The Optimal Length of Contracts With Application to Outsourcing

42 Pages Posted: 24 Jul 2007

See all articles by Matthew Ellman

Matthew Ellman

Institut d'Anàlisi Econòmica (CSIC); Barcelona Graduate School of Economics (Barcelona GSE)

Date Written: February 2006

Abstract

This paper resolves three empirical puzzles in outsourcing by formalizing the adaptation cost of long-term performance contracts. Side-trading with a new partner alongside a long-term contract (to exploit an adaptation-requiring investment) is usually less effective than switching to the new partner when the contract expires. So long-term contracts that prevent holdup of specific investments may induce holdup of adaptation investments. Contract length therefore trades of specific and adaptation investments. Length should increase with the importance and specificity of self-investments, and decrease with the importance of adaptation investments for which side-trading is ineffective. My general model also shows how optimal length falls with cross-investments and wasteful investments.

Keywords: Contract length, market forces, incomplete contracts, holdup

JEL Classification: D23

Suggested Citation

Ellman, Matthew, The Optimal Length of Contracts With Application to Outsourcing (February 2006). Available at SSRN: https://ssrn.com/abstract=1002305 or http://dx.doi.org/10.2139/ssrn.1002305

Matthew Ellman (Contact Author)

Institut d'Anàlisi Econòmica (CSIC) ( email )

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Barcelona Graduate School of Economics (Barcelona GSE) ( email )

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