Contracting to (dis)incentivize? An integrative transaction-cost approach on how contracts govern specific investments

Research Summary: Buyer–supplier collaborations are plagued by multiple frictions—haggling, non-contractible adaptation, and resource appropriation. This article examines how contracts govern relationship-specific investment in the face of these frictions. In our model, investment increases the value the supplier creates for the buyer ex post by adapting a component to her needs. At the same time, specific investment exposes the supplier to haggling, while providing him with knowledge needed to appropriate the buyer's preexisting resources. By muting both haggling and adaptation incentives, “closed price” contracts elicit higher investment than “open price” contracts when adaptation is unimportant, and lower investment otherwise. Moreover, an optimal price format seeks to incentivize investment when resource appropriation is unimportant, and to disincentivize investment otherwise. Our evidence on component procurement contracts supports both predictions. Managerial Summary: This study offers new insights on how OEMs govern their collaborations with suppliers. We examine settings where the supplier invests in producing a dedicated component, and ask under which contractual form she is more/less motivated to invest. We find that “closed price” contracts decrease supplier's investment when the component has a complex interface with the OEM's product, and hence is more subject to post-contractual adaptation. We also find that OEMs choose the contract that discourages investment when they possess unique resources that too-closely-involved suppliers may copy or appropriate. Managers at OEMs that possess proprietary technologies and customer bases are exposed to the appropriation downside of suppliers' dedicated investment, and will thus benefit from learning through our study how other professionals address this issue.