the specific
structure
for
we assume
some part
-
by choosing to dispute, the disputant necessarily takes on responsibility
by the other party.
of the overrun generated
If
the other party was reliable, he
could have avoided this part of the overrun by behaving reliably himself. This might give him
The second condition
a reason to behave reliably.
incentives, since
it
says that
if
the other party
is
in effect rules out this particular source of
reliable his contribution to overrun
is
very
small.
For most of this section wc will assume that both these conditions hold and, consequently,
unreliable firms
We
and
clients
choose high levels of overrun and then go to the dispute outcome.
realize that the first of these conditions
later that our results
convenient, since
it
is
actually quite stringent.
However we
on contractual choice do not really turn on this property:
limits the
number
will suggest
it
is
simply
of possible cases.
Matching
3.5
For most of this section we assume that firms and clients are matched randomly with each
other. This of course docs not apply to the clients
already worked with
Even
in the
there the question
more common case
especially since
The
-
-
time,
may be
arc going back to a firm that they have
whether the original match was more or
of first time matches, however, one
as will be pointed out later
possibility of selective
specific needs
is
who
matching
is,
may
approach with a request
random.
expect some selection,
there are benefits from matching appropriately.
-
however, limited by the fact that clients often have quite
and the number of firms with the capacity to meet those needs
quite small.
less
at
any point of
Moreover, clients often rely on hearsay in selecting which firms to
for
proposal and this
may imply more
17
or less
random
selection
from
the point of view of everything that
is
pubUcly observable. In such cases, random matching may
not be a bad approximation to the truth.
Reputation
3.6
Reputation
in our
pretations of what
firm
(i.e.,
have
it
model
is
reputation for being reliable. There are at least two possible inter-
makes a firm
one interpretation
reliable. In
an
it is
intrinsic property of the
the owner of the firm genuinely prefers to be reliable rather than rich) and
and others do
some
firms
not.
In a second interpretation,
all
firms arc greedy, but
restrain their greed in favor of better long
more pressing immediate
some
arc patient and therefore able to
term outcome and the
needs). In other words, reliable firms
rest are impatient (or
and
have
clients play a strategy that
corresponds to a good equilibrium of a repeated game while the unreliable play strategics that
maximize short run
profits.
Clearly this would only work
the history of past behaviors becomes pubhc.
been unreliable
the future.
in
with
who
is
known
presumption
is
there
is
some mechanism by which
therefore posit that
it
if
a firm or a client has
becomes public information
at
some point
sustained by the threat (say) that no firm will contract
been unreliable in the past and vice
where the firm and the
vcrsa.'^'^
mechanisms by which reputation can
client
evolve.
have contracted at least once before, the
that both had behaved reliably so that they both
a vis the other. '^^
whom
to have
is
cither interpretation, there are several
First, in those cases
vis
with some probability
The good equilibrium
^'"^
a client
Under
in the past,
We
if
now have a
better reputation
Forty-one percent of the contracts in our sample involved a client with
the firm had worked already. This proportion
is
roughly the same
among young and
old
firms.
Second, the age of the firm should be a source of reputation.
We
have already assumed that
a firm or a client has been unreliable, with some probability this becomes public information
if
some time
at
since
it is
in the future.
known
Once that happens no one
to be unreliable
and
it
will
will
want to contract with
it
any more
probably end up exiting from the industry.^^ This
^"This might happen because a disgruntled employee reports what really happened or an incriminating docu-
ment
gets to the
wrong hands.
•'"This formulation closely follows Tirole (1996). Sec also
Kandori (1992).
model of how reputation evolves within a specific relationship, see Rauch and Watson (1999).
.Ti
Under our second interpretation above, the equilibrium strategies actually dictate that no one contracts with
"For an
explicit
18
more
selection process ensures that older firms (and clients) will typically Ijc
reinforced by the fact that information
in the industry a long
ISO 9000
time and does not have any black marks against
it,
may be
certification, are therefore
because they think that
will
it
contracts in the sample were done
firms (only
9%
is
more
likely to
be
able to establish a reputation by demonstrating that they follow pro-
by outside agencies, such
another potential source of reputation. "^^ As we noted
the introduction, firms in the industry arc currently very keen to acquire
cisely
is
revealed over time and therefore a firm that has Ijcen
cesses which, in principle, should reduce overrun. Process certification
as
This
percent of the firms in our sample were created in 1993 or after.
reliable. Fifty-seven
Finally, firms
is
reliable.
of the
ISO
in
certification, pre-
improve their reputation. Nineteen percent of the external
bj'
ISO-certified firms. ISO-certified firms tends to be older
young firms have ISO
certification).
Theoretical Results
4
4.1
The Optimal Contract
Since
we have assumed
own
that
it
is
the firm
proposes the contract, and the firm knows
type, the proposed contract can be used as a signalling device
unreliable will prefer a contract where
to absorb
such equilibria
clients
Among
we
off
will
little
of the overrun
is
known
to have
to be unreliable should
certification
is
expect that there will be
than they would be pretending to be
the set of pooling equilibria
a firm or a client that
^'ISO
pays very
it
less
therefore,
reliable.
is
money and
equilibria.
However
all
the unreliable firms and
reliable.
first
interpretation firms and clients that
therefore should be
some approved
follow specified procedures to report on the progress of the software
more
likely to exit.
routines.
In particular, the firm
and to perform the
tests.
software development process should be easier to monitor for ISO certified firms. Moreover,
in a while,
and
lose the certification if
methods. This should give strong incentive to the ISO
problems
Given that wc
awarded by international or Indian agencies, themselves accredited, which examine that
the processes of software production in the firm follow§
monitored every once
by choosing
focus on contractual outcomes where the total joint
behaved unreliably. Under the
make
still
we
and
all
its
a firm that plans to be
-
many
pooling since in a separating equilibrium
will involve
would be worse
known
it
most of the overrun a firm may be able to signal that
are in a signalling environment,
arc
who
19
Consequently, the
certified firms arc
they cannot prove that they followed the approved
certified firms to stick to
reliably.
ISO
must
standard procedures and report
surplus of a firm and a client
who
Nash equilibrium (sustained by the
arc both reliable
is
maximized. This
This expression
for joint surplus
-dcVF -
= V - epyc(1
-
-
{I
er){l
is
is
the surplus that
0c)s*{s, Oc, 9[r){yp
+ y^).
lost
is
because the firm must allow
is
because
in a
pooling
unreliable, while the
for the possibihty that the client
unreliable.
