How Contracts and Relationships Evolve Over Time:
A Case Study of Software Contracting
Kyle J. Mayer
Marshall School of Business
Management and Organization Department (BRI306)
University of Southern California
Los Angeles, CA 90089-0808
213-821-1141
213-740-3582 (Fax)
The author would like to thank Paul Adler, Tom Gilligan, Howard Shelanski, Oliver Williamson and Bennet Zelner for their thoughtful comments.
How Contracts and Relationships Evolve Over Time:
A Case Study of Software Contracting
Abstract
There are conflicting perspectives about how contracts influence relationships between firms. Many believe that contracts will diminish in importance as relationships develop and the parties rely on other mechanisms, such as relational governance, to guide their interaction. Rather than seeing formal contracts and relational governance as substitutes, others see them as complements. This paper examines a case study of the relationship between a supplier of embedded software and one of their customers in order to better understand how formal contracts can be used to facilitate the development of close, cooperative relationships by better aligning the expectations of the parties. The potential for contracts to reduce conflict by aligning expectations is particularly important for complex transactions, where roles and responsibilities are not clear ex ante.
How Contracts and Relationships Evolve Over Time:
A Case Study of Software Contracting
The governance of inter-firm relationships has been a focus of researchers in several disciplines, but there is still a great deal that we don’t know about how firms interact with one another. One key aspect of inter-firm interaction is the contract, which can serve as a framework for the relationship (Llewellyn, 1931). A long stream of research that flows from transaction cost economics (TCE) (Williamson, 1979, 1985; 1991) has shown how specific contractual features have been used to facilitate exchanges that might not otherwise have taken place (see Shelanski & Klein (1995) for a review of the TCE empirical literature). While this research has shown how contracts have been used to safeguard exchanges involving specific investments, appropriability concerns etc., others argue that less formal mechanisms will arise to govern exchange as relationships develop between the buyer and supplier (e.g., Bradach & Eccles, 1989; Ring & Van de Ven, 1994).
While the value of formal contracts has been observed in many instances, other studies have examined the advantages of relational governance, which relies upon trust and other informal mechanisms to manage inter-firm relationships rather than formal contracts (e.g., Adler, 2001; Dyer & Singh, 1998; Gulati, 1995a). The potential gains of relational governance include, but are not limited to, lowering contracting costs and increasing flexibility.
Most researchers see relational governance as a substitute for contracts—informal governance replaces formal governance either from the outset or as a relationship develops. Gulati (1995a: 93) states that “Where there is trust, people may choose not to rely upon detailed contracts to ensure predictability.” Only recently have researchers begun to consider the possibility that contracts and relational governance may have a complementary relationship (Baker, Gibbons & Murphy, 1994; Poppo & Zenger, 2002). In this paper, I examine the process by which formal contracts between two firms evolve as they attempt to develop a cooperative exchange relationship with one another.
I conducted a case study of the relationship between an embedded software development firm (hereafter fictitiously referred to as Softstar) and a representative customer (HW Inc.) over a nine-year period that produces some interesting theoretical insights. The parties used contracts with more detail as their relationship developed as a mechanism to facilitate ex ante alignment of expectations. This case study is based on upon direct analysis of the contracts and numerous interviews with personnel from Softstar and the buyer (HW Inc.).
The case study suggests that if a formal contract is used as a blueprint for the relationship, then it can serve to facilitate the development of a close relationship. However, this is only likely to occur when firms undertake complex transactions and when contracts are not rigidly enforced. Contracts are designed to define and safeguard an exchange (Macaulay, 1963). For simple exchanges of standardized goods, the roles and expectations of each party are well understood even without a formal contract. Macneil (1974: 738) describes simple market contracting as “sharp in by clear agreement; sharp out by clear performance.” The contract is primarily a legally enforceable confirmation that a customer has placed an order and a supplier has agreed to fulfill it.
For more complex transactions, however, the role of each party is more ambiguous and disagreements can develop over who was responsible for various activities. In these complex exchanges, a contract can help by clearly defining the roles and responsibilities of each party and ensuring they have the same set of expectations, which reduces the detrimental effects of process conflict (Jehn, 1997) during the execution of the project. However, contracts can be detrimental to the development of a close relationship when they are primarily mechanisms for ensuring enforcement because they may create a perception of mistrust.
