Relational Contracts and
Organizational Capabilities
R. Gibbons
R. Henderson
Working Paper
12-061
January 18, 2012
Copyright © 2012 by R. Gibbons and R. Henderson
Working papers are in draft form. This working paper is distributed for purposes of comment and
discussion only. It may not be reproduced without permission of the copyright holder. Copies of working
papers are available from the author.
RelationalContractsandOrganizationalCapabilities
R.GibbonsandR.Henderson
MITandHBS
ForOrganizationScience
Version:July18,2011
Abstract
Alargeliteratureidentifiesuniqueorganizationalcapabilitiesasapotentsourceof
competitiveadvantage,yetourknowledgeofwhycapabilitiesfailtodiffusemore
rapidly—particularlyinsituationsinwhichcompetitorsapparentlyhavestrong
incentivestoadoptthemandawelldevelopedunderstandingofhowtheywork—
remainsincomplete.Inthispaperwesuggestthatcompetitivelysignificant
capabilitiesoftenrestonmanagerialpracticesthatinturnrelyonrelational
contracts(i.e.,informalagreementssustainedbytheshadowofthefuture).We
arguethatoneofthereasonsthesepracticesmaybedifficulttocopyisthateffective
relationalcontractsmustsolvethetwinproblemsofcredibilityandclarity,andthat
whilecredibilitymightinprinciplebeinstantlyacquired,claritymaytaketimeto
developandmayinteractwithcredibilityincomplexways,sothatrelational
contractsmayoftenbedifficulttobuild.
Acknowledgements:Wewouldparticularlyliketothankourresearchassistants,
NancyBeaulieuandTommyWang,fortheiryearsofinvaluablesupportinour
researchprogram.WearealsogratefultoourcolleaguesNelsonRepenningand
JohnStermanandMITSloan’sProgramonInnovationinOrganizationsandMarkets
fortheirsustainedintellectualandfinancialsupport.Thanksforcommentsonthis
paperareduetotheeditorsofthisspecialissueandtoDavidGarvin,RanjayGulati,
MauroGuillen,SimSitkin,BirgerWernerfeltandSidWinter,andtoseminar
participantsatColumbiaGSB,HarvardBusinessSchool,KelloggGSM,London
BusinessSchool,LSE,SydneyandTilburg.
1)
RelationalContractsandOrganizationalCapabilities
R.GibbonsandR.Henderson
MITandHBS
ForOrganizationScience
Version:June15,2011
Introduction
Itisnowwidelyacceptedthattherecanbepersistentperformancedifferences
amongseeminglysimilarenterprises—betheyworkgroups,plants,orfirms(see
Syverson(2011)forarecentsurvey).Thestrategyliteraturehaslongexploredthe
possibilitythatsuchperformancedifferencesarisefromorganizationalcapabilities
(e.g.,Wernerfelt,1984;Teece,PisanoandShuen,1997;EisenhardtandMartin,
2000;AnandandKhanna,2000;AralandWeill,2007).Oneofthecentralquestions
raisedbythisresearchiswhysuchcapabilities—iftheyareindeedasourceof
sustainedcompetitiveadvantage—donotdiffusemorerapidly.
Theexistingliteraturehasproposedthreeanswerstothisquestion.First,
incumbentmanagersmayhaveproblemsofperception—theydonotknowtheyare
behindbecausetheircognitiveframesblindthemtonewopportunities(e.g.,
HendersonandClark,1990;Christensen,1997;TripsasandGavetti,2000).Second,
managersmayhaveproblemsofinspiration—theyknowthey’rebehind,butthey
don’tknowwhattodoaboutitbecausetheorganizationalpracticesunderlyingkey
organizationalcapabilitiesinvolveeithertacitknowledge(e.g.,Winter,1987,1988)
and/orcomplementarities(e.g.,Levinthal,1997;Rivkin,2000)andsoarehardto
learnandcommunicate.Third,managersmayhaveproblemsofmotivation—they
knowthey’rebehindandtheyknowwhattodo,buttheydon’tcarebecauselackof
competitioninthemarket(orlackofincentivesinsidethefirm)givesthem
insufficientincentivetoadoptnewpractices(e.g.,Reinganum,1989;BloomandVan
Reenen,2007;Bresnahan,GreensteinandHenderson,2011).
Whilepersuasiveinmanysettings,thesethreeanswerstotheproblemofslow
diffusionarelesshelpfulinatleastoneimportantcase:settingswheremanagers
acknowledgethattheyarebehindandarespendingheavilytocatchup,andwhere
thereappearstobeindustry‐wideagreementaboutbestpractice.Forexample,
therehavebeenmorethan300booksandthousandsofarticleswrittenabout
Toyota,yetuntilquiterecentlymanyautomobilecompaniesappearedtohavegreat
difficultyimitatingitspractices(PilandMacDuffie;1996).Similarlythepracticeof
science‐drivendrugdiscoverywassurprisinglyslowtodiffuseacrossthe
pharmaceuticalindustrydespitewidespreadagreementaboutitseffectiveness
(Cockburn,Henderson&Stern,2000).Inthisessay,wearguethatsuchfailuresof
diffusionmayarisefromdifficultiesinadministration—managersknowthey’re
1
behind,knowwhattodo,andaremotivatedtodoit,buttheycan’tgetthe
organizationtogetitdone.1
Ourargumentisintwoparts.First,wesuggestthatmanyorganizational
capabilitiesrestonmanagerialpracticesthatinturnrelyonrelationalcontracts—an
economist’stermforcollaborationsustainedbytheshadowofthefuture,as
opposedtoformalcontractsenforcedbycourts.Second,wesuggestthatmany
relationalcontractsarehardtobuildandtorefine,andthatthisisoftenwhy
managers“can’tgettheorganizationtogetitdone.”
Tounpackthefirstpartofourargument—thatkeymanagerialpractices
frequentlyrequirerelationalcontracts—weemphasizethatsuchpracticesinvolve
actionsthatcannotbefullyspecifiedinadvance.Considerthefollowingthree
exampleswedevelopbelow.First,LincolnElectric’senduringsuccessrestsinpart
onthepaymentofbonusesthatbothmanagersandemployeesconsidertobe“fair,”
butnomanualcandefineexactlywhatconstitutesafairbonusforaparticular
workerinaparticularyear.Second,beyondcompensation,theToyotaproduction
systemaskslineworkerstobecome“activeproblemsolvers,”butcannotdefinein
advanceexactlywhichproblemstheymightfindorhowtheyshouldbesolved.
Third,beyondmanufacturing,Merckasksitsresearcherstobehave“almostasif”
theywereacademics,butwhatthismeansintermsofactualbehaviorshadtobe
workedoutovermanyyearsandisstilldifficulttocommunicatetoday.
Becausethesemanagerialpractices—eachofwhichisfundamentaltothe
successofthesethreefirms—involveactionsthatcannotbespecifiedinadvance,it
istypicallyimpossibletomotivatetheirperformanceviaformalcontracts(i.e.,
contractsthatattachobjectiveweightstoobjectivemeasures).2Instead,ifitis
necessarytoprovidemotivationforpartiestotaketheseactions,itwillhavetobe
donethroughinformalagreementsthatinvolvesubjectiveweightsorsubjective
measures.Inthisessayweinterpretsuchinformalagreementsasrelational
contracts.3
Ofcourse,theideathatrelationalcontractsarewidespreadandimportanthas
alongpedigree,acrossmanydisciplinesandsettings:insociology,Macaulay(1963)
studiedinformalrelationshipsbetweenfirms;inanthropology,Geertz(1962,1978)
studiedrotatingcreditassociationsandbazaareconomies;andinpoliticalscience,
Ostrom(1990)studiedcommunitiesofresourceusers.Morerecently,inthe
1WethankJanRivkinforbringinghis“four‘tion”labelstoourattention(andallowingustoadapt
themforourownpurposeshere).
2Underspecialcircumstances,itmightbepossibletowriteformalcontractsbasedonoutcomes
ratherthanonactionsandtherebymotivatethedesiredactions.Muchmoreoften,however,
availableoutcomemeasuresarethemselvesincompleteandsoformalcontractsbasedonsuch
measuresinducegaminginsteadofconsummateperformance.SeeGibbons(2005)forareview.
3Wedonotmeantoimplythatthepresenceofrelationalcontractsimpliesthatthefirmwillnotalso
relyonformalcontracts.Indeedthetwoareoftencomplementary.
2
strategyliterature,manyauthorshavedrawnonrelatedideastoanalyzelong,
productiverelationshipsbetweenfirms(e.g.,Dyer,1997;DyerandSingh,1998;
PoppoandZenger,2002;GulatiandNickerson,2008).