To
optimal contract we need to maximize the above expression for
find the
W with respect to
This expression
or
either
It is
is
independent of
is
decreases in
0/?
(1
— 9c){yF +yc)] >
and increases
in
9c
0.
The
gives us:
always either a fixed price or a time and material contract
when most
clients are reliable while firms are
fact,
(s
more
the reverse situation.
reported above, that these arc the only two types of con-
also confirms the intuition, given above, that fixed-price contracts are instituted to
have a high reputation
'The reader may
feel
will get
is
firms.
Firms that
time and material contracts while the rest of the firms will not.
is
partly true, in the sense that
a less extreme contract will be chosen.
effective contract
and material contracts protect
that the result that the contracts arc always at one or other extreme
assumption of risk-neutrality. This
is
— 9p){yc + Vf) —
s,
protect clients against opportunism, while time
contract
- dc){yF + yc)]-gj
and a time and material contract in
This accords well with the
It
(1
if [(1
a fixed-price contract
likely to be opportunists,
tracts.'^'*
and only
if
optimal contract
1).
Differentiating
ds*
- OF){yc + yF) -
positive
is
fact that this last expression
Claim 2 The
W.
s gives us the expression:
[(1
is
lost
is
also
- s%s,9c,eF)){yc+W)
third term in this expression gives the total surplus that
term
it is
an obvious focal outcome.
equilibrium a reliable client must allow for the possibility that the firm
fifth
fact that
is:
W{s,Bc,9r)
The
it
always a Baycsian-
The
belief that only opportunists deviate).
Pareto o])timal from the point of view of the reliable types makes
is
However note
never very extreme. Therefore
it
also that s*
may
consistent with optimal risk-sharing.
20
well
if
is
is
driven by the
the two parties are sufficiently risk-averse
always strictly between zero and one
be the case that the
initial
-
the
choice of an extreme
The Sharing
4.2
The expected
Overrun
of
share of the overrun paid by the average firm with reputation 6p that works for
a chent of reputation Oq,
is:
epOc
Vfi
hi the previous section
an increase
effect
term
on
and through
and
sizes of s*
—=—
fLxed-price contract
or even
we showed that the optimal
its effect
on
above expression to the
in the
if it
- OfOc)
(1
{s*is,ep,ec))
s
is
s.
An
first
increase in
The
term.
a decreasing function of Op. Therefore
is
6p reduces the share of the overrun paid
in
s*
^+ yc +
for
6p
by the firm both through
depends on the
For firms with a relatively low reputation, the contract
.
and
positive
be negative and could
s* will
it
be high. Therefore
should be small.
in principle
For
this third effect
verj^
is
is
may
relative
likely to
reputed firms, however, this
be a
be negative
likely to also
effect
be negative enough to counteract the two other
such firms an increase in their reputation
direct
from the second
also shifts weight
effect of this shift
its
might
effects:
for
actually increase their share of the overrun.
To
summarize:
Claim 3
If two firms are
the higher reputation
relation
may
matched with
is likely to
not hold
is
who have
clients
the
same
hear less of the overrun on average.
reputation,
the firm with
The one case where
this
With random matching, the negative relation
for very reputed firms.
between reputation and the share of overrun also holds without controlling for the reputation of
the client.
The mean overrun generated by
a firm of reputation
6'FyF
This
+
(l
6p
is
given by the expression:
-dp)yF-
clearly decreasing in 6p. Likewise, the overrun generated
is
in the client's reputation.
independent,
it
With random matching,
follows that the total overrun
is
by a
client is decreasing
since the reputations of the
also decreasing as
two parties are
a function of the reputation
of the firm.
Claim 4 The overrun
tion.
generated by the firm (client) decreases with the firm's (client's) reputa-
With random matching, the
the firm
's
total
overrun generated in a relationship
reputation.
21
is
also decreasing in
Extensions of the Model
4.3
Non-random Matching
4.3.1
The assumption
there
that firms and clients
a repeat match.
is
words compared to the
among
firms than
it
The
of
clearly indefensible for the case
the
is
reasonable to assume that since there are
clients"^^,
new
contract will be
random matching
is
more
likely to
-
where
in other
to be higher.
The
therefore potentially
many more
the firm's reputation will improve by
firm's share of the overrun should also go
The assumption
is
contract will differ from the initial contract
client's reputation. In this case, the
contract.
random
match between them, both Oq and Of ought
may be
among
at
repeat match clearly signals high levels of mutual respect
initial
new
direction in which the
amljiguous. However
A
match
start-ups
more than the
be a time and material
down.
questionable even for
first
time matches. Firms with
low reputations expect to get a fixed-price contract. Therefore, they have the most to lose from
being matched with a client
who
has a low reputation. Formally this
is
captured by looking at
the properties of the function
S
=
V- 0Fyc-{^
-dcvz -
Now
if
6c
is
(1
-
^f)(1
- s*(s(%,0^)),0c,M)(yc + y?)
- 0c)s*{s{ec.eF),ec.eF){yF: + m-
greater than 6'q
\v*{ec,ep)
- w%9'c,9f) =
- eF){s*{s{9c,eF)),9c,9F)
(1
-s*is{9'c,9F)),9'c,9F)){yc
-{&c - 0c)yF
+
{ec
+ yF)
- e'c>*{si9c,9F),ec,dF){yF + yc)
+9'cis*{s{9c,9p),9c,9F)
-
s*isi9'c,9p),9'c,9F)).
Ignoring terms that depend on the second derivative of the s*{-) function (the last term in the
above expression), the
effect of
an increase
in
9f on W*{9c, 9f) — W*{9'q, 9f)
'57% of the firms were created before 1993, while more than half of the
22
client are fortune
is
unambiguously
500 firms or equivalent.
An
negative. '^^
unreputed firm
(client) benefits
than a more reputed firm
(firm)
While
it
is
more from being matched with a reputed chcnt
(client).
beyond the scope of
paper to explicitly model the matching process that
this
leads to this outcome, the implication of this result
be more
likely to
be matched with reputable
is
that firms with low reputations should
and vice
clients
versa.**'
It is
easy to sec that this
kind of matching will reinforce our results in Claim 2 about contractual choice
same
higher 6p and a lower 6c always go in the
-
the effects of a
direction.
