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Relational Contracts and Organizational Capabilities R. Gibbons R. Henderson

Working Paper

12-061 January 18, 2012

RelationalContractsandOrganizationalCapabilities

R.GibbonsandR.Henderson

MITandHBS

ForOrganizationScience

Version:July18,2011

AbstractAlargeliteratureidentifiesuniqueorganizationalcapabilitiesasapotentsourceofcompetitiveadvantage,yetourknowledgeofwhycapabilitiesfailtodiffusemorerapidly—particularlyinsituationsinwhichcompetitorsapparentlyhavestrongincentivestoadoptthemandawelldevelopedunderstandingofhowtheywork—remainsincomplete.Inthispaperwesuggestthatcompetitivelysignificantcapabilitiesoftenrestonmanagerialpracticesthatinturnrelyonrelationalcontracts(i.e.,informalagreementssustainedbytheshadowofthefuture).Wearguethatoneofthereasonsthesepracticesmaybedifficulttocopyisthateffectiverelationalcontractsmustsolvethetwinproblemsofcredibilityandclarity,andthatwhilecredibilitymightinprinciplebeinstantlyacquired,claritymaytaketimetodevelopandmayinteractwithcredibilityincomplexways,sothatrelationalcontractsmayoftenbedifficulttobuild.Acknowledgements:Wewouldparticularlyliketothankourresearchassistants,NancyBeaulieuandTommyWang,fortheiryearsofinvaluablesupportinourresearchprogram.WearealsogratefultoourcolleaguesNelsonRepenningandJohnStermanandMITSloan’sProgramonInnovationinOrganizationsandMarketsfortheirsustainedintellectualandfinancialsupport.ThanksforcommentsonthispaperareduetotheeditorsofthisspecialissueandtoDavidGarvin,RanjayGulati,MauroGuillen,SimSitkin,BirgerWernerfeltandSidWinter,andtoseminarparticipantsatColumbiaGSB,HarvardBusinessSchool,KelloggGSM,LondonBusinessSchool,LSE,SydneyandTilburg.

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RelationalContractsandOrganizationalCapabilitiesR.GibbonsandR.Henderson

MITandHBS

ForOrganizationScienceVersion:June15,2011

1) Introduction

Itisnowwidelyacceptedthattherecanbepersistentperformancedifferences

amongseeminglysimilarenterprises—betheyworkgroups,plants,orfirms(seeSyverson(2011)forarecentsurvey).Thestrategyliteraturehaslongexploredthepossibilitythatsuchperformancedifferencesarisefromorganizationalcapabilities(e.g.,Wernerfelt,1984;Teece,PisanoandShuen,1997;EisenhardtandMartin,2000;AnandandKhanna,2000;AralandWeill,2007).Oneofthecentralquestionsraisedbythisresearchiswhysuchcapabilities—iftheyareindeedasourceofsustainedcompetitiveadvantage—donotdiffusemorerapidly.

Theexistingliteraturehasproposedthreeanswerstothisquestion.First,

incumbentmanagersmayhaveproblemsofperception—theydonotknowtheyarebehindbecausetheircognitiveframesblindthemtonewopportunities(e.g.,HendersonandClark,1990;Christensen,1997;TripsasandGavetti,2000).Second,managersmayhaveproblemsofinspiration—theyknowthey’rebehind,buttheydon’tknowwhattodoaboutitbecausetheorganizationalpracticesunderlyingkeyorganizationalcapabilitiesinvolveeithertacitknowledge(e.g.,Winter,1987,1988)and/orcomplementarities(e.g.,Levinthal,1997;Rivkin,2000)andsoarehardtolearnandcommunicate.Third,managersmayhaveproblemsofmotivation—theyknowthey’rebehindandtheyknowwhattodo,buttheydon’tcarebecauselackofcompetitioninthemarket(orlackofincentivesinsidethefirm)givestheminsufficientincentivetoadoptnewpractices(e.g.,Reinganum,1989;BloomandVanReenen,2007;Bresnahan,GreensteinandHenderson,2011).