Closertoourfocusonthedevelopmentofmanagerialpracticeswithinfirms,
thereisalsoalongtraditioninorganizationtheoryemphasizingtheimportanceof
informalunderstandingswithinorganizations.Forexample,BlauandScott(1962:
6)arguedthat“Itisimpossibletounderstandthenatureofaformalorganization
withoutinvestigatingthenetworksofinformalrelationsandtheunofficialnormsas
wellastheformalhierarchyofauthorityandtheofficialbodyofrules,sincethe
formallyinstitutedandtheinformalemergingpatternsareinextricably
intertwined.”Indeed,somehavearguedthathigh‐performingorganizationsrely
especiallyheavilyoninformalunderstandings,variouslydescribedasnormsor
culturesorcontracts.Forexample,Barney(1986)suggestedthatanorganization’s
culturecouldbeasourceofcompetitiveadvantage,Rousseau(1989,1995)studied
psychologicalcontractsinorganizations,explicitlyenvisioningmanagersasparties
tosomeofthem,andalongtraditioninthehuman‐resourcesliteraturehas
documentedtheperformanceadvantagesofhigh‐commitmentworkpracticesand
thesocialcontractsthatsustainthem(e.g.,Hoffer‐Gittell,2002;Lincolnand
Kalleberg,1990;Kochanet.al.,1995).
Toourknowledge,however,thisliteraturehasnotexplicitlylinkedtheseideas
totheideathattheseinformalunderstandingsmaybeoneofthereasonsthat
competitivelyimportantpracticesaresometimessurprisinglyslowtodiffuse.Much
ofthecapabilitiesliterature,forexample,haseithermadetheimplicitassumption
thatincentiveswithintheorganizationarealigned,sothattheadoptionofnew
practicesisprimarilyaproblemofinformationtransmission,orhaslabeled
“appropriateincentives”asadistinct,separablecapability.Similarly,whilemany
writershavesuggestedthat“trust”mightbeanimportantsourceoforganizational
performance(seeforexample,BachmannandZaheer,2006andZaheerand
Venkatraman,1995),thisliteratureislargelysilentabouthowtrustisbuiltandso,
asfarasweknow,hasnotstudiedhowdifficultiesinbuildingtrustmightbeakey
sourceofcompetitiveadvantage.
Hereweexplorethisconnectionexplicitly.Wearguethatmanyrelational
contractsarehardtobuildandrefineandthisisoftenwhymanagers“can’tgetthe
organizationtogetitdone.”Inparticular,wearguethatbuildingandrefining
relationalcontractsrequiressolvingtwodistinctproblems:theproblemof
credibilityandtheproblemofclarity.Webelievethateachoftheseproblemscanbe
quitedifficultinisolationandthatincombinationtheymaycreateasubstantial
barriertoimitation.
Bytheproblemofcredibilitywemeantheproblemofpersuadingothersthat
oneislikelytokeepone’spromises.Whilecredibilitymayderivefromvarious
sources,includingwhattheliteraturehascalled“personal”or“institutional”trust
(e.g.,ZaheerandVenkatramen,1995;Nooteboom,1996),inthisessaywefocus
3
insteadonastrictlyconsequentialistlogic,whereonekeepsone’spromisesbecause
thingswillgobadlyotherwise.Somehavecalledthislogic“calculativetrust”(e.g.,
Williamson,1993;BarneyandHansen,1994;Nooteboom,1996),andRousseauet.
al.(1998)callit“deterrence‐basedtrust.”Likemanyofthoseauthors,however,we
seetheconsequentialistlogicasdistinctanddifferentfromtrust;,likeYamagishi
andYamagishi(1994),wewouldpreferthislogictobelabeled“assurance”rather
thantrust.4
Bytheproblemofclaritywemeantheproblemofcommunicatingthetermsof
therelationalcontract.Theproblemofclarityislessdiscussedandperhapsless
evidentthantheproblemofcredibility,butwebelievethatclarityisatleastas
importantaconstraintonbuildingandrefiningrelationalcontracts.Inbrief,instead
ofaskingwhetherotherswillbelieveone’spromises,wenowaskwhetherothers
willunderstandone’spromises.
Arichliteraturehassuggestedthatonereasonwhymanagerialpracticesmay
beslowtodiffuseisthatknowledgeofsuchpracticesmaybetacitor“embedded”
andhencedifficulttocommunicate(see,forexample,Winter’sworkcitedwiththe
inspirationproblemabove).Buildingonthisliterature,wearguethatdevelopinga
sharedunderstandingofarelationalcontractwillbeevenmoredifficultbecause
thereismoretocommunicate.Wesuggestthatbuildingarelationalcontract
requiresdevelopingasharedunderstandingofnotonlythenecessarytask
knowledge(whateachpartyissupposedtodo)butalsothenecessaryrelational
knowledge(whateachpartycoulddo,eithertobreakapromiseortopunish
someonewhodid,andwhatthepayoffsfromallthesepossibleactionsare).
Inadditiontothedifficultiesthattheseproblemsofcredibilityandclarity
takenseparatelyposeforbuildingandrefiningrelationalcontracts,wehypothesize
thatthebiggestdifficultiesmayarisefromtheinteractionoftheseproblems.For
example,ifonepartyactsinawaythatisunexpectedbytheother,is
miscommunicationtoblame,orgaming?Moregenerally,theimperfectalignmentof
interestsunderlyingthecredibilityproblemcreatessignificantnewimpedimentsto
thecommunicationnecessitatedbytheclarityproblem.5
Theoutlineoftheessayisasfollows.Tolayafoundation,webegininSection2
withabriefoverviewofrelationalcontracts.Inparticular,weprovidesomebasic
modelsofwhencollaborationcanbesustainedbytheshadowofthefuture,andwe
suggestthatthesemodelsarebroadlyconsistentwithevidencedrawnfrombothlab
experimentsandfielddata.
4Infocusinghereonthequestionofcalculativetrustwedonotmeantoimplythatotherformsof
trustareunimportant.Indeedoneofourhopesforthispaperisthatitmightcontributetothe
ongoingdiscussionoftherelationshipamongdifferentformsoftrustandtheirevolutionovertime.
5SeeSpence’s(1973)signalingmodelandCrawfordandSobel’s(1982)cheap‐talkmodelforan
introduction.
4
InSection3,wedevelopourhypothesisthatcompetitivelysignificant
managementpracticesoftenrelyonrelationalcontractsbyexaminingthreefamiliar
examples:subjectivebonusesatLincolnElectric,theproductionsystematToyota,
andscience‐drivendrugdiscoveryatMerck.Ourgoalhereistwofold.First,wehope
tomakecrediblethehypothesisthatsomecompetitivelyimportantmanagerial
practicesarecruciallydependentonrelationalcontracts.Whilethisideamaybe
familiarregardingsubjectivebonuses,itseemslessappreciatedregardingother
managerialpractices.Second,webegintouseourdescriptionsofthesepracticesto
illustratetheproblemofclarity—i.e.,theextensiveamountofinformationthatboth
employeesandmanagersmustholdincommonifthenecessaryrelationalcontracts
aretobeself‐enforcing.
InSection4weexpandonthequestionofclarity.Webeginbydistinguishing
between“taskknowledge”and“relationalknowledge”,suggestingthatmanyofthe
samemechanismsthatmakeitdifficulttolearnhowtodonewtasksalsomakeit
difficulttolearnabouttherelationalcontractsthatmightsupportthem.We
illustratethisideathroughaccountsofmomentsatLincolnElectricandCredit
Swissewhererelationalcontractsthreatenedtobreakdown,anddiscussanumber
ofexperimentsandmodelsthatmayprovidebuildingblockstowardsatheoryof
whyrelationalcontractsmaybehardtobuild.Finally,Section5concludes. 2) APrimeronRelationalContracts:TheoryandEvidence
Inthissectionweprovideabriefintroductiontoeconomictheoryand
evidenceonrelationalcontracts.Thetheory,inSection2.1,beginswiththesimplest
caseandthensketchesseveralenrichments.Theevidence,inSection2.2,includes
bothlabandfielddata.
2.1 Theory:CredibilityfromIncentiveCompatibility
Thereisnowalargetheoreticalliteratureonhowrelationalcontractscan
facilitateefficientbehaviors,bothontheirown(e.g.,Bull(1987),MacLeodand
Malcomson(1989),Levin(2003),Fuchs(2007),andHalac(2011))andin
combinationwithformalaspectsoforganizationsandcontracts(e.g.,Baker,
Gibbons,andMurphy(1994,1999,2002,2011));seeMalcomson(2012)fora
survey.AsdescribedintheIntroduction,theessentialintuitionisstraightforward
andfamiliar:insomesettings,onekeepsone’spromisesbecausethingswillgo
badlyotherwise.
Kreps(1990)capturesthisintuitionusingthesimplegameshowninFigure1.
AlthoughKrepscallsthisthe“TrustGame,”weemphasizethattherelational‐
contractsargumentisentirelyconsequentialist.Therefore,wewouldprefer
“assurance”to“trust.”Inshort,whenspeakingoftrust,weadoptMarchandOlsen’s
(1989)viewthat“[t]hecoreideaoftrustisthatitisnotbasedonanexpectationof
itsjustification.Whentrustisjustifiedbyexpectationsofpositivereciprocal
5
consequences,itissimplyanotherversionofeconomicexchange”(p.27,emphasis
added).Inthisessay,weareindeedconsidering“anotherversionofeconomic
exchange.”
Figure1:TheTrustGame
Inaone‐shotversionofthisgame,player1’sinitialchoiceamountstoeither
endingtherelationship(andsoreceivingapayoffofzero)ortrustingplayer2(and
soreceivingapayoffof‐1,assumingthatplayer2wouldmaximize2’spayoffandso
betray1’strust).Sincezeroexceeds‐1,player1shouldendtherelationship.Ifthe
players’relationshipisongoing,however,verydifferentoutcomesarepossible.