Turning next to the average share of the overrun borne by the firm, OpBc
Gp^c) {s*{s,6f,0c))
^vc sec that the fact that
j
reinforces the result given above in
The
effect of
While
case.
generates
We
Claim
an increase
6p on
3,
so the net effect
summarize these
may
not
is
is
^^^'s
now
(1
~
associated with lower 9c's
increasing in 9c-
however no longer unambiguous
more overrun,
Ijc
are
1"
its
partner, the
the one given in Claim
in this
more reputed
client,
4.
results in
5 Less reputed firms will try
to
our previous results on the
sharing of overrun.
since s*
total overrun
a less reputed firm generates
less,
will reinforce
clients
in
Claim
higher
—=T
Clients
match with more reputed
who work with more reputed
firms.
less
As
and
vice versa.
This
on contractual choice and the
effect of firm reputation
who work with
clients
reputed firms will generate less overrun than
a result, total overrun
is
no longer necessarily
decreasing as function of the reputation of the firm.
Choice of Projects
4.3.2
The
fact that firms
with low reputation pay for most of the overrun should clearly influence their
choice of projects. This can be introduced into our
model by making the plausible cissumption
that the most rewarding projects (the ones with the highest
possibility of large overruns {yc
this
large). It
is
will also
have the highest
easy to show by introducing
assumption into the model of the previous section, that keeping the reputation of the
fixed, less
"'This
s'
and Yf are going to be
V)
reputed firms will be more willing to trade
follows
from
the
fact
that
s'{s{ec,dF)),Oc,OF)
off
-
a lower
V
for
client
a lower yc than more
s'(s{e'c,dF)),9'c,dF)
is
positive,
while
{s{0c,0f),Gc,0f) goes down when Of goes up.
Since
client
wc do not have data on
generated overrun
is
client reputation
we cannot
smaller for younger firms, which
23
is
directly test this prediction.
We
consistent with this prediction.
do observe that
Formally this
reputable firms.
seen by difTcrentiating the expression for ^V*{9c-,6f) with
is
respect to yc- This yields
-{i-ec)s*{s{6c,eF),ec,Bjr),
which
is
clearly increasing in 6^- less reputed firms benefit
Here we have assumed that
especially implausible:
client side
Y2K
opportunism
is
is
it
a
is
This
is
not
On
It is
the other hand the firm always has the
what hap-
interesting nonetheless to look at
always accompanied by an equal reduction in yp. Differentiating
W*{6c,0p) with
-{1 - ep){i
jTf-
projects are sufficiently simple and standardized that the scope for
probably very limited.
reduction in yc
the expression for
reduce yc without affecting
possiljle to
option of simply doing the job lackadaisically.
pens when
more from a low yc-
respect to
yc and yF
- s*{si0c,er)),6c,ep)) -
yields the expression
- ec)s*{siec,Bp),ec.er).
{1
Differentiating this expression with respect to 9p, yields
(1
-
{s{ec,0F)),8c,0F))
s
+
[Be
-Of)
:t7,
which, for low reputation firms, should be positive (since 9c
us that even
benefit
if
— 9f should be
yc and yp move together, the youngest firms
most from choosing a low yc (and yp) project.
Claim 6 Low
will
This
tells
probably be among those
who
positive).
'^'^
reputation firms will tend to be specialized in projects which have low potential
for client-side opportunism.
In terms of
what we observe,
projects which arc simple
work to make
clear
reputable firms
and well-understood so that the
is
easily defined.
may
Y2K
client
who
will
choose
does not have to do very
much
cither short projects"*^, or projects
projects arc typical in this respect.^''
also prefer projects with low
fact that these projects protect the clients,
The complexity
seems to suggest that low reputation firms
what he wants. These projects can be
where the main goal
"Very
this
yc and yp
in this case will
of a software project increases sharply with
-
the benefit in that case comes from the
be the vulnerable party.
its size,
sec
Pressman
'"Other projects where the objectives arc relatively easily defined include
existing software from one platform to another.
24
CAD
(1997).
projects and migration of an
The
possibility of switching to a low
overrun
It
yc project should not
our model, since yc never enters the expression
in
does however makes
mean overrun
will
more
it
likely that the results
be ambiguous. Because firms with low reputation
may go up with
therefore, total overrun
reputation.
scope for opportunism on the part of the firm, the
fall
share of the overrun.''^
when
will
choose projects so as
the firm has no reputation and
Moreover,
if
these projects have also less
mean overrun generated by
the firm
not
with reputation.
Under the assumptions made so
tunistic behavior
effects to the
on the other
contracts only protect the contracting parties from oppor-
far,
side.
They have no
model by assuming that when
be close enough to
1
s is
direct incentive effects.
that even unreliable firms will prefer to act reliably.
client to act reliably
rule out the possibility of getting the first-best
still
We
can add incentive
chosen to be high enough, the resulting s*
symmetrical possibility of inducing an unreliable
We
In this ease, once s
by setting
it
contract with a lower
it
further.
will still
On
s.
s
low enough.
outcome by assuming that
in order to
weak
incentives.
high enough to induce reliable behavior from unreliable firms, there
is
be no reason to raise
extremes. However
will
also allow for the
give any one side the incentive to be reliable, the other side has to be given very
will
may
Contracts for Incentives
4.3.3
We
for the firm's
on the relation between reputation and
to limit overrun, client generated overrun will be smaller
always
affect the firm's share of the
never behave unreliably,
it
In other words, the optimal contract
be the case that an increase
in
Op and a
may
fall in
not be at the
6c
will favor
a
the other hand, since the least reputable firms in this world will
turns out that for a certain specific range of values of 6p (those
exactly around the value at which the contract switches from a high s to a low s) firms with
lower 6p will both generate less overrun and bear a smaller share of
it,
compared to firms with
a higher Op-'^^
'This
is
not strictly true.
the sharing of the overrun.
this cfTcct
It
may
A
lower yc and yr
may
affect the choice of the
optimal contract and thereby affect
However, since most low reputation firms almost always have fixed cost contracts,
not be very important.
should be noted that this perverse consequence of the incentive effect
where the firm (and the
client)
quite as dramatic and hence
it
make
may
discrete choices.
With a smoother
is
most
likely in
model
like
set of choices, the incentive effect
is
ours
never
never be the case that more reputable firms actually pay a higher share of
the overrun.
25
Evidence
5
document that the central imphcations
In this section, \vc
of the
model arc consistent with the
data, by showing that contractual forms as well as the actual sharing of the overrun vary with
characteristics likely to be correlated with the reputation of the firm.
