A Comparison of Exit and Voice Relationships Under Common Uncertainty

Abstract

We consider a repeated interaction between a manufacturing firm and a subcontractor. The realtionship between the two parties is characterized 1) by moral hazard, 2) by the fact that they do not have perfect knowledge about the base cost level of the project carried out by a subcontractor (the parties only have identical a priori beliefs) and 3) that both subcontractor and manufacturer have access to an additional signal about the base cost level. We consider a two-period model where the players can update their estimate of the base cost level according to incoming information. Short term and long term relationships which are governed by short or long term contracts are compared in terms of the overall expected price of the projects. It is shown that in such a dynamic framework with common uncertainty the precision of the additional signal plays a crucial role in determining the characteristics of the optimal relationship: long term relationships with long term contracts are preferable if the precision of additional information about the base cost level is high. If the precision of the additional signal is low, short term contracts with frequent changes of the subcontractors are optimal for the manufacturer.

Keywords: Agency Relationships, Moral Hazard, Commitment, Learning

JEL Classification: C72, D82, D83