Aclassicformulationistomodelarelationshipbetweenplayer1andplayer2
asarepeatedgamethatisequallylikelytoendafteranyperiod.Theprobabilitythat
thegamewillendinfluencestheinterestraterperperiodthattheplayersusein
discountingtheirpayoffsacrossperiods.Iftheplayersarepatientenough(i.e.,ris
sufficientlysmall,inpartbecausetheprobabilitythatthegamewillendis
sufficientlysmall)thenthefollowing“trigger”strategiesareanequilibriumofthe
repeatedgame.
Player1:Inthefirstperiod,playTrust.Thereafter,ifallmovesinallprevious
periodshavebeenTrustandHonor,playTrust;otherwise,playNot
Trust.
Player2:Ifgiventhemovethisperiod,playHonorifallmovesinallprevious
periodshavebeenTrustandHonor;otherwise,playBetray.
Thebroadermessagefromthisexampleisthatcooperationmaybeproneto
defection,butinsomecircumstancesdefectioncanbemetwithenoughpunishment
tomotivatecooperation.Tobegintogeneralizetheexample,imaginethatplayer2’s
payoffs(perperiod)areCfromcooperation(generalizingthepayoff1above),D
6
fromdefection(generalizingthepayoff2above),andPfrompunishment
(generalizingthepayoff0above),whereD>C>P.Thedecisionofwhetherto
cooperateordefectthenamountstocomparingtwotime‐pathsofpayoffs:(C,C,C,
...)versus(D,P,P,P,...),asshowninFigure2.
Figure2:PayoffsfromCooperationVersusDefectionandPunishment
Thetime‐pathofcooperationyieldsahigherpresentvaluethanthetime‐pathof
defectionif
(1)
 1 
1
1 C  D  P ,
 r 
r
where1/risthepresentvalueofadollartobereceivedeveryperiod(untilthe
gameends)startingnextperiod.Rearranging(1)yields
(2)
r
CP
,
DC
whichisoftenrestatedas:iftheplayersaresufficientlypatient(i.e.,ifrissufficiently
closetozero)thenitisoptimaltocooperate,foregoingtheshort‐runtemptation(D
–Cnow)forthelong‐termgain(C‐Pthereafter).
Thisstylizedmodelnotonlyillustratesthemainideabehindrelational
contractsbutalsosuggestssomelimitationsoftheapproach(atleastasithasbeen
developedandappliedtodate).Oneseeminglimitationmightbethatwehavecast
theplayers–and,morebroadly,thepartiestoanycontractofthistypeasbeing
motivatedby“payoffs,”whichmayseemtoonarrow.Butwetakeabroadviewof
suchpayoffs.Inparticular,wedonotmeantosuggestthatmoneyisthemost
important—orevennecessarilyanimportant—sourceofmotivationinsidefirms.In
Section3(wherewediscussrelationalcontractswithinorganizations),wetherefore
conceiveof“payoffs”asincludingeverythingthatmightaffectanindividual’s
experienceofhisorherjob,includingfactorssuchasjobassignment,degreeof
7
autonomy,statuswiththefirmorworkgroup,andotherintangiblessuchasfeelings
ofbelongingorthatoneismakingadifference.
Amoreseriouslimitationisthattheanalysisleadingto(1)considersonlythe
payoffsfromcooperation,defection,andpunishment,takingforgrantednotonly
thatthepartiesknowthesepayoffsbutalsothattheyknowwhatactionsconstitute
cooperation,defection,andpunishment(suchasTrust,Honor,andBetrayinFigure
1).AswewillseeinthedetaileddescriptionsofmanagerialpracticesinSection3,
takingitforgrantedthatthepartiesknowwhattheseactionsaremaybeaheroic
assumption,especiallywhenthepartiesarejustbeginningtheirrelationship.For
therestofthissection,however,wecontinuetomakethisassumption(thus
implicitlyfocusingonsteady‐staterelationships,wherethepartieshavesubstantial
sharedexperienceabouttheseactionsandtheirpayoffs).
Toconcludethissub‐section,wesketchsomesimpleenrichmentsofthebasic
theory,toprepareforthediscussionofevidenceinthenextsub‐section.First,and
informally,Figure1couldbeenrichedinvariousways,suchasbyallowingtwo
levelsofcooperation:fullandpartial.FullcooperationyieldspayoffCbuthas
defectiontemptationD,asabove,whereastheanalogousvaluesforpartial
cooperationarecandd,whereC>c>0andD>d>0.Givenplausibleassumptions
aboutthesepayoffs,partiesthatarepatientenoughcansustainfullcooperation,as
in(2),whereaspartiesthataresomewhatmoreimpatientcansustainonlypartial
cooperation(and,asalways,partiesthataretooimpatientcannotsustainany
cooperation).
Second,andshiftingattentionfromcross‐sectionalcomparisonsacross
relationshipstolongitudinalcomparisonswithinanongoingrelationship,imagine
thatthereisnotonlyaprobabilitythatthegamewillendafteranyperiod,butalso
anindependentprobabilityaftereachperiodthatthepayoffsinFigure2willchange
permanentlyfrom(C,D,P)to(C,D,P),whereD>D.(Aparallelargumentholdsif
thepayoffschangeto(C,D,P),whereP>P.)Ifthepartiesareimpatientenough
that
(3)
CP
 r ,
D' C
thencooperationwillendoncethepayoffschange.Nonetheless,ifthepartiesare
nottooimpatient(i.e.,risbelowanupperboundnotshownin(3)),thenitisan
equilibriumforthepartiestobeginthegamebycooperating,planningtocooperate
untileitherthepayoffschangeorthegameends.
Third,thepayoffsmightneitherbeconstantnorchangepermanently(asinthe
firstenrichment),butinsteadfluctuaterandomlyacrossperiods.Thatis,suppose
thatthepayoffsareindependentlyandidenticallydistributedovertimeandthatthe
partiesobservethecurrentpayoffsbeforetakingactionseachperiod.Inperiodt,
8
thecurrentpayoffsfromcooperationanddefectionareCtandDt,andtheexpected
futurepayoffsfromcooperationandpunishmentareE(Ct)andE(Pt),so(1)becomes
(4)
1
1
Ct  E(Ct )  Dt  E(Pt ) .
r
r
Inthissetting,ifthelong‐termgainofE(Ct)‐E(Pt)ineachfutureperiodoutweighs
allpossiblerealizationsoftheshort‐runtemptationDt‐Ct,then(4)impliesthe
criticalvalueofrbelowwhichthepartiescansustainpermanentcooperation
despitefluctuatingpayoffs.Alternatively,ifthereareextremerealizationsofthe
short‐runtemptationthatviolate(4)thencooperationwillendoncetheshort‐run
temptationhitsahighenoughvalue,butifthepartiesarenottooimpatientthenitis
anequilibriumtobeginbycooperating,planningtocooperateuntileitheran
extremetemptationarrivesorthegameends.
Finally,inthemostsophisticatedoftheseenrichments,wherethepartiesmust
repeatedlyadjusttheircollaborationoverthecourseoftheirrelationship,suppose
thattherearetwolevelsofcooperation(fullandpartial,withpayoffsC>candD>
d,asabove)andthatthepayofffromdefectingonfullcooperationfluctuates
randomlyacrossperiods(e.g.,Dtcanbeeitherhighorlow,DH>DL).Iftheparties
areimpatientenoughthat
(5)
CP
 r ,
DH  C
thenthepartiescannotsustainfullcooperationinperiodswhenthedefectionpayoff
ishigh.Ontheotherhand,ifthepartiesarenottooimpatient,thenitisan
equilibriumforthepartiestoachievefullcooperationinperiodswhenthedefection
payoffislowandpartialcooperationwhenitishigh.Strikingly,thereisevidencefor
thissophisticatedbehavior(aswellastheothersdescribedhere),aswediscuss
next.
2.2 EvidencefromtheLabandfromRelationshipsBetweenFirms
Wenowbrieflyintroduceevidencethatmodelslikethesecaptureimportant
aspectsofbehavior.Webeginwiththebasicmodel,summarizedbyequations(1)
and(2),afterwhichweturntotheenrichments,summarizedbyequations(3)
through(5).Inthissection,werestrictourattentiontolabexperimentsandtofield
dataonrelationshipsbetweenfirms,savingdiscussionofrelationshipswithinfirms
forSection3.Alltheevidencewedescribeisonlyillustrative;manyfurther
examplescouldalsobegiven.
9
Condition(1)predictsthatcooperationislesslikelyasthereturnstodefection
rise(i.e.,asDorPincreases).6Asevidenceinthisspirit,considerthefieldstudyby
McMillanandWoodruff(1999)andthelabstudybyBrownandSerra‐Garcia
(2010).McMillanandWoodruffuseasampleoffirmsinVietnamduring1995‐97to
studytradecredit(i.e.,theextenttowhichabuyer’spaymentismadesignificantly
afterthesupplierdeliversthegoods).Theyfindthatsuppliersgrantbuyersmore
tradecreditiftherearefewersimilarsupplierswithin1kilometerandifthe
supplier’smaincompetitorislocatedmorethan1kilometeraway(i.e.,when
punishmentpayoffsarelowerforbuyers).Turningtolabevidence,Brownand
Serra‐Garciaconductanexperimentthatvariesaborrower’sabilitytoexpropriate
loanedfundsbyallowing(ornotallowing)theborrowertoreinvestfundsfollowing
default.Theyfindthatthevolumeoftradedecreasesandthatborrowersaremore
likelytodefault(ininitialperiods)whenexpropriationispossible(i.e.,when
defectionpayoffsarehigher).