Wc
other i^redictions of the model match with the software data. Finally,
wc consider some obvious
then examine how the
alternative explanations of the patterns observed in the data.
Measures of Reputation
5.1
Wc
have already suggested three alternative measures of
or not
it
We
is
also
in a
make use
of a fourth metric
companies) and external projects.
Wc
be similar to the difference between
there
is
clearly
-
wc compare
first
time and repeated relationships,
like in a
behavior in this type of relationship
after the client has spent a very long
is
much more
the comparisons to firms that perform
is,
some
US
together."'''
Second, the scope
limited, since
both parties share
in part, a substitute for reputation.
OSDCs
office of
for internal clients arc
will
be established only
the firm.
We therefore restrict
internal projects (e.g. subsidiaries that works for
Note that wc think of the reputation as being an attribute of the
firm,
more than of the individuals who
could be that an experienced professional leaving his job to create a software firm takes his
individual reputation with him.
what the past career
It
of the person
turns out that individual reputation seems difficult to transport (wc asked
who founded
the software firm was, and examined whether this was related
with sharing of the overrun, but did not find that this was the case).
CEO
First,
time studying the firm. Fully-owned subsidiaries are often
run by people who had been previously working in the
the
two reasons.
for
know much more about each other (and what they know must be
potentially very different from other companies. In particular,
It
and mother
repeat contract but even more strongly,
However, we need to be sensitive to the fact that companies working
it.
whether
would expect the difference between external projects to
the control rights. In other words, this kind of relationship
compose
OSDC
internal (projects for
they have decided to establish a long term relationship
for unreliable
its age,
certification.''"^
an element of reputation: much
the firm and the client must
I)ositive) if
ISO
repeat contract and
a firm's reputation:
of a software firm has to provide
is
the
management
The main reason
of the team, which
is
may
that the important input
or
may
not be related to
his ability as a software professional.
The
internal/external comparison
comparison
-
since the
matching
in
is
therefore closer to a repcatcd/first-time comparison than to a young/old
an internal project
is like
26
that in a repeat project.
their
mother company and
also for external client). This insures that the selection of firms for
internal projects does not invalidate the comparison (since
some
selected for
internal work).
Choice of Contract and Sharing of the Overrun
5.2
5.2.1
An
firms in this sub-sample have been
all
Structure of the Contracts
implication of the model
ex ante rule
that contractual forms will be restricted to contracts where the
is
that firms will bear cither
is
this implication rests
all
or nothing of the cost overruns.
on the particular assumptions we have made,
Ijut
it
As pointed
out,
matches well with the
observed pattern.
As we describe
in Section 2, there are three
major types of contracts:
fixed-price, time
and
material and "mixed" contracts. Fixed price contracts arc linear contracts with s
=
1.
As we
=
0.
In
mixed
discuss above, time
and material contracts arc similar to such contracts, with
contracts, the initial agreement specifies a
specification phase, another
kind of contract
sharing rule
is
eff"ectively splits
chosen, which
and fixed-price
for the
In other words,
contracts.
It
agreement
is
is
is
payment
for the specifications only.
specified for the
At the end of the
development and testing phases. This
the projects into two sub-projects. For each of them, a separate
either 1 or
(often,
time and material for the specification phase
subsequent work).
mixed contracts arc a juxtaposition of
easy to understand why,
specifications tend to
s
when
fixed-price
the project
be written on time and material and the
is
and time and material
broken into these two phases,
rest of the
work tends to be done
using a fLxcd-price contract. In the specification phase, the potential for the client to generate
an overrun
is
extremely large. In particular, when the firm
first
sends the specifications, he can
The whole
effort
important to give the
client
pretend that the specifications written do not correspond to what he wanted.
of the firm until that point
becomes
higher powered incentive.
On
it is
the other hand, at the time the second sub-contract
large part of the uncertainty about
(in writing) to the specifications.
to the firm, can
in effect useless. Therefore,
what the
client really
is
is
written, a
resolved, since he has agreed
Therefore a fixed-price contract, which give better incentives
become optimal from that point
the second phase of the project
wants
is
on. In practice, the choice of the contract for
often endogenous:
27
if
the firm feels that a substantial
amount
of uncertainty remains,
it
can
in general insist
on getting a second time and material contract.
Mixed contracts arc therefore ex ante more constraining
for the client
than
for the firm.
Reputation and the Choice of Contract
5.2.2
The reputation
share of the overrun
likely to
both which contract
of the firm determines
it
will
end up paying (actual
s*).
it
will get (choice of s)
Firms without a reputation
and what
will
be have fixed-price contracts than time and material or mixed contracts.
more
fixed-price contracts should bear
Finally, conditional
be more
Firms
in
of the overrun than firms with other types of contracts.
on having any particular type of contract, firms without
bear more of the overrun than firms with a reputation.
The combined
a
reputation will
effect of these
that firms without a reputation will bear a larger share of the overrun.
is,
of course,
'''^
This sub-section presents data related to these implications.
We
presented evidence that age does matter in the introduction, as a motivation for this
project.
The
relationship
is
and the share of the overrun
illustrated in Figures
l^orne
1
and
2.
and old firms (created
in
In column
firms.
external firms. In columns (2) to (4),
or after)
difference
is
(1),
for
1993 or before).
wc report the mean
is
26%
Young
higher).
firm.
each type of firm, and the difference
for the
sample of
we show the contrast between young firms (created
have fixed-price contracts (the probability
of the overrun both
of fixed-price contracts
by the firm are increasing with the foundation date of the
Table 5 shows the means of the firm's share of the overrun
between low and high reputation
The proportion
firms arc significantly
They
more
in
1994
likely to
also bear substantially
more
on average (19%), and within the projects with fixed-price contracts (the
13%).
The pattern
is
less clear for
fixed-price contracts
ISO
certification: ISO-certified firms arc not less Hkcly to get
and they do not pay
for
a lower fraction of the overrun in general. However,
conditional on doing fixed-price contracts, they bear less of the overrun (20.4%).
A
''It
relationship with a client has the
should be emphasized that the
the cfTect of reputation per
se.
full efFcct
power
will
effects
is
a general reputation. Firms engaged in a
of reputation potentially includes things that arc not necessarily
may
effect of
reputation on the actual sharing of the overrun
include a bargaining power effect because the determinants
tend to be correlated with the determinants of reputation
evidence on the choice of the
and other
effect as
As pointed out above, the
conditional on any particular initial contract,
of bargaining
same
initial
less likely to
like age.
