Contract's Role in Relational Contract

Abstract

What role do contracts play in long-term relationships? Very little, if any, according to the relational contract literature. It is not the contract that induces promise-keeping but the imposition of (or threat of imposing) relational or informal sanctions, such as suspension or termination of trade. Yet, in reality, parties in long-term relationships write elaborate contracts enforceable through litigation (often with vague, open-ended clauses such as “best efforts”) or set up dispute resolution mechanisms that mimic formal adjudication process. Why go through all that trouble if formal mechanisms are to be used rarely? This paper attempts to answer these questions. The paper argues that formal sanctions have two important advantages that informal sanctions often lack. First, with formal sanctions, parties can design the remedy (e.g., liquidated damages) and even the adjudication process (e.g., arbitration), and such flexibility allows them to decouple the deterrence benefit of the sanction from the cost of its imposition in achieving a better deterrence cost-benefit ratio. With relational sanctions, by contrast, both the deterrence benefit and the imposition cost are largely dictated by the value of future relationship: the more valuable the future relationship, the larger the deterrence benefit from threatening to terminate it, but also the larger the cost of carrying out that threat. Second, the formal adjudication process often uncovers evidence that parties and other market actors can use to better tailor relational sanctions. In fact, the desire to generate more accurate information can explain why contracting parties use vague, open-ended standards, such as “best efforts.” Recognizing these benefits but wary of inducing too much litigation, the most effective means for deterring breach of contract will often combine relational and legal sanctions, an approach commonly observed in the real-world. The paper also shows how various empirical findings are consistent with the theoretical predictions and how the findings can inform courts in interpreting “good faith” obligations.