Scaffolding: Using Formal Contracts to Build Informal Relations in Support of Innovation

Abstract

In a study that follows in Macaulay's (1963) footsteps, we asked businesses what role formal contract law plays in managing their external relationships. We heard similar answers to the ones Macaulay obtained fifty years ago from smaller companies that described important but non-innovation-oriented external relationships. But we also uncovered an important phenomenon: companies, large and small, that described innovation-oriented external relationships reported making extensive use of formal contracts to plan and manage these relationships. They do not, however, generate these formal contracts in order to secure the benefits of a credible threat of formal contract enforcement. Instead, like Macaulay's original respondents, they largely relied on relational tools such as termination and reputation to induce compliance. In this paper we first present examples of this phenomenon from our interview respondents, and then consider how conventional models of relational contracting can be enriched to take account of a very different role for formal contracting, independent of formal enforcement. In particular, we propose that formal contracting -- meaning the use of formal documents together with the services of an institution of formal contract reasoning -- serves to coordinate beliefs about what constitutes a breach of a highly ambiguous set of obligations. This coordination supports implementation of strategies that induce compliance -- despite the presence of substantial ambiguity ex ante at the time of contracting--with what is fundamentally still a relational contract.

Keywords: relational contracts, innovation, reputation, coordination, non-contractual practices, formal contracts, informal enforcement

JEL Classification: D23, K12, L14, L22