Asdirectevidencefortheideathatcooperationismorelikelyinenvironments
withlowerdiscountrates,aspredictedby(2),considertheexperimentbyDalBo
(2005),whoconductsarepeatedPrisoners’Dilemmaandvariestheprobabilitythat
thegamewillbecontinued.DalBofindsthathigherprobabilitiesofcontinuation
(whichimplylowervaluesofr)leadtohigherratesofcooperation.Engle‐Warnick
andSlonim(2004)providearelatedexperimentalfinding.
Therearealsoindirectexamplesof(2),basedontheideathattheremaybe
morethantwopartiesavailableanddifferentpairingsofpartiesmayoccurover
time.Asableakbaselinecase,supposethattherearemanyparties,thatpairingsare
randomeachperiod,andthateachpartyknowsonlyitsownexperience(i.e.,there
isnoinformationaboutwhatotherpartiesdidwhileinotherpairings).Inthiscase,
itislikelytotakemanyperiodsbeforeagivenpairmeetseachotheragain,soris
highandcooperationisunlikely.Buttherearevariousalternativestothisbleak
baselinecase,eachofwhichcanbeinterpretedasreducingrandsomaking(2)
morelikelytohold,asfollows.
Inlabstudies,BrownandZehnder(2007)allowpartiestochoosetheir
partnerseachperiod,leadingtobothlong‐standingrelationshipsandimproved
cooperation,andDuffyandOchs(2009)findgreatercooperationinfixedpairsthan
inrandompairs.Usingfielddata,RobinsonandStuart(2007)studybiotechnology
alliances,findingthatalliancepartnerswithcloserproximitytoeachotherinthe
industrynetworkarelesslikelytouseequity(anduselessequitywhenitis
involvedinthedeal)andusemorefundingpledgedupfrontratherthanfunding
basedonmilestones.Similarresultsholdwheneitherofthefirmsismorecentralin
theoverallnetwork(asdistinctfrommoreproximatetoitspartner).Thesefindings
areconsistentwiththeideathatfirmsthataremoreproximate(andhencemore
6Forfixedparameters,either(1)holdsoritdoesnot,socooperationiseitherpossibleornot.Ifwe
imaginedatawith,say,heterogeneousvaluesofC,however,thenanincreaseinDorPcanbesaidto
reducethelikelihoodofcooperation,suchasinthesenseofaprobit.
10
likelytoencountereachother)ormorecentral(andhencemorelikelytohavetheir
actionsvisibletoothers)arelesslikelytodefect.
Turningfromcross‐sectionalevidencetolongitudinal,recalltheideathatan
increaseinthedefectiontemptationcaninducedefection,asdiscussedin
connectionwith(3)and(4).Inthisspirit,Guriev,Kolotilin,andSonin(forthcoming),
studynationalizationsofforeign‐ownedoilassetsin161countriesfrom1960‐2006.
Duringthisperiodtherewere98nationalizationsin42countries.Controllingfor
countryfixedeffects,theyfindthatnationalizationismorelikelywhenoilpricesare
high(i.e.,defectionpayoffsarehigh)andwhenpoliticalinstitutionsareweak(i.e.,
punishmentcostsarelow,sothepayoffduringpunishment,Pdiscussedwith(3),is
high).Theseindependentvariables—theoilpriceandpoliticalinstitutions—maybe
somewherebetweenthepermanentchangeenvisionedin(3)andthetemporary
fluctuationenvisionedin(4).
Finally,asevidenceonthesophisticatedbehaviorin(5),wheretheparties
repeatedlyadjusttheircollaborationoverthecourseoftheirrelationship,consider
RotembergandSaloner(1986),whostudyvariationsintheextentofcollusionover
thebusinesscycle.Intheirmodel,fullcollusion(whereallfirmschargethe
monopolyprice)producesmoderaterenegingtemptationsinlow‐demandperiods
buthigherrenegingtemptationsinhigh‐demandperiods,sothecolludingfirmscan
implementonlypartialcollusioninthehigh‐demandperiods,asdiscussedin
connectionwith(5).Empirically,RotembergandSalonerstudybothprice‐cost
marginsoverthebusinesscycleforavarietyofindustries,aswellasactualprice
warsinspecificindustries,andinbothcasesfindevidencebroadlyconsistentwith
theirtheory:marginsaresmallerinbooms(i.e.,cooperationisreducedatmoments
whendefectiontemptationsarehigher).
Toconcludethissection,werecaptheargumentwehavemadethusfar.First,
repeated‐gamemodelsofcollaborationpredictthatcooperationcanoccurif
defectioncanbemetwithsufficientpunishment(wherepunishmentoccursover
time,sotheprospectofpunishmenthasagreaterimpactonparties’current
decisionswhentheycaremoreaboutthefuture).Second,inbothlabstudiesand
fielddataonrelationshipsbetweenfirms,thereareempiricalfindingsthatare
consistentwithsuchmodels.Asnotedabove,however,boththemodelsandthe
evidencewehavedescribedfocusontheproblemofcredibility(i.e.,whetherone
actorshouldbelieveanother’spromises)andignoretheproblemofclarity(i.e.,
whetheroneactorcanunderstandanother’spromises).Theythusimplicitlyfocus
onsteady‐staterelationships,wherethepartieshavesubstantialsharedexperience
abouttheiractionsandpayoffs,andavoidtheproblemofhowthesesteady‐state
relationshipscomeabout.
Inthenextsection,weaddtwoaspectstoourargument.First,weconsider
relationalcontractswithinfirmsratherthanbetween.Inparticular,wedescribe
threeimportantmanagementpracticesthatweseeasrelyingcruciallyonrelational
contracts.Second,weprovidesufficientlydetaileddescriptionsoftheserelational
11
contractswithinfirmstosuggestthatitcannothavebeeneasytodevelopashared
understandingofexactlywhatthesecontractsentailed,thuslayingthegroundwork
foramoreextendeddiscussionoftheproblemofclarityinsection4.
3) ManagerialPracticesandRelationalContracts
Wenowdescribeimportantmanagerialpracticeswithinthreeleadingfirms:
subjectivebonusesatLincolnElectric,theproductionsystematToyota,andscience‐
drivendrugdiscoveryatMerck.Ineachofthesesettings,wefocusonkeyactions
thatwebelievecouldnotbemotivatedbyformalcontractsandthatwethus
hypothesizearethesubjectofrelationalcontracts.WetreatLincolnbriefly,because
itcorrespondsreasonablywelltothemodelinSection2.1,whereonepartyrelies
ontheothertokeepitspromises,butwediscussToyotaandespeciallyMerckin
moredetail,becausetheyillustratethemoretypicalandmoreinterestingcase
whereeachpartyisrelyingontheother.
Inadditiontopresentingaplausiblecasethatcompetitivelysignificant
managerialpracticesrelyonrelationalcontracts,ourgoalinthesedescriptionsisto
begintoillustratetheideathatbuildingarelationalcontractmayrequire
addressingproblemsofclarityaswellasofcredibility.Weshowthattheserelational
contractsrequirenotonlyahighleveloftaskknowledge—i.e.,oftheactionsthat
constitutecooperation,butalsoagreatdealofrelationalknowledge—i.e.,ofthe
payofftocooperationforeachparty,ofeachparty’sabilityandincentivetodefect,
andoftheactionsandpayoffsthatconstitutepunishment.Section4buildsonthese
descriptionstoexploretheproblemsinherentinbuildingrelationalcontractsin
moredetail.
LincolnElectricmakesarcwelders.Theirproductivity,innovation,and
profitabilityhavemadethemarguablytheworld’sleaderintheirindustry,andtheir
managementpracticeshavebroughtthemsubstantialscrutiny—fromFastandBerg
(1975)throughHastings(1999)andbeyond.Forbrevity,wefocusonthefirm’s
incentivescheme,whichinvolvesbothapiecerate(specifyingtherateofpayper
taskcompleted)andasubjectivebonus(basedonfactorsthatcanbedifficultto
measure,suchasdependability,quality,andideas/cooperation).SeeMilgromand
Roberts(1995)fordescriptionsofhowLincoln’sotherpracticescomplementthe
subjectivebonuswedescribe.
Lincoln’sbonusisveryimportantforboththeworkersandthefirm:over
severaldecades,theaveragebonustoanindividualwasapproximatelyaslargeas
theindividual’stotalpiece‐ratepay(dependingonthepersonandtheyear)andthe
averagebonuspoolwasabouthalfofthefirm’spre‐tax,pre‐bonusearnings(again
withsubstantialvariationacrossyears).Crucially,however,neithertheindividual
bonusreceivedbyaworkernortheaggregatepoolpaidbythefirmisdetermined
byaformula(i.e.,anobjectiveweightattachedtoanobjectiveperformance
measure).Instead,botharediscretionary.