The role of contracts is determined over time when the firms discover how the other party reacts to unexpected changes that arise during a transaction. If the contract is rigidly enforced by one party even in the face of changing circumstances that disadvantage the other party, then a contract is highly unlikely to lead to a close, cooperative relationship. However, if both firms are willing to adjust the contract in the face of changing circumstances, then the give and take that develops can form the basis for a strong relationship between the firms. The mutual adjustment helps create a positive perception of the contract by the parties governed by it.
This paper will proceed as follows. I will discuss prior work on contracting and relational governance. I will then present the Softstar-HW Inc. case study and discuss its implications, including the mediating role of complexity. This will be followed by discussions of alternative explanations, limitations, and concluding comments.
THE ROLE OF CONTRACTS IN INTER-FIRM RELATIONSHIPS
There is a vast literature on inter-firm relationships, but very little emphasis has been placed on the evolution of these relationships over time (see Doz (1996) and Mayer and Argyres (2003) for exceptions). Most studies have been cross-sectional comparisons of different types of inter-firm relationships, such as international comparisons (Helper, 1990), comparisons of specific sourcing practices (Richardson, 1993), and comparisons of different ways of governing relationships (Heide and Miner, 1992; Ring and Van de Ven, 1992; Dyer 1996).
One particular tool for governing inter-firm relationships that has received a great deal of attention is a formal contract. Drawing largely upon transaction cost economics (TCE), many researchers have examined the efficiency of various contract terms to mitigate hazards arising from specific investments and uncertainty. For instance, several studies have shown that contract duration increases with asset specificity (e.g., Joskow, 1985, 1987; Crocker and Masten, 1988) and temporal specificity (e.g., Pirrong, 1993). Other studies have shown that contracting hazards can be overcome by utilizing various contractual features, including price adjustments (e.g., Joskow, 1988, 1990; Goldberg and Erickson, 1987), take-or-pay provisions (e.g., Hubbard and Weiner, 1986; DeCanio and Frech, 1993; Masten and Crocker, 1985), exclusivity (e.g., Gallick, 1984), or more complete contracts (e.g., Crocker and Reynolds, 1993). Another stream of research has examined how firms choose different types of contracts (e.g., fixed fee, cost plus) (Allen and Lueck, 1992a, 1992b, 1999, Cheung, 1969; Chisholm, 1997).
Most empirical work on contracting has focused on attributes internal to the transaction and paid scant attention to the social or institutional context within which the exchange is embedded (Granovetter, 1985; Gulati, 1995a, 1995b). The social context refers to the relationship between the parties and/or social norms that lead the parties to engage in or refrain from certain behaviors. However, there is a stream of research that has analyzed how norms and other informal constraints can provide an alternative to formal contracts. Social sanctions, reputation and other non-contractual factors have been shown to facilitate exchange in the Maine lobster market (Acheson, 1985), furniture production in Mexico (Acheson, 1995), the whaling industry (Ellickson, 1989), and the New England fresh fish market (Wilson, 1980). In each of these cases, the transactions faced serious contractual hazards and were well understood by the entire community and the focus was on using the threat of social sanctions or damage to a firm’s reputation to prevent opportunistic behavior.
In general, however, the work on contracting has focused on overcoming the threat of opportunism by providing the means for third-party enforcement of the agreement. What these streams of research agree upon is that the preferred governance structure is the one that reduces the risk of opportunistic behavior and ensures that the exchange takes place; while the key difference is in the mechanism identified to safeguard the exchange (e.g., long-term contract, social sanctions, and repeated exchange).
