Forgiveness in Vertical Relationships: Incentive and Termination Effects

Organization Science, Forthcoming

42 Pages Posted: 11 Jan 2012 Last revised: 13 Oct 2015

See all articles by Bart Vanneste

Bart Vanneste

University College London

Douglas H. Frank

The Catholic University of America

Date Written: July 4, 2013

Abstract

Two types of contractual solutions have been proposed for resolving incentive conflicts in vertical relationships: formal and relational (i.e., enforceable or not by third parties). Much is known about the optimal structure of formal contracts, but relatively little is known about the structure of relational contracts. We study a core feature of the latter: the conditions leading to continuation of the relationship, whose prospect gives relational contracts their force. We build a formal model of a vertical relationship between two parties that endogenizes the choice of the minimum performance necessary for continuation as a function of the values of contractibles, noncontractibles, and outside options. The model highlights a basic trade-off between providing strong incentives for the present (incentive effect) and safeguarding relationships for the future (termination effect). The stable relationships that follow from a more forgiving contract are more important under certain conditions (high contractible and noncontractible value); however, strong incentives from a less forgiving contract are more important under other conditions (high noncontractible relative to contractible value and attractive outside options). We discuss implications for the choice of governance of interorganizational relationships.

Keywords: Vertical relationships, shadow of the future, theory of the firm

Suggested Citation

Vanneste, Bart and Frank, Douglas H., Forgiveness in Vertical Relationships: Incentive and Termination Effects (July 4, 2013). Organization Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1982597 or http://dx.doi.org/10.2139/ssrn.1982597

Bart Vanneste (Contact Author)

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Douglas H. Frank

The Catholic University of America

Washington, DC 20064
United States