12
InthelanguageofSection2,Lincoln’sworkersmayearnhighpayoffsfrom
workinghard,asbonusescanapproachhalfoftotalcompensation,butsince
paymentofthebonusisdiscretionary,Lincoln’smanagementcaninprincipledefect
bypayingtoosmallabonusornoneatall.Severalformalmodelshaveexploredthe
conditionsunderwhichsuchadiscretionarybonusplansatisfiesacredibility
constraintsuchasequation(1)above.7Butthesemodelsignorethedegreetowhich
suchcontractsmustalsosolveapotentiallysevereclarityproblem:Lincoln’s
relationalcontractrestsonanumberofsharedunderstandingsthatmaywellbe
difficulttoimitate.Forexample,thesizeofthebonusiscontingentnotonlyonthe
productivityofanemployee,butalsoontheemployee’s“dependability,”the
“quality”oftheirworkandthedegreetowhichtheycontributednewideasand
“cooperated”intheimprovementoftheproductionprocess—noneofwhichiseasy
todefineormeasure.
Asimilarrelianceonrelationalcontracts—andanassociatedrelianceonthe
developmentofanextensivesharedunderstandingofconceptsthatareintrinsically
hardtodefinewithoutsharedexperience—isevidentinournextexample,from
Toyota’sproductionsystem(TPS).
ManyresearchershavedocumentedthattheTPSreliesoninnovative
contributionsbytheworkforcethroughshop‐floorproblem‐solving(see,for
example,Ohno,1995andWomack,JonesandRoos,1991).Thekindsofbehaviors
askedoftheworkforceinclude“raiseproblemswhenyouseethem”and“bean
effectivememberofproblem‐solvingteams.”Aswiththeaspectsofworker
performancethatarerewardedinLincoln’ssubjectivebonus,weconjecturethat
thesedesiredbehaviorsinToyota’sproductionsystemcannotbespecifiedprecisely
enoughtobemeasuredandrewardedinaformalcontract.
Asoneexample,akeydiscretionarybehavior(bybothworkersand
supervisors)involvesthe“andoncord”(aropeontheassemblylinethat,when
pulledbyaworker,sendsanalerttosupervisorsthattheremaybeaproblemonthe
line).Ifthesupervisorfailstoresolvethepotentialproblem,thenpullingtheandon
cordmayresultinstoppingtheline—anenormouslydisruptiveeventinmany
continuous‐flowproductionsystems.Buildinganeffectiverelationalcontract
aroundtheuseoftheandoncord—andaroundparticipationinproblemsolving
morebroadly—requiresnotonlysolvingthecredibilityproblem,butalso
developingasharedunderstandingofahostofsubjectiveideas.Forexample,both
employeesandmanagersmustdevelopasharedunderstandingofquestionssuchas
whichtypesofproblemsareworthpullingthecordforandhowsupervisorsshould
respondinthosecasesinwhichthecordhasbeenpulledinappropriately.They
mustalsolearnatwhatpoint,ifany,willsupervisorspenalizeworkers(financially
7SeeBull(1987),MacLeodandMalcomson(1989),andLevin(2003)forrepeated‐gamemodelsof
suchrelationalincentivecontractsandBaker,Gibbons,andMurphy(1994)foratwo‐partpayplan
likeLincoln’s,combininganobjectivepieceratewithadiscretionarybonus.
13
orsocially)formistakesinpullingthecord,andwhatkindsofrewardsare
appropriatewhenthecordhasbeenusedwell.
Noticethateventhissimplifieddiscussionoftheuseoftheandoncordraises
animportantissuenotpresentintheTrustGameinSection2orinourdiscussionof
Lincoln’sbonus.IntheTrustGame,Player1chooseswhethertotrustPlayer2,who
thenchooseswhethertohonor/cooperateorbetray/defect.Likewise,inLincoln’s
bonus,theworkerissubjecttothefirm’sdiscretionoverwhatbonustopay.With
theandoncord,however,eachpartyisbeinggivendiscretionbytheother:the
workertostopthelineandthemanagertoimplementworkersuggestionsandto
supportproblemsolvingin“appropriate”ways.Wesuspectthatsuchmutual
dependenceismoretherulethantheexception.Butinsuchsettings—whereboth
partiescancooperate,defect,andpunish—evenmoreknowledgemustbeheldin
commoniftherelationalcontractistobesustainable.Toillustratethismutual
dependence,andmorebroadlythecomplexityoftheknowledgeonwhichrelational
contractsoftenrely,Table1sketchessomeofthepotentialactionsbyworkersand
managersthatmustbemutuallyunderstoodinordertobuildarelationalcontract
aroundtheuseoftheandoncord.
Table1:Cooperation,Defection,andPunishmentintheuseoftheAndoncordat
Toyota.
Worker
Supervisor
Cooperate
Actions:
1.Pulltheandoncord
whenyouseeaproblem
2.Offersuggestionson
improvementstothe
productionprocess(that
mightmakeyourjob
redundant)
Defect
Actions:
1a.Neverpulltheandon
cord(outoffearofbeing
punished)
1b.Pulltheandoncordto
stopthelineandavoid
workwhenthereisno
trueproblem
2.Keepimprovements
hiddenfromco‐workers
andmanagers
Actions:
Actions:
1.Recognizepotential
1.Punishworkersfor
problemwhenandoncord pullingandoncord(even
pulledandaidinproblem‐ appropriately)
solving
2.Cutworkforceonce
2.Implement
theydiscoverpotential
improvementswithout
innovations
necessarilycuttingjobs
3.Interfereinworkteams
3.Acceptauthorityof
andoverridetheir
workteamstomakesome decisions
shop‐floordecisions
Punish
Actions(inresponseto
perceiveddefectionby
manager):
1.Sabotagethe
manufacturingline
2.Pullandoncord
frequently
3.Engageinabsenteeism
Actions(inresponseto
perceiveddefectionby
worker):
1.Penalizeworkers
(financiallyorsocially)for
pullingandoncord
2.Removetheandoncord
JustasourdiscussionofLincoln’sbonusignoredahostofcomplementary
practicesthatsustainperformanceatLincoln,hereourdiscussionofToyota’sandon
14
cordfocusesononlyonesmallaspectoftheTPS.Nonetheless,eventhissmallaspect
illustratestherangeofknowledgethatmayberequiredtobuildthenecessary
relationalcontract.Furthermore,whiletheseissuesareimportantinmanufacturing
settingssuchasLincolnandToyota,theyareperhapsevenmoreimportantin
knowledge‐worksettings,whichweillustratenextbydiscussingscience‐driven
drugdiscoveryatMerck.
Formanydecades,pharmaceuticalresearchfirmsattemptedtodiscovernew
drugsthroughalarge‐scaleprocessoftrialanderror.Forexample,several
successfulpsychotropicdrugswerediscoveredbyputtinglargenumbersof
potentiallybiologicallyactivecompoundsintodistressedratsandchemically
tinkeringwiththefewcompoundsthatseemedtohavesomeeffectontherats’
behavior(Henderson,1994).Thisprocessofdrugdiscoveryreliedprimarilyonthe
skillsofhighlytrainedmedicinalchemistswhocoulddesignandconstructchemical
compoundsthatwerelikelytohavepharmacologicaleffects.Evenforvery
successfuldrugs,however,thespecificbiochemicalmechanismsresponsibleforthe
drug’stherapeuticeffectswereoftennotwellunderstood.
Beginninginthe1980s,advancesinthescientificliteratureofferednew
understandingsofthebiochemicalmechanismsunderlyingmanydiseases,makingit
possiblefordrugcandidatestobetargetedatspecificmechanisms.Pharmaceutical
firmsseekingtochangefromtheoldprocessofdrugdiscovery(large‐scaletrialand
error)toanewone(basedonthemechanismsofdisease)neededtoundergo
severalsignificantchanges(Henderson,1994).First,completelynewkindsof
scientistshadtobehired,suchasmolecularbiologists.Second,thenewprocess
requiredrichcommunicationacrossscientificdisciplinesandtherapeuticareas,
whereastheoldprocesshadperformedwellwhenconductedindisciplinaryand
functionalsilos.Finally(andmostimportant,forourpurposes),thenewprocess
requiredthefirm’sscientistsnotonlytostaycurrentwiththepromising
mechanismsbeingdiscoveredintheacademicliteraturebutalsotoconductsuch
leading‐edgesciencethemselves,in‐house.
Perhapsnotsurprisingly,stayingcurrentwiththeacademicliteratureinvolved
morethansittinginthefirm’slabandreadingthejournals.Forexample,therewas
greatvalueinalsoattendingconferences,butonetypicallycouldnotfully
understand(or,insomecases,evenbeinvitedto)manyconferenceswithouthaving
one’sownactiveresearchinthearea—aclassicinstanceof“absorptivecapacity”
(CohenandLevinthal,1990).Asaresult,somepharmaceuticalfirmsencouraged
theirscientiststopublish—eventhoughofcourseanultimategoalwastosecure
patentsondrugcandidates.HendersonandCockburn(1994)callafirm“PROPUB”if
anindividualscientist’scareerinsidethefirmdependedonthescientist’sstanding
intheoutsidescientificcommunity,andtheyfindthatpatentoutputissignificantly
greaterinPROPUBfirms(evenwithdummyvariablesfortherapeuticareaand
firm).
