Long-Term Contracts and Short-Term Commitment: Price Determination for Heterogeneous Freight Transactions

Abstract

This paper considers a class of contracts in which parties write detailed, long-term performance obligations yet leave one or both parties broad discretion to terminate the agreement on short notice with little or no penalty. If the purpose of formal contracting is to make agreements legally enforceable, why would transactors go to the trouble of specifying complex price and performance obligations that either party can walk away from at will? The paper shows that formal contracts may be valuable, even where termination is the only sanction available to the parties, as a way of economizing on the cost of determining prices for a series of heterogeneous transactions. The theory is then used to analyze the structure of contracts between freight carriers and drivers and, in particular, the means by which haul prices are determined. Both the overall structure and pricing arrangements in these contracts support the proposition that ex post bargaining costs can affect the use and design of contracts even in the absence of significant relationship-specific investments.

Keywords: contracting, price determination, negotiation costs, self-enforcement

JEL Classification: L14, J41, L92, K12