The Optimal Length of Contracts With Application to Outsourcing
42 Pages Posted: 24 Jul 2007
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: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Subjective Performance Measures in Optimal Incentive Contracts
By George P. Baker, Robert S. Gibbons, ...
-
By Luigi Zingales and Raghuram G. Rajan
-
By Raghuram G. Rajan and Luigi Zingales
-
Implicit Contracts and the Theory of the Firm
By George P. Baker, Robert S. Gibbons, ...
-
Relational Contracts and the Theory of the Firm
By George P. Baker, Robert S. Gibbons, ...
-
The Firm as a Dedicated Hierarchy: A Theory of the Origin and Growth of Firms
By Raghuram G. Rajan and Luigi Zingales
-
The Firm as a Dedicated Hierarchy: A Theory of the Origin and Growth of Firms
By Raghuram G. Rajan and Luigi Zingales