Relational contracts

Question 1

Which two distinct elements are included in a contract?

Answer 1

1. Rational planning of the transaction with careful provision for as many future contingencies as can be foreseen
2. The existence of use of actual or potential legal sanctions to induce performance of the exchange or to compensate for non-performance

Question 2

Businessmen often enter contracts with only a minimal degree of advance
planning.

Answer 2

• Businessmen desire to “keep it simple and avoid red tape” even when large amounts of money and
significant risks are involved. They often prefer to rely on “a man’s word” in a brief letter, a handshake, or “common honesty and decency”.
• It is more likely that businessmen pay more attention to describing the performances in an exchange than to planning for contingencies or defective performances or to obtaining legal enforceability of their contracts (the latter, i.e., legal sanctions, is least likely to happen).

Question 3

The creation of exchanges (which is fairly non-contractual) usually is actually more
contractual than the adjustment of such relationships and the settlement of
disputes.

Answer 3

• Disputes are frequently settled without reference to the contract or potential or actual legal actions.
• There is a hesitancy to speak of legal rights or to threaten to sue in these negotiations.
• Even where the parties have a detailed and carefully planned agreement which indicates what is to happen, if, say the seller fails to deliver on time, often they will never refer to the agreement but will
negotiate a solution when the problem arises apparently as if there had never been any original
contract.

Question 4

Contract planning is common when there is a likelihood that significant problems
will arise

Answer 4

• Complexity of the agreed performance over a long period
• The degree of injury in case of default is thought to be potentially great
• Differences in bargaining position and relative power of the parties to the relationship

Question 5

When are legal sanctions used?

Answer 5

when no other device will work and when the

gains are thought to outweigh the costs (e.g., wrongful termination of a dealer’s franchise by a manufacturer)

Question 6

What is rational contracts?

Answer 6

A self-enforcing agreement so rooted in the parties’ particular circumstances that the agreement cannot be enforced by a third-party such as a court

Question 7

What makes rational contracts credible?

Answer 7

• The net present value from cooperation.
• The net present value from defection.
• Tradeoff: a party will only cooperate if the net present value of the long-term income from cooperation is greater than the net present value of the incomes resulting from defection and punishment.

Question 8

What to the firm do that the court cannot enforce? Instead of enforcing contracts. (business culture)

Answer 8

• good reputation -> more business
• put aside reserves to “rainy days”
• have more than one partner/delivery
• norms
• personal relationships
• want to continue the relationship later
• hold investment/payment