Whilepersuasiveinmanysettings,thesethreeanswerstotheproblemofslow

diffusionarelesshelpfulinatleastoneimportantcase:settingswheremanagersacknowledgethattheyarebehindandarespendingheavilytocatchup,andwherethereappearstobeindustry‐wideagreementaboutbestpractice.Forexample,therehavebeenmorethan300booksandthousandsofarticleswrittenaboutToyota,yetuntilquiterecentlymanyautomobilecompaniesappearedtohavegreatdifficultyimitatingitspractices(PilandMacDuffie;1996).Similarlythepracticeofscience‐drivendrugdiscoverywassurprisinglyslowtodiffuseacrossthepharmaceuticalindustrydespitewidespreadagreementaboutitseffectiveness(Cockburn,Henderson&Stern,2000).Inthisessay,wearguethatsuchfailuresofdiffusionmayarisefromdifficultiesinadministration—managersknowthey’re

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behind,knowwhattodo,andaremotivatedtodoit,buttheycan’tgettheorganizationtogetitdone.1

Ourargumentisintwoparts.First,wesuggestthatmanyorganizational

capabilitiesrestonmanagerialpracticesthatinturnrelyonrelationalcontracts—aneconomist’stermforcollaborationsustainedbytheshadowofthefuture,asopposedtoformalcontractsenforcedbycourts.Second,wesuggestthatmanyrelationalcontractsarehardtobuildandtorefine,andthatthisisoftenwhymanagers“can’tgettheorganizationtogetitdone.”

Tounpackthefirstpartofourargument—thatkeymanagerialpractices

frequentlyrequirerelationalcontracts—weemphasizethatsuchpracticesinvolveactionsthatcannotbefullyspecifiedinadvance.Considerthefollowingthreeexampleswedevelopbelow.First,LincolnElectric’senduringsuccessrestsinpartonthepaymentofbonusesthatbothmanagersandemployeesconsidertobe“fair,”butnomanualcandefineexactlywhatconstitutesafairbonusforaparticularworkerinaparticularyear.Second,beyondcompensation,theToyotaproductionsystemaskslineworkerstobecome“activeproblemsolvers,”butcannotdefineinadvanceexactlywhichproblemstheymightfindorhowtheyshouldbesolved.Third,beyondmanufacturing,Merckasksitsresearcherstobehave“almostasif”theywereacademics,butwhatthismeansintermsofactualbehaviorshadtobeworkedoutovermanyyearsandisstilldifficulttocommunicatetoday.

Becausethesemanagerialpractices—eachofwhichisfundamentaltothe

successofthesethreefirms—involveactionsthatcannotbespecifiedinadvance,itistypicallyimpossibletomotivatetheirperformanceviaformalcontracts(i.e.,contractsthatattachobjectiveweightstoobjectivemeasures).2Instead,ifitisnecessarytoprovidemotivationforpartiestotaketheseactions,itwillhavetobedonethroughinformalagreementsthatinvolvesubjectiveweightsorsubjectivemeasures.Inthisessayweinterpretsuchinformalagreementsasrelationalcontracts.3

Ofcourse,theideathatrelationalcontractsarewidespreadandimportanthas

alongpedigree,acrossmanydisciplinesandsettings:insociology,Macaulay(1963)studiedinformalrelationshipsbetweenfirms;inanthropology,Geertz(1962,1978)studiedrotatingcreditassociationsandbazaareconomies;andinpoliticalscience,Ostrom(1990)studiedcommunitiesofresourceusers.Morerecently,inthe

1WethankJanRivkinforbringinghis“four‘tion”labelstoourattention(andallowingustoadaptthemforourownpurposeshere).2Underspecialcircumstances,itmightbepossibletowriteformalcontractsbasedonoutcomesratherthanonactionsandtherebymotivatethedesiredactions.Muchmoreoften,however,availableoutcomemeasuresarethemselvesincompleteandsoformalcontractsbasedonsuchmeasuresinducegaminginsteadofconsummateperformance.SeeGibbons(2005)forareview.3Wedonotmeantoimplythatthepresenceofrelationalcontractsimpliesthatthefirmwillnotalsorelyonformalcontracts.Indeedthetwoareoftencomplementary.