15
Thisnewprocesshasbeenlabeled“science‐drivendrugdiscovery”(Cockburn,
Henderson,andStern,2000).Notethatitisnotthemerepresenceofmoreor
differentscientistswithinpharmaceuticalfirmsthatpromptsthislabel;forexample,
thereweremanysyntheticchemistsinvolvedintheoldprocess.Rather,thelabel
reflectsthefactthatthenewprocesswithinthefirmreliessoheavilyon
interactionswithandassessmentsfromtheoutsidescientificcommunity.Itisthis
roleforthescientificcommunity(andthepossibletensionofthisrolewiththe
firm’sgoalofpatentsondrugcandidates)thatweexploreasafinalexampleofboth
thepresenceofrelationalcontractsunderlyingkeymanagerialpracticesandthe
difficultiesinbuildingarelationalcontract,asfollows.
Firmspursuingscience‐drivendrugdiscoveryneededscientiststobehave
almostasiftheywereacademicscientists—toexplorequestionsoffundamental
scientificinterest,topublishintherefereedliterature,andtoattendacademic
conferences.Atthesametime,however,thesescientistscouldnotactcompletely
likeacademics.Theyhadtoalsotakeactionsthatincreasedthelikelihoodofthe
discoveryofnewdrugs.Makingamajorscientificbreakthrough—evenwinninga
Nobelprize—withoutsimultaneouslygeneratingknowledgethatcouldbequickly
appliedtothesearchfornewdrugswouldnotconstitutefullsuccess.Thosefirms
thatsuccessfullydevelopedthissharedunderstanding,ofwhomMerckisthemost
wellknown,introducedmore“significant”drugsandgrewfasterthananyoftheir
competitors,butthepracticewasrelativelyslowtodiffuseacrosstheindustry
(Cockburn,HendersonandStern,2000).
Weseescience‐drivendrugdiscoveryasacomplexmanagerialpracticethat
cannotbesustainedwithoutarelationalcontract.Nomechanisticformulacouldtell
aresearchsupervisorwhetheraparticularscientistwasappropriatelystraddling
thefinelinebetweenbehavinglikeanacademicscientistandbehavinglikea
commerciallyorienteddrughunter,andthusnoformalcontractalonecouldensure
thatresearcherswerebehavingasthefirmdesired.Stayingconnectedtothe
academicworldrequiredpublishinginthejournalsandattendingconferences—but
noonecouldspecifyhowmanypapersascientistshouldpublishandwhich
conferencesheorsheshouldattend,particularlywheneveryscientist’sresearch
trajectorywaslikelytobedifferent.Whenwasgoingtoconferencesvitaltothe
research,andwhenwasitconsumption?Andonthemanager’sside,whena
scientisthadpublishedextensivelyinavitalnewfieldbutfailedtoreceivean
increasedresearchbudget,washermanagerrenegingontherelationalcontractor
respondingappropriatelytothefactthatthescientist’slabstillhadnotproduced
anyplausibledrugcandidates?
Table2sketchesourconceptionofcooperation,defection,andpunishmentfor
thescientistandthemanagerintherelationalcontractunderlyingscience‐driven
drugdiscovery.AswithLincoln’sbonusandToyota’sproductionsystemour
descriptionhereisnecessarilypartial,butitnonethelessillustratestheextentand
complexityoftheinformationthatmustbeunderstoodbyallpartiesifthe
necessaryrelationalcontractistobeself‐enforcing.
16
Table2:Cooperation,Defection,andPunishmentinScience‐DrivenDrugDiscovery
Scientist
Cooperation
Action:behavealmost
likeanacademic
scientist,butbesureto
developuseful
knowledgefor
discoveringnewdrugs.
Manager
Action:rewardthe
scientistwhodisplays
high‐sciencebehavior
evenifnonewdrugs
result.
Defection
Action:eithershirk
(representlackof
resultsasunlucky
research)orbehave
likeanacademic
scientist(pursue
problemsfortheirown
sake,buildexternal
reputation)
Punishment
Action(inresponseto
perceiveddefectionby
manager,andperhaps
dependingonnatureof
thatdefection):behave
likeanacademic
scientist,orignore
researchandbecomea
drughunter
Action:failtoincrease Action(inresponseto
resourcesforscientists perceiveddefectionby
whopublish;reward
scientist,andperhaps
onlythosewho
dependingonnatureof
producedrugs
thatdefection):firethe
scientist,orcutfunding
4)
BuildingandRefiningRelationalContracts
OurdescriptionsofsomeoftherelationalcontractsinplaceatLincoln
Electric,ToyotaandMerckhavehighlightedboththatmanysignificantmanagerial
practicesmayrelyonrelationalcontractsandthatthe“relationalknowledge”thatis
requiredtosustainthesecontractsmaybeveryextensive.
Inthissectionwebuildonthesetwoideastofocusmoresquarelyonthekey
questionofwhyrelationalcontractsmaybehardtobuildandrefine—andhence
hardtoimitate.Thethreecasesinsection3constitutesamplingonsuccess,inthe
sensethatthoserelationalcontractsdidgetbuilt.Forasharperviewofthe
difficultiestheclarityproblemcancreate,wenowsamplefromtheotherendofthe
distribution,whenfailuretocommunicateandtheresultinglackofshared
understandinginhibitedthedevelopmentorrefinementofrelationalcontracts.
4.1
BuildingClarity:TaskandRelationalKnowledge
InourdescriptionsofLincoln,Toyota,andMerck,wesawthatdevelopinga
sharedunderstandingofthedesiredbehaviorswasnoteasybecausetherewas
uncertaintyaboutbothappropriateactionsand(althoughwedidnotemphasizeit
asmuch)associatedpayoffs.WecanstatethesedifficultiesabstractlyusingFigures
1and2.ToparticipateintherelationalcontractinvolvingthoseFigures,player1
needstoknow(a)whatbehaviorsconstitutecooperationbyher(Trustratherthan
NotTrust),(b)whatbehaviorsarethenavailabletoplayer2ascooperationor
defectionbyhim(HonorandBetray,respectively),(c)whatpayoffsplayer2would
receivefromthoseavailablebehaviors(1versus2inFigure1,orCversusDin
17
Figure2),and(d)whatpayoffsplayer1wouldreceiveifeveryonecooperates
versusnot(1versus0inFigure1).8
Ofalltheactionsandpayoffsdescribedin(a)through(d),only(a)seemstous
akintowhatissometimescalledtaskknowledge(i.e.,howoneshouldbehaveinthe
organization),sowehereaftercall(b)through(d)theadditionalrelational
knowledgeneededtoparticipateinarelationalcontract.Asnotedinthe
Introduction,otherresearchtraditions(e.g.,Winter(1987,1988)ontacit
knowledgeorLevinthal(1997),MilgromandRoberts(1995)andRivkin(2000)on
complementarities)havemadeimportantstridesexploringthedifficultiesof
learningandcommunicatingtaskknowledge.Ashardasitmaybetolearnor
communicateone’sowntaskknowledgein(a),however,itmustbeatleastashard
andpresumablyhardertolearnsomeoneelse’staskknowledgein(b),butplayer1
cannotparticipateintherelationalcontractwithoutthisunderstandingofplayer2’s
availablebehaviors,aswellastheassociatedpayoffsin(c).Inthissense,thereis
simplymore(anddifferentandprobablyharder)knowledgetolearnand
communicateinthecaseofarelationalcontractthaninthecaseofone’sowntask
knowledge.Notice,too,thatthetaskmaybefurthercomplicatedbythefactthatif
allgoeswellandbothpartiescooperatewitheachother,eventsofftheequilibrium
path—i.e.,thebehaviorsandpayoffsassociatedwithbothdefectionand
punishment—cannotbeobservedbutmustbeinferred.
Asonestrikingexampleofthedifficultyofcommunicatingrelational
knowledge,wereconsiderLincolnElectric.Afterdecadesofhighproductivityand
apparentlyappropriatebonusesintheirClevelandoperations,Lincolnexpanded
overseas,withinitiallyverynegativeresults(Hastings,1999).Infact,earningsin
Clevelandwereatrecordlevels,butoverseaslossesweresolargethatthecompany
asawholewasinthered.Anewquestionthusaroseaboutwhatconstituteda“fair”
bonusforClevelandworkers:shouldthebonusbebasedonClevelandprofitsoron
thoseofthefirmasawhole?Naturally,whenthefirmhadoperationsonlyin
Cleveland,thisdistinctionneverarose,butithadsuddenlybecomecrucial.
Formally,therewasnowdeepambiguityaboutwhichofmanagement’sactions
wouldbeconsidered“cooperation”.
WeprovidetheresolutionofLincoln’sstoryinthenextsub‐section.Fornow
wesimplynotethatevenalongstandingrelationalcontractmaynotentailshared
understandingofallthedesiredbehaviorsinallthepossiblecircumstancesthat
couldarise.Inasimilarspirit,EllisonandHolden(2009)analyzeamodelwherea
principalattemptstoteachanagenthowtorespondtofluctuatingcircumstances.
