Substitutes or Complements? Exploring the Relationship between Formal Contracts and Relational Governance
32 Pages Posted: 28 Apr 2000
Date Written: April 17, 2000
Transaction cost economics advocates that greater exchange hazards be met either with more tightly crafted contracts or, when the costs of crafting and enforcing complex contracts are sufficiently high, with vertical integration. However, many argue that transaction cost economics vastly overstates the need for either integration or contractual safeguards in exchange settings commonly labeled as hazardous. In many industries, firms engage in complex, collaborative exchanges that involve rather high levels of asset specificity and are characterized by other known hazards, yet are managed without vertical integration and with limited formal contracts. These relational exchange arrangements supported by trust are viewed as substitutes for complex contracts or vertical integration. Others argue that formal contracts may in fact undermine trust and thereby encourage, rather than discourage, opportunistic behavior. In this paper, we develop and test an alternative perspective - that formal contracts and relational governance function as complements. Using data from a sample of information service exchanges, we find empirical support for this complementary position. Managers appear to accompany their increasingly customized contracts with increased levels of relational governance (and visa versa). Moreover, this interdependence underlies their ability to generate improvements in exchange performance. Implications as well as related hypotheses regarding the determinants of relational governance and contracts are also explored.
JEL Classification: L14, L22, L33, L86
Suggested Citation: Suggested Citation