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strategyliterature,manyauthorshavedrawnonrelatedideastoanalyzelong,productiverelationshipsbetweenfirms(e.g.,Dyer,1997;DyerandSingh,1998;PoppoandZenger,2002;GulatiandNickerson,2008).

Closertoourfocusonthedevelopmentofmanagerialpracticeswithinfirms,

thereisalsoalongtraditioninorganizationtheoryemphasizingtheimportanceofinformalunderstandingswithinorganizations.Forexample,BlauandScott(1962:6)arguedthat“Itisimpossibletounderstandthenatureofaformalorganizationwithoutinvestigatingthenetworksofinformalrelationsandtheunofficialnormsaswellastheformalhierarchyofauthorityandtheofficialbodyofrules,sincetheformallyinstitutedandtheinformalemergingpatternsareinextricablyintertwined.”Indeed,somehavearguedthathigh‐performingorganizationsrelyespeciallyheavilyoninformalunderstandings,variouslydescribedasnormsorculturesorcontracts.Forexample,Barney(1986)suggestedthatanorganization’sculturecouldbeasourceofcompetitiveadvantage,Rousseau(1989,1995)studiedpsychologicalcontractsinorganizations,explicitlyenvisioningmanagersaspartiestosomeofthem,andalongtraditioninthehuman‐resourcesliteraturehasdocumentedtheperformanceadvantagesofhigh‐commitmentworkpracticesandthesocialcontractsthatsustainthem(e.g.,Hoffer‐Gittell,2002;LincolnandKalleberg,1990;Kochanet.al.,1995).

Toourknowledge,however,thisliteraturehasnotexplicitlylinkedtheseideas

totheideathattheseinformalunderstandingsmaybeoneofthereasonsthatcompetitivelyimportantpracticesaresometimessurprisinglyslowtodiffuse.Muchofthecapabilitiesliterature,forexample,haseithermadetheimplicitassumptionthatincentiveswithintheorganizationarealigned,sothattheadoptionofnewpracticesisprimarilyaproblemofinformationtransmission,orhaslabeled“appropriateincentives”asadistinct,separablecapability.Similarly,whilemanywritershavesuggestedthat“trust”mightbeanimportantsourceoforganizationalperformance(seeforexample,BachmannandZaheer,2006andZaheerandVenkatraman,1995),thisliteratureislargelysilentabouthowtrustisbuiltandso,asfarasweknow,hasnotstudiedhowdifficultiesinbuildingtrustmightbeakeysourceofcompetitiveadvantage.

Hereweexplorethisconnectionexplicitly.Wearguethatmanyrelational

contractsarehardtobuildandrefineandthisisoftenwhymanagers“can’tgettheorganizationtogetitdone.”Inparticular,wearguethatbuildingandrefiningrelationalcontractsrequiressolvingtwodistinctproblems:theproblemofcredibilityandtheproblemofclarity.Webelievethateachoftheseproblemscanbequitedifficultinisolationandthatincombinationtheymaycreateasubstantialbarriertoimitation.

Bytheproblemofcredibilitywemeantheproblemofpersuadingothersthat

oneislikelytokeepone’spromises.Whilecredibilitymayderivefromvarioussources,includingwhattheliteraturehascalled“personal”or“institutional”trust(e.g.,ZaheerandVenkatramen,1995;Nooteboom,1996),inthisessaywefocus

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insteadonastrictlyconsequentialistlogic,whereonekeepsone’spromisesbecausethingswillgobadlyotherwise.Somehavecalledthislogic“calculativetrust”(e.g.,Williamson,1993;BarneyandHansen,1994;Nooteboom,1996),andRousseauet.al.(1998)callit“deterrence‐basedtrust.”Likemanyofthoseauthors,however,weseetheconsequentialistlogicasdistinctanddifferentfromtrust;,likeYamagishiandYamagishi(1994),wewouldpreferthislogictobelabeled“assurance”ratherthantrust.4