Formally,thetimingofeachperiodis:(1)theagentobservesthestateoftheworld,
(2)theagentchoosesanaction,(3)theprincipalobservesthestateandsendsa
messagetotheagent,and(4)bothpartiesreceiveacommonpayoffthatispositive
iftheagentchoosetheappropriateactionforthestateandzerootherwise.The
8RecallfromSection2.1thatplayer1needstoknow(b)and(c)toassesswhetherplayer2will
cooperate;ifso,player1thenneedstoknow(a)and(d)todecidewhethertocooperateherself.
18
novelassumptionintheEllison‐Holdenmodelisthattherearesomestatesofthe
worldthatthepartiescannotdiscussuntiltheyhaveexperiencedthemtogether.In
thissetting,therecanbemoreorlessusefulearlyrealizationsofthestate,allowing
moreorlessusefulinstructionsfromtheprincipaltotheagent.Tothedegreethat
thisphenomenonisrealitsuggeststhatthedevelopmentofrelationalcontractsmay
besignificantlypath‐dependent,withsomestatesoftheworldenablingthecreation
ofmuchmorerobustcontractsthanothers;seealsoourdiscussionofChassang
(2010)below.
Asasecondcaseaboutlackofsharedunderstanding,considerStewart’s
(1993)accountofhowCreditSuisse,alargeEuropeanbank,boughttheUS
investmentbankFirstBoston,takingthecompanyprivateunderthenameCSFirst
Boston(CSFB).Roughlyspeaking,inthefirsttwoyearsthatCreditSuissecontrolled
CSFB,allfirmsintheinvestment‐bankingindustryperformedpoorlyandemployees
receivedbonusesthatwerelowerthanthehistoricalaveragebutcomparableto
bonusespaidatotherinvestmentbanks.Inthethirdyear,however,CSFB
performedbetterthanpreviouslyandyetworsethanitscompetitors,andCredit
SuissepaidbonusesthatwereabovebonusesatCSFBinthefirsttwoyearsbut
lowerthanthoseatotherfirmsinthethirdyear.Acrisisensued.Inbrief,CSFB
assertedthatthebonuspolicyintheirindustrywasmatch‐the‐market,meaningthat
bonusesshouldbecompetitivewithbonusesatothertop‐bracketfirms.Incontrast,
theSwissassertedthatintheirindustrythebonuspolicywaspayforperformance,
meaningthatabanker’sbonusdependedonhowheandhisbankperformed.Note
thatthesetwopoliciesmakeidenticalpayprescriptionswhenallfirmsinthe
industryhavethesameperformance,aswasbroadlytrueinthefirsttwoyears.
Moregenerally,partieswithdifferentunderstandingsmaynotappreciatethatthis
differenceexistsuntilkeyeventsoccur—withthefurthercomplicationthat
behaviorbyonepartyduringsuchaneventmaybeintendedascooperationbut
nonethelessbeviewedbytheotherasdefection.
Forinspiringevidencethatdifferentgroupscanindeedreachdifferentshared
understandingsinsimilarenvironments,considerthelabstudiesbyWeberand
Camerer(2003)andSeltenandWarglien(2007).Bothexplorecommon‐interest
games,wheretwoplayersreceivethesamepositivepayoffiftheysuccessfully
coordinate,buttheyreceivenopayoffiftheyfailtocoordinate.Morespecifically,the
playersareattemptingtobuildasharedlanguageduringrepetitionsofagamelike
thefollowing:(1)player1observesthestateoftheworld,sS;(2)player1sendsa
costlessmessagetoplayer2,mM;(3)player2choosesanactionaS;(4)
payoffstoeachplayerareU(s,a)=1ifa=sandU(s,a)=0otherwise;(5)player2
observess.Thus,player1wouldliketosendamessagem(s)thattellsplayer2that
thestateiss(sothatplayer2willthenchoosetheactiona=s).Theproblemisthat,
atleastintheearlygoing,player2haslittlebasisforunderstandingplayer1’s
messages.
19
Bothpapersfindthatdifferentpairsofplayersdevelopdifferentlanguages,
eventhoughthesepairsareplayinginthesameenvironment(exceptforthe
randomrealizationsofthestatesoftheworldovertime).Becausetheseare
common‐interestgames,weinterprettheknowledgebeingcommunicatedastask
knowledge,notrelationalknowledge.Inparticular,thereisnoconcernwith
defectionorpunishmentinacommon‐interestsetting.Nonetheless,consistentwith
thelargeliteratureonthedifficultiesofcommunicatingtacitknowledge,different
pairsofplayerstakedifferentlengthsoftimetodevelopasharedunderstanding,
anddifferentpairsholddifferentsharedunderstandingsoncetheyreachthem.
Fromthislabevidence,wefinditonlyasmallstretchtoimaginethatsimilarforces
couldcausereasonablepeopletoholddifferentunderstandingsinsituationslike
thoseatLincolnorCSFB.Ofcourse,theissueatthesetwocompaniesinvolved
bonuses,sothesewerenotcommon‐interestsettings;rather,theproblemof
credibilityalsoarose,aswediscussnext.
4.2
TheDynamicsofCredibility
Beyondthefactthatimplementingarelationalcontractrequires
communicatingnotonlytaskknowledgebutalsorelationalknowledge,thereis
anotherdifficultythatcomplicateslearningandcommunicatingarelationalcontract
comparedtolearningandcommunicatingtaskknowledge:relationalcontractsare
relevantonlywhengoalalignmentisimperfect.9Thus,whatevertheinformation
thatneedstobecommunicated(taskand/orrelational),itmaynotbeinsomeone’s
interesttorevealthatinformation.Instead,informationmightbewithheldor
distorted.Thereisofcourseanenormouseconomicsliteratureontheseissues,and
wenotethatdiscussionalongtheselinesstartedinorganizationtheorybefore
informationeconomicsororganizationaleconomicsexisted,suchasinCyertand
March(1963).10Thequestionweface,however,ishowimperfectalignmentof
interestsaffectsparties’effortstobuildarelationalcontract(aspartofamanagerial
practice).
ReturningtoouraccountsofLincolnElectricandCreditSuisseFirstBoston,we
findtwodifferentscenariosunfoldingafteralackofsharedunderstandingwas
discovered.AtLincolnElectric,wherethequestionwaswhetherCleveland’s
bonusesshouldbebasedonClevelandprofitsoronthoseofthefirmasawhole,the
firmultimatelydecidedinfavoroftheformerprinciple(eventhoughdoingso
9
Thepartoforganizationaleconomicscalled“teamtheory,”initiatedbyMarschakandRadner
(1972),canbeinterpretedasexploringinformationacquisition,communication,anddecision‐
makingwhenallpartieshavethesameinterests(butgatheringandcommunicatinginformationare
costlyactivities).SeeGaricanoandVanZandt(2012)forarecentdiscussionofapproachesinthis
vein.
10Forexample:“Where different parts of the organization have responsibility for different pieces of
information relevant to a decision, we would expect some bias in information transmitted due to …
attempts to manipulate information as a device for manipulating the decision. … [But] we cannot
reasonably introduce the concept of communication bias without introducing its obvious corollary –
‘interpretive adjustment’” (pp. 79 and 85, Cyert and March, 1963).
20
requiredthefirmtoborrowinordertopaythebonus).AtCSFB,incontrast,CS
stucktoitspolicyofpayforperformance(ratherthanthebankers’preferredpolicy
ofmatchthemarket),leadingtothedepartureofmanyprominentbankers.
Therearemanywaystorelatethedynamicsofthesecasestotheoriesofthe
kindwehaveconsideredinthisessay.Ourpointhereisnottoendorseparticular
theoreticalinterpretationsofthesetwocases,butrathertosurfacethegeneralissue
thatthesecasespresent:howwillpartiesrespondwhenapossible
misunderstandingsurfaces?Wenowsketchthreecomplementaryapproachesto
thisissue,inthehopethatfurthertheoryandevidenceonthedynamicsof
relationshipswillensue.
Oneapproach,inthespiritofSection2.1,istoimaginethatthecritical
momentsinthesecasescorrespondtosuddenchangesinpayoffs.Forexample,
CreditSwissemayhavereachedapointwherethedefectiontemptation
permanentlyincreasedfromDtoD,alongthelinesof(3),causingthebankto
defect.(Toputthispointlessabstractly,itmaybethatwhattheSwisswantedall
alongwasaglobalfinancialsupermarket,forwhichitneededaninvestmentbank,
butnotnecessarilyatop‐bracketinvestmentbank,sotheygaveuponthelatter
whenitspriceincreased.)ButthisandanyotheranalysisfromSection2.1assumes
thatthepartieshaveasharedunderstandingofwhatactions(inwhatstates)
constitutecooperationintheirrelationship,whereasthebankersatCSFBandtheir
Swissownersapparentlydidnothavesuchasharedunderstanding.Wetherefore
turntomodelswherethepartieshavesomethingtolearn.
