Lecture 11 - Self-enforcing Contracts

Question 1

Mechanisms for enforcing agreement to cooperate & coordinate

Answer 1

• Law, courts, ultimately backed up by state power
• Trust
• Social norms
• The Blockchain
• Adopting a “WE-attitude”
  o Internalize the goals of the relationship
• Self-enforcing agreements
• Reputation
• Threats backed up by private power (e.g., hierarchy)

Question 2

Contractual hazards

Answer 2

Contractual hazards: Problem of opportunism, moral hazard, hold up
- How are these hazards avoided?
- We already looked at contractual safeguards, such as
o Contacting with multiple suppliers (Cluj Hardware)
o Termination for convenience clauses (franchising)
o Owning assets used by supplier (franchising, some supplier relations)

Question 3

Mechanisms for enforcing good behavior

Answer 3

1. The state (formal contracts)
2. Formal relational contracting
3. Irreversible threats
4. Hostages

Question 4

1st mechanism: The state (formal contracts)

Answer 4

• Contractual compliance, and good behaviors more generally, enforced by the state
• Law, police, courts, surveillance… ultimately the state’s monopoly on violence

Question 5

“Shading”

Answer 5

- Shading: Dissatisfied party cuts down on cooperativeness, ceases to be proactive, doesn’t invest in the relationship
o Not really opportunism or moral hazard; happens because the party isn’t getting the outcome it expected from the deal and feels the other party is to blame
 Moral hazard: exploiting asymmetric information
- Reciprocal shading: parties hit a “bad” equilibrium (that they cannot escape) or the reciprocal shading behavior becomes a death spiral

Question 6

2nd mechanism: Formal relational contracting / “We” mentality

Answer 6

• Adopt a ”What’s in it for We” mentality.
• Transparency about aspirations, goals and concerns—e.g., by having relevant counterparts from the different companies mutually clarify this.
• Co-create the goals of the relation.
• Adopt guiding principles designed to prevent hold-up and shading: honesty, loyalty, integrity, etc. and mechanisms that ensure that the parties live up to the principles.
• These guiding principles are court-enforceable if they are written down!
  o In the U.S. and partly in Denmark

Question 7

3rd mechanism: Irreversible threats

Answer 7

To make a threat credible, a player must make an irreversible commitment that changes his or her incentives or constrains his or her action.

Example:
- In 1519, Captain Hernán Cortés landed in Veracruz to begin his great conquest of Mexico.
- One of the first actions of Cortés, was to order the sinking of his ships so there would be no option for his men but to continue. The sinking would set an irreversible course for the conqueror.

If you enter our industry, we will smash you with a price war

Question 8

4th mechanism: Hostages

Answer 8

• Chapter 8 example: Hold-up problem: In the equilibrium of the game, the efficient investment will not be made (0,0).
• But what if the downstream firm posts a valuable ”hostage” (e.g., a bank deposit) before the game starts.
• The hostage —a credible commitment —is forfeit in the event of contract breach.
  o E.g. swapping shares (e.g., recent deal between SKT, KaKao) … self-enforcing deal!

Example
- The hostage/deposit should be at least $30 to make the two options equally attractive

Question 9

The basic (simple) idea of self-enforcing agreements

Answer 9

Underlying self-enforcing agreements is that parties make ”cheating” (engaging in moral hazard, opportunism) expensive.

Question 10

Definition: Self-enforcing agreement

Answer 10

Self-enforcing agreement: 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 11

The Folk Theorem

Answer 11

All positive payoff combinations can be sustained as equilibrium in a repeated prisoners’ dilamma setting

Resolves the prisoners’ dilemma because:
it introduces reciprocity (i.e., current bad behavior can be punished in the future) in the player’s strategies.

Question 12

Strategies in repeated games

Answer 12

Tit-for-tat strategy:
Start playing nicely (S); subsequently choose the same action that the other player just took.

The grim strategy:
Start playing nicely (S); continue to do so as long as the other player plays nicely (S). If he plays badly (T), reciprocate with bad (T) forever.
- Stronger threat, useful to signal that this is the strategy you will play
- Signal by getting a reputation of over the top retaliation, or state publicly your commitment to the strategy

Whether they will bring the optimal choices depends on the costs and benefits of you making the choice T when the other player retaliates with the grim strategy:
- If the benefit (first column) is greater than the sum of all the future costs, you will play T
- If the sum of all the future costs are greater than the benefit, you will play S

Question 13

Determinants of stability

Answer 13

• Costs and benefits of ending a relationship:
  o The interest rate (discount factor for the future cashflows)
  o The profile of costs and benefits across time
• The history of the relationship:
  o E.g., given one person using the grim strategy, a relationship is hard to restore, once it is damaged
• Observability of decisions
• Hostages in the relation

Question 14

When to use self-enforcing contracts depending on frequency & asset specificity

Answer 14

High frequency
Medium & High asset specificity

Self-enforcing agreements can potentially even work in situations with high asset specificity, b/c there’s too much at stake for both parties to behave badly

Question 15

Advantages of self-enforcing agreements

Answer 15

• Save on transaction costs
  o Contract drafting costs
  o Costs of using third-party enforcement
• Allows for contracting when third-party enforcement is not possible
• Allows for more flexibility
• Sometimes more incompleteness is better than less, e.g., when
  o Clauses can be used as levers for opportunism (e.g., cost-plus contracts)
  o The prevailing contract law insists on full adherence to the terms of the contract
  o The parties expect that they will only know later what exactly they need, want

Because of such advantages, parties will usually try to make their agreements self-enforcing, i.e., structure agreements so that the gain from hold-up < loss

Hence, many business contracts are highly incomplete (or even no formal contract)

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
- Gain from hold-up > the other party’s sanction

Question 16

Blockchain governance

Answer 16

Highly codified, like contractual governance, but doesn’t rely in the law
Unlike relational governance, blockchain governance can apply to many anonymous actors

Question 17

Blockchain impact on Transaction costs

Answer 17

Impact on ex ante transaction costs:
- Reduces costs of assessing trustworthiness of transaction partners
- Willingness to commit to the blockchain itself is a signal
- Potentially huge set-up costs (codifying transactions)

Impact on ex post transaction costs:
- Reduces costs of monitoring
- Reduces costs of dispute resolution (everything is transparent)

Question 18

Scope of blockchain governance

Answer 18

Particularly attractive in settings with
- many anonymous actors who are placed in different jurisdictions
- face latent coordination & cooperation problems
- and interact using codifiable information
o E.g., shipping

• Particularly appropriate for “search goods” (i.e., product or service with features and characteristics easily evaluated before purchase) – easy to verify quality

Less useful when
- transactions involve much tacit knowledge,
i.e., it is costly to codify key transaction characteristics

• For experience goods, quality can only verified upon consumption;
• for credence goods, it is inherently difficult to verify quality