Session 11: Self-enforcing contracts

Question 1

Informal contracts and repeated relationships

Answer 1

Informal contracts: Seeks to utilize the parties’ detailed knowledge of their situation to adapt to new contingencies once they arise

Repeated relationships: Offers many possibilities for co-operation between opportunistic parties. It has previously been assumed that the principal and the agent conclude a contract only once, which results in a lot of inefficiencies. Ongoing relationships in and between firms serve to reduce the transaction costs of short-term relationships

Question 2

Self-enforcing contracts

Answer 2

A self-enforcing agreement is an agreement or contract between two parties that is enforced only by those two parties (third party enforcement is not involved). This agreement stands so long the parties believe it is beneficial and is not breached by either party.

Question 3

Drivers of self-enforcing contracts

Answer 3

Reputations play an important role because they induce adherence to the informal agreement

Future exchange is dependent on past behavior  Affects current behavior

If the costs of breaking the informal agreement are higher than the short-run gains of breaking the informal contract, then it is credible that the contract will be honored

Question 4

The Folk Theorem

Answer 4

Attractive outcomes can be sustained in as equilibrium outcomes in the repeated prisoners dilemma

Repeated prisoners dilemma (PD): Repetition provides possibilities for establishing an attractive equilibrium outcome in the prisoners dilemma  Repeated interaction allows for punishment in the subsequent period

(see picture in notes)

• Point (0,0): PD equilibrium: Reflects the equilibrium payoffs when the game is played only once
• All the points to the North-east of (0,0) are payoff combinations which can be sustained as equilibrium payoffs in the repeated PD

Question 5

Reciprocity

Answer 5

Folk theorem resolves the prisoner’s dilemma because it introduces reciprocity (i.e., current “bad behavior” can be punished in the future) in the players’ strategies
* Incentive: The perspective of low payoffs in the future when corporation is withheld will prevent each player from exhibiting such behavior

Question 6

Game strategies in repeated games

Answer 6

Tit-for-tat and grim strategies are examples of strategies that can be used in repeated games
Tit-for-tat strategy: Start playing nicely (S); subsequently choose the same action that the other player just took (The winning strategy)
The grim strategy: Start playing S; continue to do so as long as the other player plays S. If he plays T, reciprocate with T forever

Discounted (δ) payoffs in the repeated PD for the tit-for-tat and grim strategy:

(see picture in notes)

The costs and benefits of you making the choice T when the other player retaliates with the grim strategy (remember the loss is being discounted):

(see picture in notes)

If the value of δ is high enough (the future is important enough) then the action T will not be chosen because the costs of choosing T are higher than the benefits

Question 7

Stability of repeated games

Answer 7

The Folk theorem specifies three aspects which determine the stability of attractive long-term relationships:
1. The costs and benefits of finishing a relationship: Illustrated by the height of the columns: If the first column is higher than all the subsequent columns, then it is predicted that the relational contract will fall apart
2. The history of the relationship: A relationship is hard to restore once it has fallen apart
3. The observability of decisions: Cheating on implicit agreements becomes more attractive when the observability of decisions decreases

Question 8

Advantages of self-enforcing agreements

Answer 8

1. Save on transaction costs (Contract drafting costs, Costs of using of third-party enforcement)
2. Allows for contracting when third-party enforcement is not possible
3. Allows for more flexibility
4. Sometimes more incompleteness is better than less
   a. E.g., when clauses can be used as levers for opportunism (e.g., cost-plus contracts); the prevailing contract law insists on full adherence to the terms of the contract
   b. The parties expect that they will only know later what exactly they need, want (e.g., “Statements of Work” in IT development contracts)

Question 9

Formal vs. informal contracts

Answer 9

1. Formal contracts cover more contingencies, then there is less to surplus to remaining to haggle about  Reduces incentive to breach
2. However, if a relational contract is breached, then the penalty is also lower because many other issues and claims are already covered by the complete contract  Increases incentive to breach

 The net effect of the impact of formal contracts on implicit contracts are therefore not clear

Question 10

Impact on governance structure / TCE

Answer 10

(see picture in notes)

Vertical integration then only takes place when, under high levels of asset specificity, contracts are pushed out of their self-enforcing range
* E.g., because of unforeseen changes to legislation, customers’ wants/preferences, etc.
* Gain from hold-up > The other party’s sanction

Question 11

Frydlinger, Hart & Vitasek (2019): Focus of paper

Answer 11

Highlight the issue of traditional contracts and proprose formal relational contracts as a solution

Question 12

Frydlinger, Hart & Vitasek (2019): Traditional contracts and relational contracts

Answer 12

Issue with traditional contracts: In an era when businesses increasingly have to depend on their suppliers to lower costs, improve quality, and drive innovation, traditional contracts don’t work. They often undermine the partner like relationships and trust needed to cope with external uncertainty

Formal relational contract: Specifies mutual goals and establishes governance structures to keep the parties’ expectations and interests aligned over the long term. Designed from the outset to foster trust and collaboration, this legally enforceable contract is especially useful for highly complex relationships in which it is impossible to predict every what-if scenario.

Question 13

Frydlinger, Hart & Vitasek (2019): Use of contracts

Answer 13

Companies have traditionally used contracts as protection against the possibility that one party will abuse its power to extract benefits at the expense of the other

Question 14

Frydlinger, Hart & Vitasek (2019): Hold-up problem

Answer 14

The fear that one party will be held up by the other. The fact that virtually all contracts contain gaps, omissions, and ambiguities only exacerbates hold-up behavior.

Result: In response to the combined problems of hold-ups and incomplete contracts, companies are very likely to make distorted investments that produce poor outcomes

Question 15

Frydlinger, Hart & Vitasek (2019): Shading

Answer 15

One party stops cooperating, ceases to be proactive, or makes countermoves. Shading happens when a party isn’t getting the outcome it expected from the deal and feels the other party is to blame or has not acted reasonably to mitigate the losses
* Not really opportunism or moral hazard; Happens b/c the party isn’t getting the outcome it expected from the deal and feels the other party is to blame
* Reciprocal shading; parties hit a ”bad” equilibrium (that they cannot escape) or the reciprocal shading behavior becomes a death spiral

Question 16

Frydlinger, Hart & Vitasek (2019):