Contractual Flexibility, Rent Seeking and Renegotiation Design: An Empirical Analysis of Information Technology Outsourcing Contracts

Abstract

This paper examines renegotiation design in contracts for outsourced information technology (IT) services. While prior literature in information systems (IS) has highlighted the likelihood of ex post rent seeking engendered by renegotiation, we build upon literature on incomplete contracts to posit that renegotiation can be Pareto improving by incorporating contingencies revealed ex post. Research on contract renegotiation has been hampered by two sets of challenges: the lack of appropriate data and empirical challenges in identification. We circumvent this problem both by appropriate data collection and by employing an identification strategy to address alternate causal explanations. We propose a measure, Pareto Improving Amendments, to assess renegotiation outcomes that enhance the value from outsourcing by hazard equilibration and by incorporating learning. Using a unique sample of 141 IT outsourcing contracts, we examine the role of decision rights delineated ex ante in enabling Pareto improving amendments and in resolving the tradeoff between adaptation and rent seeking. We find that flexibility provisions, termination for convenience rights and contractual rights whereby vendors are granted rights to reuse know how are associated with Pareto improving amendments. The results are robust to potential endogeneity of contractual provisions when parties have feasible foresight, and the possibility of adverse selection in the sample. We also examine alternate explanations from the literature on contractual breach. Implications for practitioners and researchers are discussed.

Keywords: contractual flexibility, rent seeking, IT outsourcing, incomplete contracts, renegotiation design

JEL Classification: L14, L22, L86