In this sense, the
contract tends to be "cleaner". This kind of conflation of reputation effects
be the case when we arc comparing internal and external contracts.
28
repeated relationship with their client are about as likely as other firms to have fixed contracts,
but they pay significantly
among
Finally,
firms
less of
the overruns
who have
(20%
internal contracts, firms
they deal with external clients than
when they
external contracts are fixed-price contracts (a
contracts
among
They pay
a
In
pay
for
more
of the overrun
when
deal with internal clients. Almost half of their
number
close to the proportion of fixed-price
of the internal contracts are fLxed-price contracts.
smaller share of the overrun (20% instead of 47%) in internal contracts than
in external contracts.
but this
23%
old firms), whereas only
much
less).
The
diff'ercnee conditional
on doing fixed-price projects
is
not significant,
probably due to the small number of fixed-price contracts among internal projects.
is
summary,
it
seems that young firms, firms working with a new
client
and firms working
with an external client bear a larger share of the overrun compared respectively to older firms,
and firms working
firms engaged in a repeated relationship
pany.
Wc
low, but the
if
an
OSDC
or their
interpret these results as showing that reputation does influence the
are shared between the client
projects,
for
first
and the
firm.
We
will
way the
is
that these firms do different tj'pcs of
different types of incentives or entail different types of risk. For
old firms do mostly project
to do the project unless they
where there
know they
is
a possibility of very large overruns, they
be covered
will
o\'crruns
address some alternative explanations be-
possible caveat to this interpretation
which require
mother com-
in case this happens."*^
Table 4 shows that young firms, non ISO-certified firms, and firms working
example
may
refuse
In particular,
for external clients
do on average smaller and simpler projects than old firms, ISO firms and firms working
internal clients. It
is
is
for
therefore important to check that the simple contrast between the groups
not an artifact of the different composition of their contracts.
In Table
6,
wc show the
project-size cells (panel B)
differences
between the overrun paid
and complexity
uncontroUed difference of Table
5.
cells
In panel C,
(panel D)."*^
we show
The
for
first
a crude
way
of projects
to take into account the
and that the
two
in
panel reproduces the
the "controlled contrast": this
a weighted average of the differences between the young and old firms
where the weights are given by the fraction of projects
by each type of firm
is
simply
in the project size cells,
falling into this project size cell.
This
is
facts that different tjqjcs of firms choose different type
differences across
young and old firms are not necessarily the same
"'Wc will comment more on the choice of project per se below.
''We used the subjective complexity measure given by the firms.
29
for
project sizes.
all
Firms tend to bear
simple projects. There
of the o-\'crrun paid for
for
less of
is
the overrun
also a
by the
when they do complicated
weak relationship between the
firm.
Young
old firms
is
slightly smaller
when they do
size of the project
and the share
firms pay a larger share of the overrun than old firms
small and large projects, but not for medium-sized projects.
young and
jnojccts than
The
controlled contrast Ijctwcen
than the simple difference, but
high.
still
The
controlled
contrast becomes positive, though insignificant, for ISO-certified firms, mainly because the ISO-
doing small projects do not pay any of the
certified firms
does not affect the difTerence between repeated and
size
Whatever the complexity
external contracts.
than old firms, firms working with a new
repeated
ISO
and firms
client,
certification
tiear less
new
of the project,
client
Controlling for project
overrun.'^*'
clients
and between internal and
young firms bear more overrun
bear more overrun than firms working with a
overrun when they do internal projects. The evidence for
once again, mixed.
is,
In summar}', even after taking into account the size of the projects, firms with low reputation
bear more of the overrun than other firms (although the evidence in favor of ISO certification
remains
A
less
than overwhelming).
evidence
final piece of
is
presented in Tabic
different kinds of reputation arc substitutes.
still
bear more of the overrun
we present the
(line 1)
and
difference
in the
certified firms,
if
Young
some
The
'"'This
Mc
A
whether young firms
benefit from another kind of reputation. In the tabic,
in the proportion of fixed-price contracts
new
who do some
Non
non ISO-certified old
but among ISO-certified firms, there
client,
more
but not
if
internal contracts, the
firms,
likely
when they work with an
ISO-certified
young firms bear 27%
they have already worked with this
same contrast appears: young
ISO
client.
firms are
external client and pay for
internal client or an
caution, as very few
is
no
firms
OSDC^^
do small
In panel B,
Among
more Hkely
more of the
we perform
projects.
Millan and Woodruff (1999) report comparable evidence in transition economies.
30
jobs
than old firms to have fixed-price contracts
when they work with an
number should be taken with
Johnson,
in panel
contrasts arc interesting.
to have fixed-price contracts
overrun, but not
we examine whether the
clients, internal/external contracts (for firms
firms are significantly
they work with a
firms that do
Namely, wc ask
between young and old firms
repeated/new
of the overrun than
difference.
In this table,
share of overrun they pay (line 2) within groups of ISO-certified/non ISO-
for internal firms).
more
when they
7.
Sellers arc
the
same
exercise,
but we look at how the difference between the share of the overrun paid
for
by firms working with a new rather than repeated cHent varies across different kind of firms.
Interestingly, a very different pattern emerges. Tlic difference
persists for old firms
and
for ISO-certified firms,
mechanism of reputation formation
some
for
W'^c
time,
much remains
between new and repeated
and docs not
decline.
It
clients
suggests that the
rather inefficient: even after a firm has been in the market
is
to be learned
about
it.
have documented systematic differences in the way cost overruns are shared across young
and old
with repeated and new
firms, contracts
and firms
reputation
in internal
is
clients, ISO-certified firms
and external contracts. This evidence
is
and other
consistent with a
firms,
model where
an important determinant of the contracts and the sharing of the overrun. In the
next subsection, we examine the whether the other empirical predictions of the model also hold.
Further Results
5.3
Choice of Project
5.3.1
A
simple extension to our model also predicts that the firms with a low reputation will tend
to choose simpler projects
where the objectives are
We
the overrun generated by the client.
Table
4,
and Figures
5,
6
and
7.
Young
easier to define,
which
will
tend to limit
present evidence relating to the choice of project in
firms do smaller projects (Figure 6), which have smaller
overrun (even expressed in proportion of predicted costs). ^" They also tend to carry more often
"simple" projects (Y2K,
arc easily defined,
CAD,
and are
data manipulation) (Figure
We
easier to monitor.
7),
which generate lower overruns,
have also asked them to subjectively rate
the complexity of the project, and even according to this subjective measure, young firms do
more simple projects (Figure
project (cost multiplied by
This could be at
5).