Bytheproblemofclaritywemeantheproblemofcommunicatingthetermsof

therelationalcontract.Theproblemofclarityislessdiscussedandperhapslessevidentthantheproblemofcredibility,butwebelievethatclarityisatleastasimportantaconstraintonbuildingandrefiningrelationalcontracts.Inbrief,insteadofaskingwhetherotherswillbelieveone’spromises,wenowaskwhetherotherswillunderstandone’spromises.

Arichliteraturehassuggestedthatonereasonwhymanagerialpracticesmay

beslowtodiffuseisthatknowledgeofsuchpracticesmaybetacitor“embedded”andhencedifficulttocommunicate(see,forexample,Winter’sworkcitedwiththeinspirationproblemabove).Buildingonthisliterature,wearguethatdevelopingasharedunderstandingofarelationalcontractwillbeevenmoredifficultbecausethereismoretocommunicate.Wesuggestthatbuildingarelationalcontractrequiresdevelopingasharedunderstandingofnotonlythenecessarytaskknowledge(whateachpartyissupposedtodo)butalsothenecessaryrelationalknowledge(whateachpartycoulddo,eithertobreakapromiseortopunishsomeonewhodid,andwhatthepayoffsfromallthesepossibleactionsare).

Inadditiontothedifficultiesthattheseproblemsofcredibilityandclarity

takenseparatelyposeforbuildingandrefiningrelationalcontracts,wehypothesizethatthebiggestdifficultiesmayarisefromtheinteractionoftheseproblems.Forexample,ifonepartyactsinawaythatisunexpectedbytheother,ismiscommunicationtoblame,orgaming?Moregenerally,theimperfectalignmentofinterestsunderlyingthecredibilityproblemcreatessignificantnewimpedimentstothecommunicationnecessitatedbytheclarityproblem.5

Theoutlineoftheessayisasfollows.Tolayafoundation,webegininSection2withabriefoverviewofrelationalcontracts.Inparticular,weprovidesomebasicmodelsofwhencollaborationcanbesustainedbytheshadowofthefuture,andwesuggestthatthesemodelsarebroadlyconsistentwithevidencedrawnfrombothlabexperimentsandfielddata.

4Infocusinghereonthequestionofcalculativetrustwedonotmeantoimplythatotherformsoftrustareunimportant.Indeedoneofourhopesforthispaperisthatitmightcontributetotheongoingdiscussionoftherelationshipamongdifferentformsoftrustandtheirevolutionovertime.5SeeSpence’s(1973)signalingmodelandCrawfordandSobel’s(1982)cheap‐talkmodelforanintroduction.

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InSection3,wedevelopourhypothesisthatcompetitivelysignificantmanagementpracticesoftenrelyonrelationalcontractsbyexaminingthreefamiliarexamples:subjectivebonusesatLincolnElectric,theproductionsystematToyota,andscience‐drivendrugdiscoveryatMerck.Ourgoalhereistwofold.First,wehopetomakecrediblethehypothesisthatsomecompetitivelyimportantmanagerialpracticesarecruciallydependentonrelationalcontracts.Whilethisideamaybefamiliarregardingsubjectivebonuses,itseemslessappreciatedregardingothermanagerialpractices.Second,webegintouseourdescriptionsofthesepracticestoillustratetheproblemofclarity—i.e.,theextensiveamountofinformationthatbothemployeesandmanagersmustholdincommonifthenecessaryrelationalcontractsaretobeself‐enforcing.