Few studies have paid significant attention to how relationships evolve. Kranton (1996) theoretically shows that cooperative relationships can only develop for simple exchanges if an initial bond is posted or if the exchanges increase in value monotonically over time. Ring and Van de Ven (1994) show how firms can build a strong, trusting relationship by starting with simple exchanges and working up to more complex ones as the relationship develops. Formal contracts are phased out as the relationship develops. By eliminating the contract in future interaction, Ring and Van de Ven implicitly assume that contracts become obsolete, because verbal communication is sufficient to define the roles and responsibilities of each party. In addition, as firms work together, they can develop norms for reliability, sharing information, and flexibility that help overcome exchange hazards without relying on a formal contract (e.g., Macaulay, 1963; Palay, 1984). Like the empirical literature on contracting, however, this approach assumes that contracts serve primarily to enforce the exchange and discounts the role of contracts in defining the exchange, which can be especially important when conditions change over time. One study that has viewed contracts as more than enforcement tools, Mayer and Argyres (2003), examines how firms learn to more effectively contract with one another over time by using contracts as repositories to codify relationship-specific knowledge.
To date, research on formal contracts and relational (or informal) governance has evolved in such a way that the two are seen primarily as alternatives to one another (Dyer and Singh, 1998, Ring and Van de Ven, 1994). However, there is some research that suggests a complementary relationship. Poppo and Zenger (2002) show that formal contracts and relational governance are complements in an analysis of information services exchanges. Baker, Gibbons and Murphy (1994) suggest that failing to specify key aspects of the exchange in the contract can lead to greater incentives to cheat and lower expected levels of cooperation. This stream of research suggests that formal contracts can play a role in helping relationships develop and do not necessarily need to be phased out as a relationship develops.
There is no consensus in extant theory regarding how contracts can influence, positively or negatively, the development of a relationship between two firms. Such a situation is a prime candidate for case study research, which can highlight specific mechanisms that are at work and potentially identify mediating factors that affect how contracts influence relationships.
METHODS
I draw my data from interviews with managers of a computer software firm (fictitiously referred to as “Softstar”) in the San Francisco Bay Area, and it customers, as well as contracts provided by Softstar. Incorporated in 1979, Softstar become profitable in the early 1990s and survives as of 2003. Softstar’s software products consist of customized programming that is embedded into various computer hardware products such as microprocessors. With development facilities in North America, Japan, and Europe, Softstar is a multinational firm with a global customer base. At the time the interviews were conducted (1996-7), a typical Softstar development project took from three to nine months to complete and required innovative solutions to programming challenges. The length of customer relationships ranged from a few years to over a decade. Customers typically required one to three products per year from Softstar. As of 1996-7, Softstar was just beginning to develop its custom products with an eye toward code re-use, with the idea of reaching some economies of scope across products. Code re-use was therefore not an aspect of the earlier development projects studied for this analysis.
I was also given access to the contracts that governed the relationships between Softstar and several of its customers. While I examined the relationships between Softstar and four of its larger customers, my most detailed data on contractual features and their evolution come from the eleven contracts between Softstar and a customer that I refer to as “HW Inc.” that were written over the period 1989-1997. HW Inc. was, and remains today, a major diversified Japanese electronics producer with a strong presence in the personal computer industry. Softstar produced embedded software for other major computer hardware producers as well. Softstar managers explained that the contracts between Softstar and HW Inc. were quite representative of Softstar’s contracts with other customers.[1]
Numerous employees from Softstar and HW Inc. were interviewed. Interviewees included engineering project managers, engineering managers (up to the director level), programmers, marketing personnel, and quality assurance. Many of these managers had extensive experience in the computer industry. For example, the Softstar project manager in charge of working with HW Inc. had 25 years of experience as an engineer and manager at IBM. The interviews were semi-structured, with broad, general questions oriented toward understanding the role of contracts in the evolution of Softstar’s relationships with its customers, especially HW Inc. As will be evident from the narrative below, I consistently asked subjects to describe the chronology and details of events that led to contract changes, rather than relying on unsupported or idiosyncratic interpretations they might offer. I also triangulated these descriptions with other interviewees.
With regard to the Softstar-HW Inc. relationship in particular, the project manager in charge was interviewed twelve times over a one-year period. Ten additional personnel from Softstar and HW Inc. were interviewed from one to six times each. The combination of archival data (the contracts—going back to the beginning of the relationship) and extensive interviews provided a comprehensive picture of the relationship between Softstar and HW Inc, and a good picture of a typical relationship between Softstar and its customers in the 1990’s.