As a
markup)
is
result of these
two combined
facts,
the returns from each
smaller on average for young firms than old firms.
least partly explained
by the
fact that
young firms arc on average
less
com-
petent (and that therefore clients do not want to entrust them with large or complex projects).
more
willing to extend trade credit to a
or business network than
if
now customer
if
they have obtained information about him from a social
they have not, but the weight given to this information declines as the length of the
relationship with this buyer increases.
'
Moreover, by doing that they keep the share of overrun accounted for by each project more or
across
young and old
firms: this could therefore
be explained by adding
31
risk aversion to the
model.
less similar
However the same contrast holds between
and
size
Y2K
projects. Since
internal work, the difference
this bias.
we have
internal
and external projects (Tabic
restricted the
4), for
comparison to firms that do at
between internal projects and external projects
This confirms that part of this difference between young and old
is
project
least
some
not tainted
is
Ijy
due to difference
in behavior.
Overrun generated by the firm and by the cHent
5.3.2
Our
Ijaseline
model predicts
that,
on average, firms with a
Ijetter
reputation will generate
o\-crrun (and therefore, total overrun will also tend to be smaller for their project).
less
However,
once wc take into account non-random matching and the choice of projects, the prediction about
the relationship between overrun generated by the firm and reputation arc not unambiguous.
On
the other hand, these extensions predict that clients matched with firms with low reputation
should generate
less
overrun.
Table 8 presents evidence on overruns generated
Ijy
the firm and the client. ^^
There
is
systematic relationship between total overrun and the reputation of the firm: total overrun
smaller for \'oung firms, firms without
firms dealing with a
new
generated by the firm
but larger
is
client.
argument that
less
is
certification,
of these contrasts
slightly larger for
for ISO-certified firms
generated by the client
None
ISO
and external
is
all
it
is
close to being significant.
client. ^^
cases for less reputed firms, wliich
is
is
larger for
Overrun
young firms and firms dealing with a new
and firms dealing with an internal
smaller in
projects;
no
client,
Finally, overrun
consistent with our
reputed firms try to protect themselves from absorbing large overruns by
dealing with reliable clients or by choosing projects where the scope for client generated overrun
is
smaller.
The data seems
consistent with our
model of how reputation determines contractual out-
comes. In the next section, we examine the most obvious alternative explanation to the observed
pattern.
Overrun generated by the firm and overrun generated by the
among
do not necessarily add up to total overrun:
sources of overruns proposed to the firms, there was an 'other' category, which
''"These results could be consistent with the idea that overrun
First, there
as
client
is
in
general no compelling evidence that
wc have noticed
ISO
is
slightly lower
when
we
left
unattributcd.
firms have a
good reputation.
certification really gives a firm a reputation. Second,
already, overruns are less costly for internal projects, so they tend to be larger.
32
Alternative Interpretations of the Data
6
This section reviews alternative explanations to the pattern
young firms bear a
to the
main
6.1
Pure Risk Sharing
One
possible interpretation of
result that
as explained in
much
what
going on in this industry
is
showed
// the
(in particular
is
pure
risk sharing.
However,
greater detail in a previous version of this paper, this interpretation very
where there
is
we assume
CRRA
preferences (which
is
standard
we
substantial variation in the size of the contracting parties)
in the previous version of this
Claim 7
data
larger share of the overrun than old firms).
quickly runs into trouble. In the case where
in cases like this
ol:)Scrvcd in the
paper that
firm and the client have
CRRA
preferences, for a fixed project size, the share of
the risk that they each bear will be approximately in the inverse proportion of their coefficients of
relative risk- aversion, keeping fixed the ratio of their total revenues. It will also be
approximately
in the direct proportion of their total revenues, keeping fixed the ratio of their risk- aversions.
Given that the
this proposition
risk averse
is
client's
revenues are
much
bigger than that of the firm,^'' an implication of
that the client should bear most of the risk unless the client
than the firm. In
fact,
is
much more
the firm bears on average more than half of the cost overrun,
suggesting that the client's coefficient of risk-aversion must be very large relative to the firm's.
is
however
difficult to
It
think of a basis for such differences in risk aversion. Moreover, this result
has systematic predictions about the relationship between firm size and the share of the risk
that
it
bears, controlling for client size
paid by the firm by client
size,
in
size.
Tabic 9 presents the share of overrun
project size and firm age. In
firms bear less of the overrun than
shown
and project
young
firms.
Figure 4 and in columns 2 to 4 in Table
all
4:
old firm's turnover
is
26%
is
larger
are with
$ 10 million.
Among
old
Small
27%
is
million,
sized client,
median turnover of the software companies
only $1.2 million, and the largest firm had a turnover of $47 million. Only
above
by $3.7
medium
arc with small clients. Large clients are in general fortune 500 companies or equivalent.
firms with turnover below $10 million. In contrast, the
cells,
Since old firms are on average larger (this
''^Morc than half of the contracts in the sample arc with "large" clients,
19%
project size-client size
and
clients are
in the
sample
of the firms have a turnover
the firms engaged in contracts with small clients, the median firm has a turnover of
$0.5 million.
33
or inoic than
100%, than young firms),
imphcation of the risk-sharing
this contradicts the basic
model.
One
miglit also speculate that old
explains
why
and new firms generate
different risk profiles
and that
old firms bear less risk: perhaps old firms simply generate less risk. However, the
evidence on the standard deviation of total overrun presented in Table 8 shows that this
the ease.
firms.
more
The standard
There
is
is
deviations of total project overrun are very similar across
therefore no evidence to support the view that
Another
risky to deal with.
of o\'errun
this
different for
are not different),
possibility,
and that the particular form of the
We
young and old firms (Figure
examined the
8).
The two
not
types of
young firms are systematically
however, would be that the underlying distribution
young and old firms (despite the
risk sharing rule optimal.
all
is
fact that
risk faced
mean and standard
by old firms made
de\'iation
this particular
entire distribution of overrun generated for
both
distributions arc very similar, except for four old firms
which generated very large overrun (150% and higher). These four old firms are however not
driving the results, since
all
of
them paid 100% of the overrun. Moreover,
above, the difference between old and young firms
type (complexity or
The evidence we
of course,
many
size),
is
maintained when we control
which arc presumably good indicators of project-specific
give above strictly only applies to the case of
classes of risk preferences
which do not
fall
on the one
very hard to explain
falls
slower than a
CRRA
why
the firm bears any risk at
(so that the preferences
that project size and client size effects also
all.
risk.