InSection4weexpandonthequestionofclarity.Webeginbydistinguishing

between“taskknowledge”and“relationalknowledge”,suggestingthatmanyofthesamemechanismsthatmakeitdifficulttolearnhowtodonewtasksalsomakeitdifficulttolearnabouttherelationalcontractsthatmightsupportthem.WeillustratethisideathroughaccountsofmomentsatLincolnElectricandCreditSwissewhererelationalcontractsthreatenedtobreakdown,anddiscussanumberofexperimentsandmodelsthatmayprovidebuildingblockstowardsatheoryofwhyrelationalcontractsmaybehardtobuild.Finally,Section5concludes. 

2) APrimeronRelationalContracts:TheoryandEvidence

Inthissectionweprovideabriefintroductiontoeconomictheoryand

evidenceonrelationalcontracts.Thetheory,inSection2.1,beginswiththesimplestcaseandthensketchesseveralenrichments.Theevidence,inSection2.2,includesbothlabandfielddata.

2.1 Theory:CredibilityfromIncentiveCompatibility

Thereisnowalargetheoreticalliteratureonhowrelationalcontractscan

facilitateefficientbehaviors,bothontheirown(e.g.,Bull(1987),MacLeodandMalcomson(1989),Levin(2003),Fuchs(2007),andHalac(2011))andincombinationwithformalaspectsoforganizationsandcontracts(e.g.,Baker,Gibbons,andMurphy(1994,1999,2002,2011));seeMalcomson(2012)forasurvey.AsdescribedintheIntroduction,theessentialintuitionisstraightforwardandfamiliar:insomesettings,onekeepsone’spromisesbecausethingswillgobadlyotherwise.

Kreps(1990)capturesthisintuitionusingthesimplegameshowninFigure1.

AlthoughKrepscallsthisthe“TrustGame,”weemphasizethattherelational‐contractsargumentisentirelyconsequentialist.Therefore,wewouldprefer“assurance”to“trust.”Inshort,whenspeakingoftrust,weadoptMarchandOlsen’s(1989)viewthat“[t]hecoreideaoftrustisthatitisnotbasedonanexpectationofitsjustification.Whentrustisjustifiedbyexpectationsofpositivereciprocal

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consequences,itissimplyanotherversionofeconomicexchange”(p.27,emphasisadded).Inthisessay,weareindeedconsidering“anotherversionofeconomicexchange.”

Figure1:TheTrustGame

Inaone‐shotversionofthisgame,player1’sinitialchoiceamountstoeitherendingtherelationship(andsoreceivingapayoffofzero)ortrustingplayer2(andsoreceivingapayoffof‐1,assumingthatplayer2wouldmaximize2’spayoffandsobetray1’strust).Sincezeroexceeds‐1,player1shouldendtherelationship.Iftheplayers’relationshipisongoing,however,verydifferentoutcomesarepossible.

Aclassicformulationistomodelarelationshipbetweenplayer1andplayer2asarepeatedgamethatisequallylikelytoendafteranyperiod.Theprobabilitythatthegamewillendinfluencestheinterestraterperperiodthattheplayersuseindiscountingtheirpayoffsacrossperiods.Iftheplayersarepatientenough(i.e.,rissufficientlysmall,inpartbecausetheprobabilitythatthegamewillendissufficientlysmall)thenthefollowing“trigger”strategiesareanequilibriumoftherepeatedgame.

Player1:Inthefirstperiod,playTrust.Thereafter,ifallmovesinallpreviousperiodshavebeenTrustandHonor,playTrust;otherwise,playNotTrust.

Player2:Ifgiventhemovethisperiod,playHonorifallmovesinallpreviousperiodshavebeenTrustandHonor;otherwise,playBetray.

Thebroadermessagefromthisexampleisthatcooperationmaybeproneto

defection,butinsomecircumstancesdefectioncanbemetwithenoughpunishmenttomotivatecooperation.Tobegintogeneralizetheexample,imaginethatplayer2’spayoffs(perperiod)areCfromcooperation(generalizingthepayoff1above),D

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fromdefection(generalizingthepayoff2above),andPfrompunishment(generalizingthepayoff0above),whereD>C>P.Thedecisionofwhethertocooperateordefectthenamountstocomparingtwotime‐pathsofpayoffs:(C,C,C,...)versus(D,P,P,P,...),asshowninFigure2.