ManyauthorshaveenrichedthecredibilitymodelsfromSection2.1toinclude
privateinformationaboutplayers’payoffs,sothatpartieslearnabouttheirpartners
asanequilibriumprogresses;seeMacLeodandMalcomson(1988),Watson(1999,
2002),andHalac(2011),forexample.Asanillustration,inFigures1and2,suppose
thatplayer1isuncertainaboutplayer2’sdiscountrate,whichplayer1believes
couldbehigh(rH)orlow(rL).Inmodelslikethese,itcanbeoptimaltoterminatea
relationshipafterlearningenoughbadnewsaboutone’spartner’stype(perhapsas
atCS).Likewise,itcanbeoptimaltoenricharelationship,suchasmovingfrom
partialtofullcooperation,afterlearningenoughgoodnewsaboutone’spartner’s
type.Asaresult,onecouldimagineplayer2searchingforwaystosignalthatsheis
thepatient(or“hightrust”)type,rL,soastoinducegreatercooperationfromplayer
1.
Modelsoflearningaboutone’spartneroftensuggestempiricalapproaches
basedonunmeasurablemanagerialattributes.Suchempiricalworkhasastrong
tradition,fromatleastMundlak(1961)throughatleastBertrandandSchoar
(2003).Butthereisanalternativeapproachthatalsoshedslightonperformance
differences,basedonpath‐dependenceratherthanunmeasuredheterogeneity.
Chassang(2010)offersonemodelinthisalternativespirit,inwhichaPrincipaland
anAgentbuildarelationalcontract,asfollows.
21
In each period, the Principal first chooses whether to invest or not, where
investingimposesacostkonthePrincipalbutdeliversabenefitbtotheAgent(and
not investing delivers zero to both parties and ends that period). If the Principal
doesinvestthendifferentactionsfromthefeasiblesetArandomlybecomeavailable
thatperiod,andbothpartiesobservewhichactionsareavailablethatperiod.
In the feasible set A there are two kinds of actions, unproductive and
productive.AnunproductiveactioncostsnothingfortheAgenttotakebutproduces
no output for the Principal, whereas a productive action costs c to take and
producesagivenpositiveoutputwithprobabilityqandzerowithprobability1‐q.It
iscommonknowledgewhatthenumberofproductiveactionsisandwhatagiven
productiveactionproduceswhenitproducespositiveoutput,butinitiallyonlythe
Agentknowswhichactionsaretheproductiveones.
In the first period, to induce the Agent to take a productive action (if one is
available)insteadofanunproductiveaction,thePrincipalthreatensnottoinvestin
severalfutureperiodsifthisperiod’soutputiszero.Notethatthispunishmentwill
occur on the equilibrium path, because a productive action could produce zero
output. In this sense, learning (i.e., identifying a new action as productive) is
expensive.Ontheotherhand,laterinthegame,ifanactionhasalreadyproduceda
positive output then the Principal knows that the action is productive, so if the
AgentnowtakesthisactionanditproduceszerooutputthenthePrincipaldoesnot
needtopunishtheAgent.
Because learning is expensive (in the sense of punishments, and also in the
senseofopportunitycostafteratleastoneproductiveactionhasbeenidentified),it
canbeoptimaltostoplearningbeforeallproductiveactionsareidentified.Because
opportunitiestolearnarriverandomly,otherwiseidenticaldyadsmaystoplearning
afteridentifyingdifferentsetsofproductiveactions.Thatis,eachdyadconvergesto
a steady‐state relational contract, but different dyads can converge to different
relationalcontractsthatproducevaryingdegreesofcooperation.Thus,Chassang’s
model can produce persistent performance differences among otherwise similar
dyadsbecauseofpath‐dependenceinbuildingarelationalcontract—verymuchin
thespiritoftheadministrationproblemthatanimatedthisessay.
5) Conclusion
Anextensiveliteraturehassuggestedthatorganizationalcapabilitiesare
difficulttoimitatebothbecausetheyrequirethecommunicationoftaskknowledge
thatisoftendeeplyembeddedinorganizationalroutinesandbecauseproblemsof
complementarityandlocalsearchmeanthattheprocessesofincrementallearning
thatcharacterizemanyorganizationsmakeitdifficulttocommunicatethis
knowledge.Herewehaveattemptedtodevelopacomplementaryexplanationfor
theoftenslowdiffusionofcompetitivelysignificantcapabilitiesbyfocusingonthe
factthatmanykeymanagerialpracticesrelyonrelationalcontracts,andby
22
suggestingthatbuildingtheserelationalcontractsrequiresmovingbeyondtask
knowledgetothedevelopmentof“relationalknowledge.”Wesuggestedthat
relationalknowledgemaybesubstantiallymoredifficulttodevelopthantask
knowledgebothbecausethereismuchmoreofitandbecauseitsacquisitionis
complicatedbyincentiveproblems.
Whilewehopethatthisargumentiscompellingasahypothesis,thereis
clearlymuchthatremainstobedonetoproveitsvalidityanddetermineits
boundaryconditions.Forexample,whileitiswellestablishedthatorganizationsare
repletewithrelationalcontracts,andwhilewebelievethatmanycompetitively
significantmanagerialpracticesrelyonrelationalcontracts,carefulempiricalwork
thatputtheseideastothetestwouldclearlybeuseful.Similarly,empiricalwork
thatexploredthedevelopmentofrelationalcontractsovertimeasanintegralpart
ofthedevelopmentofmanagerialpracticeswouldalsobeofsignificantvalue.One
approachmightbetobeginwithcarefulqualitativestudiesandthenprogressto
moresystematic,potentiallysurvey‐basedworkthatcouldenablecomparisons
acrossfirmsovertime.
Wealsosuspectthattheseideas,iftheydoindeedproverobusttocareful
empiricalinvestigation,mayhavesignificantimplicationsformanagerialaction.A
considerableliteraturehasexploredtheprocessesthatenablefirmstobecome
“learningorganizations”(see,forexample,Argote,1999andSenge,1993).One
couldimagineacomplementaryfocusontheprocessesthatenablefirmstobuild
relationalcontracts.Extensiveandcrediblecommunicationisalmostcertainly
important,andwesuspectthatinmanycircumstancestheabilitytocommunicate
convincinglythatoneisa“hightrust”typewouldbeveryuseful.Anotherpossibility
isthatmanagerswhoexcelinthedevelopmentofrelationalcontractstake
advantage—orperhapsevencreate—situationsthattestthelimitsofthecurrent
contracttothentakeactionsthatrefinethecontract,suchasbycommunicating
crediblyaboutotherwiseunrevealedpayoffsandpreferences.Similarlyitmightbe
thecasethatsuccessfulmanagersdeveloptheabilitytochangerelationalcontracts
withouttriggeringtheperceptionthattheyarerenegingonexistingagreements;
KaplanandHenderson(2005)suggestthatthelatterperceptionmaybea
significantbarriertoorganizationalchange.
Anotherpotentialextensionoftheseideasistoexploretheirimplicationsfor
theroleoforganizationalcultureandritual.Onepointofconnection,forexample,
mayflowfromthefactthataneffectiverelationalcontracttendstoachieve
cooperation,ratherthandefection.Asaresult,itmaybeeasytoforget(orfor
newcomersnevertohaveobserved)whatsomeoneelse’sopportunitiesfor
defectionmightbe,orhowtemptingtheseopportunitiesmightbe,orwhatsomeone
else’sopportunitiesforpunishmentmightbe,orhoweffectivethesepunishments
mightbe.Thissituationisakintoonewhere“meansbecomeends,”whereaperson
orgroupforgetswhyitdoessomething,andinsteadremembersonlywhatitis
currentlysupposedtodo,thusleavingitselfunpreparedtorespondtofluctuating
23
circumstances.Partiestoarelationalcontractthereforemighttellstories:toremind
eachotherofwhatcouldoccur,andtosketchappropriatebehaviorifitdoes.
Morebroadlywebelievethatourframingopensupsomeintriguingissuesas
totherelationshipbetweenthedynamicsofconventionalrelationalcontracts(i.e.,
purely“calculative”trust)andotherformsofsocialcapital.Astheextensive
literatureontrusthasdemonstrated,organizationsareshotthroughwithbeliefs
andexpectationsderivedfrompersonalandsocialdynamicsthatgiverisetomany
differentkindsoftrust.Wehopethatourattempttoclarifytheroleofrelational
contractsmaycontributetothedevelopmentofabroaderunderstandingofthe
relationshipamongdifferentformsoftrustandtheirrolewithinthefirm.Withinthe
firm,forexample,arecalculativeandaffectiveand/orsocialtrustcomplementsor
substitutes?Mightitbethecasethatfirmscharacterizedbyhighlevelsofpersonal
trustfinditsignificantlyeasiertobuildandrefinenewrelationalcontracts?
Organizationalresearchershavelongsuggestedthattheinformalstructuresof
firmsarecriticallyimportanttotheirperformance—andthatinsomecircumstances
high‐commitmentworkpracticesortheabilitytosustainhighlevelsoftrustmaybe
verypowerful.Ourhopeisthatbylinkingtheseideastotheanalyticalconstructofa
relationalcontractwewillbeabletocatalyzefurtherresearchintheareaand,
ultimately,tosupportpracticingmanagersinbuildingeffectiveorganizations.If
buildingrelationalcontractsisasimportantaswebelieveittobe,researchthat
yieldsinsightintothemechanismsbehindtheirdevelopmentandthestrategic
choicesonwhichtheyrestcouldmakeanimportantcontributiononawidevariety
offronts.
24
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