There
arc,
into this category. However, there
work particularly
than a
side, if the coefficient of absolute risk aversion falls faster
it is
for project
CRRA preferences.
are two basic intuitions which suggest that these other preferences will not
well either:
we have shown
as
On
approach the
become smaller and
the other side,
CARA
model),
CRRA,
if
the coefficient
it
can be shown
this leaves very little to explain
the inter-firm differences.^'*
6.2
Vcirying Levels of
Competence
Our model has assumed that both
that firms and clients
contracted upon.
''
clients
and firms arc
make mistakes which
In this case, one possible
In the extreme case of
CARA
risk-neutral.
Suppose we now assume
lead to overrun but that these mistakes can be
first
best contract
is
one
in
which firms take the
preferences neither project size nor chent size affects risk-sharing.
34
responsibility of
full
competent, then
The
it is
to be expected that they
point against this explanation
first
assumption.
If
the firm against
the firm was at
all
if
young
firms^'' arc
would pay on average
is
for
more
simply that risk-neutrality
risk-averse then the optimal contract
sources of risk that are beyond
all
Now
any mistake that they make.^^
its
on average
less
of the overrun.
is
a very extreme
would try
control. Therefore, since
to insure
young firms do
not choose to be incompetent, they should be insured against overrun that results from their
mistakes.
Of
to bear risk, but as
than the
this
may
course, the extent of such insurance
firm,
and
we have already argued, the
in particular small firms
client
well be limited by the client's willingness
is
in a
much
better position to Ijear risk
should only bear a small part of the
assumes that the mistakes are not made deliberately. The case of varying
hazard
will
tantly), firms
in
pay much more of the overrun than the share
Table
average
51%
entirely
by
of
3,
it.
even when the
client
is
difi'crcnccs in the share of
is, if
tliis
for
view:
levels of
moral
overrun that
is
caused by the firm,
more overrun than old firms
The
in
Table
to old firms
8.
is
The
difference
it
is
would have to be the
between the share of
clearly not large
more
enough
Differences in sources of the
between the fraction of overrun due to young firms
only 1.18%, but they pay
20% more
of the overruns. Finally, even
within firms that do some internal work (and are therefore more homogeneous),
that firms bear
pay on
do. Recall that the total
difference
to explain the difference in the sharing of these additional costs.
and that due
(and most impor-
fully responsible for the overrun, the firms still
anything, larger for old firms than young firms.
overrun are shown
first
which they are responsible: as
overrun due to young firms and the share of overrun due to old firms
it
course,
Second, to explain the differences in the share of overrun paid by the firms
case that young firms cause substantially
overrun
Of
be examined below.
There are also some simple empirical arguments against
shown
risk.
it
is
the case
of the overrun in external contracts than in internal contracts. Therefore
does not seem to be the case that the differences in the share of the overrun borne by young
firms can be explained by systematic differences in competence between
''
'
young and old
Of course the actual contracts do not say anything about dividing the overrun. Therefore what we arc
to here
''''Or
is
a fully efficient implicit contract.
more
generally, firms that
wc have
called so far "low reputation" firms.
35
firms.
referring
Underbidding by Young Firms
6.2.1
One
could imagine that even in a world where contracts are efTectively complete, young firms
might systematically underbid (quote a price based on intentionally low estimates) to win the
Of course the
project.
them responsible
end up paying
knows
this,
and
in the
we
optimal contract corrects
the extra overrun resulting from the underbidding.^^
for a higher share of the overrun.
objections that
6.2.2
for
client
list
However
it
for
Young
it
by holding
firms therefore
should be easy to see that the same
above to the competence-based explanation also apply
in this case.
Varying Level of Moral Hazard
The arguments
against the two previous alternatives are based on the assumption that the
mistakes (or prediction errors) are deliberate. Once we allow for such moral hazard, the client
may
Old firms could be
well not be willing to insure the firm.
young
firms,
and therefore bear
less risk
than young firms.
on mean and variance of the overrun cannot respond to
endogenous: young firms could be generating the same
less
prone to moral hazard than
The evidence we have presented
this kind of criticism, since they arc
level of
overruns as old firms, precisely
because they face higher punishments. Note however that this would be
view only
if
the levels of moral hazard were
about the type of the firm or the
reputation model). Moreover,
difference that a firm
to change very
is
client
it is
- if
common knowledge
there was learning,
the
if
first
client.
The
would just be a variant of our
level of
and the second contracts
that firms arc treated differently the second time around
our
there was no learning
not clear why, in this alternative scenario,
working with a repeated
much between
it
(i.e.,
a real alternative to
for
it
should
moral hazard
a specific
make any
is
client.
unlikely
The
fact
must therefore indicate that there
is
learning going on about the characteristics of the firm.
6.2.3
The
in
Dynamic Moral Hazsird
fact that repeat contracts are different
from
first
time contracts could perhaps be explained
terms of the evolution of a dynamic incentive contract, in the absence of any learning. However
this
would not explain the contrast between the first-time contracts faced by young and old
Moreover
"Again
it
\vc
is
not easy to see why, in this view, the age effect would be smaller
arc referring here to a fully efficient implicit contract.
36
when
firms.
it is
a
repeated contract.
6.2.4
Young
Varying Levels of Honesty
They
firms could also differ from old firms in their propensity to report costs honestly.
could be more prone to try to report inflated costs, or to pretend that changes due to their
incompetence are due to the
client
apart, then the analysis of such a
changing his mind.
If
model would be similar
the client could not
to the analysis of the
and lead to the same conclusion (the reputation of old firms would be
instead of a reputation for reliability).
model
a reputation for reliability,
different reason for the
Note however that
but
As wc mentioned
it is
earlier,
tell
own
the cheaters
model we propose,
a reputation for honesty
our modeling choice was to
clear that the analysis could be carried out with a
importance of reputation.
if
and honest
clients could tell apart cheaters
firms,
and punish cheaters
by imposing them to pay more of the overrun, then we would also observe that young firms
would pay on average more of the overrun (but
this
would not
result in
any social
cost, unlike in
our model or a version of the model with a reputation for honesty). Assuming that firms report
in the questionnaire
what they have reported
to the client, then the evidence that
pay more often than old firms overruns reportedly caused by the
fact that
they are lying more often than old firms.
Because
that firms are lying in what they report to us as well as in
is
client
this
young firms
would simply
argument
what they say
rests
reflect the
on the
fact
to their client,
it
not easily verified or invalidated in the data. Note however that this argument implies that
the clients never
self-defeating:
make any mistake
why would
in telling apart cheaters
firms cheat in the
found out? Moreover three facts are
first
place
if
difficult to reconcile
and honest
firms.
It is
therefore
they know that they are going to be
with this explanation: First, firms pay
on average 50% of the overrun when they report that the
client
is
fully responsible for
suggested explanation would therefore imply an implausibly high fraction of cheaters
it.
The
among
Indian software companies (young and old).
Moreover,
if
the client has perfect information and can enforce any sharing ex post, there
should be no variation in the contractual form, or at least
outcome.
it
should not be related to the
final
However, firms pay more of the overrun when they have fixed-price contracts than
when they have time and material
contracts. Furthermore,
price contracts. Therefore the ex ante contracts
young firms have more often
fixed-
seem both to be relevant and to be used by the
37
clients,
which
is
not consistent with the world
Finally, note that such a
repeated and
new
we
just descriljed.
model would not explain the difTcrcnce between contracts with
and external contracts:
chents, or the difference between internal
has perfect information, then
not easy to explain
it is
why
if
the client
firms would behave differently
when
dealing with different types of clients.
Conclusion
7
We
set out in this
paper to look
We
mining contractual outcomes.
though given that the evidence
when deciding on
tion
for
is
contracts)
evidence that reputation plays an important role in deter-
indirect (we
a
this view,
do not actually observe people looking
at reputa-
and there are important firm characteristics that arc potentially
correlated with our measures of reputation,
The conclusion
seems to strongly support
find that the evidence
that reputation matters
some doubts
is
clearly remain.
of course important in
itself:
range of theories that arc based on limitations of contracting. Moreover,
explanation of
why
the Indian software industry
is
not
much
differently,
and the
why
is it
fact that this
is
an equilibrium
it
gives support to
might suggest an
larger (Indian software exports
were only worth 3.4% of the 1995 worldwide outsourcing business) given
advantage'^*'
it
its
obvious labor-cost
a very labor-intensive industry. Or, to state the same point
for
software professionals in India to get paid so
than their U.S. counterparts? Reputation at the firm
level is
much
less
one possible explanation: most
Indian firms are simply not trusted enough to be given important contracts. While our evidence
cannot directly substantiate this view, the fact that reputation
industry suggests that
it
also ought to
is
important within the Indian
be important when an American
client
is
deciding whether
to go to a firm in India or to one in the U.S.
To add support
is
to this view, our results also suggest that the process of reputation formation
rather inefficient. This
firm
is
is
reflected in the fact that after controlling for age,
dealing with a repeat buyer
words, repeat buyers clearly
still
makes a substantial
know much more about
whether or not a
difference to the contract. In other
the firm than the market does. In other
words, the fact that a firm performed well in the past vis a vis one firm takes time to become
'''The U.S.
of
imports a very large number of Indian software professionals
more than twice what they would earn
in India.
38
for
short-term assignments at a cost
public information. This
but
it
is
of course consistent with rational behavior on the part of the client
clearly hurts the firm.
The
policy implication of this view
rating systems
may
aggregate
that a credible system for rating firms modeled on credit
play an important role in the evolution of industries such as the software
industry where contracting
efficiently
is
all
that
is
is
inherently problematic, by
known about each
making
it
possible for the market to
firm.
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40
Figure
1
Proportion of fixed cost contracts
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1995
1996
1997
or before
Foundation date of the firm
Figure 2
Sfiare of overrun paid for bytliefirm
100
1988
1989
1990
1991
1992
1993
or before
Foundation date of the firm
1994
Figure
Mean
(percentage of
1988
1989
1990
1991
3:
overrun
of project
initial
1992
evaluation)
1993
1994
1995
1996
1997
1995
1996
1997
or before
Foundation date ot the firm
Figure 4
Average Firm Turnover
1988
1989
1990
1991
1992
in
1997/98 (Millions $US)
1993
or before
Foundation date of the tirm
1994
Figure
5:
Subjective complexity measure
1988
1989
1990
1993
1992
1991
1994
1995
1996
1997
1995
1996
1997
1995
1996
1997
or before
Foundation date
Figure
Size of
1988
1989
1990
tlie
6:
project (In
man-months)
1992
1993
Foundation date
1991
or before
1994
Figure?:
Proportion of "simple" project
(cad, y2k,
1988
or before
1989
1990
1991
web pages,
data manipulation)
1992
Foundation date
1993
1994
Figure
8:
Cumulative distribution of overrun
A:
J
Young
firms
50
B: Old firms
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Table 2
Share
of
overrun for paid by the firm as a function
Proportion paying
100%
A:
and 100
Proportion paying
%
(2)
(1)
PANEL
Proporlion paying
between
of initial contract
Average share of
the overrun
0%
paid for by the firm
(3)
(4)
ALL CONTRACTS
All contracts
39.29
17.85
42.86
47.4
(3.58)
n.i
11.12
77.78
contracts
34.29
25.71
40
Fixed cost contracts
54.12
18.82
27.06
Time and
material
contracts
Mixed
15.6
(4.92)
51.6
(7.69)
63.1
(4.83)
PANEL
B:
EXTERNAL CONTRACTS
All contracts
47.58
20.97
31.45
57.1
(4.06)
Time and
material
17.65
23.53
58.82
contracts
Mixed
contracts
28.2
(9.56)
40.62
25
34.38
50.9
(8.08)
Fixed cost contracts
56.76
18.92
24.32
65.8
(5.07)
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Table 9
Share of overrun paid
by the firm, by project and
client size
Youns
Old firms
firms
Size of project
Size of project
All clients
Small or medium
clients
Big
clients
All
<median
>mcdian
All
<median
>median
(1)
(2)
(3)
(4)
(5)
(6)
68.7
72.5
63.3
46.6
54.7
45.7
(5.15)
(8.17)
(9.82)
(6.25)
(8.34)
(6.60)
77.5
79.9
73.2
65.4
61.1
68.2
(7.93)
(10.0)
(13.7)
(7.5)
(12.7)
(9.5)
59.8
63.5
55.8
37.6
50.2
29.3
(13.9)
(6.56)
(11.2)
(7.72)
(9.49)
(13.5)
DEC
<^nop
Date Due
Lib-26-67
MIT LIBRARIES
3 9080 01917 5865
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