Figure2:PayoffsfromCooperationVersusDefectionandPunishmentThetime‐pathofcooperationyieldsahigherpresentvaluethanthetime‐pathofdefectionif

(1) 11

r

C D

1

rP ,

where1/risthepresentvalueofadollartobereceivedeveryperiod(untilthegameends)startingnextperiod.Rearranging(1)yields

(2) r C P

D C,

whichisoftenrestatedas:iftheplayersaresufficientlypatient(i.e.,ifrissufficientlyclosetozero)thenitisoptimaltocooperate,foregoingtheshort‐runtemptation(D–Cnow)forthelong‐termgain(C‐Pthereafter).

Thisstylizedmodelnotonlyillustratesthemainideabehindrelationalcontractsbutalsosuggestssomelimitationsoftheapproach(atleastasithasbeendevelopedandappliedtodate).Oneseeminglimitationmightbethatwehavecasttheplayers–and,morebroadly,thepartiestoanycontractofthistypeasbeingmotivatedby“payoffs,”whichmayseemtoonarrow.Butwetakeabroadviewofsuchpayoffs.Inparticular,wedonotmeantosuggestthatmoneyisthemostimportant—orevennecessarilyanimportant—sourceofmotivationinsidefirms.InSection3(wherewediscussrelationalcontractswithinorganizations),wethereforeconceiveof“payoffs”asincludingeverythingthatmightaffectanindividual’sexperienceofhisorherjob,includingfactorssuchasjobassignment,degreeof

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autonomy,statuswiththefirmorworkgroup,andotherintangiblessuchasfeelingsofbelongingorthatoneismakingadifference.

Amoreseriouslimitationisthattheanalysisleadingto(1)considersonlythepayoffsfromcooperation,defection,andpunishment,takingforgrantednotonlythatthepartiesknowthesepayoffsbutalsothattheyknowwhatactionsconstitutecooperation,defection,andpunishment(suchasTrust,Honor,andBetrayinFigure1).AswewillseeinthedetaileddescriptionsofmanagerialpracticesinSection3,takingitforgrantedthatthepartiesknowwhattheseactionsaremaybeaheroicassumption,especiallywhenthepartiesarejustbeginningtheirrelationship.Fortherestofthissection,however,wecontinuetomakethisassumption(thusimplicitlyfocusingonsteady‐staterelationships,wherethepartieshavesubstantialsharedexperienceabouttheseactionsandtheirpayoffs).

Toconcludethissub‐section,wesketchsomesimpleenrichmentsofthebasic

theory,toprepareforthediscussionofevidenceinthenextsub‐section.First,andinformally,Figure1couldbeenrichedinvariousways,suchasbyallowingtwolevelsofcooperation:fullandpartial.FullcooperationyieldspayoffCbuthasdefectiontemptationD,asabove,whereastheanalogousvaluesforpartialcooperationarecandd,whereC>c>0andD>d>0.Givenplausibleassumptionsaboutthesepayoffs,partiesthatarepatientenoughcansustainfullcooperation,asin(2),whereaspartiesthataresomewhatmoreimpatientcansustainonlypartialcooperation(and,asalways,partiesthataretooimpatientcannotsustainanycooperation).

Second,andshiftingattentionfromcross‐sectionalcomparisonsacross

relationshipstolongitudinalcomparisonswithinanongoingrelationship,imaginethatthereisnotonlyaprobabilitythatthegamewillendafteranyperiod,butalsoanindependentprobabilityaftereachperiodthatthepayoffsinFigure2willchangepermanentlyfrom(C,D,P)to(C,D,P),whereD>D.(Aparallelargumentholdsifthepayoffschangeto(C,D,P),whereP>P.)Ifthepartiesareimpatientenoughthat

(3)C P

D 'C r ,

thencooperationwillendoncethepayoffschange.Nonetheless,ifthepartiesarenottooimpatient(i.e.,risbelowanupperboundnotshownin(3)),thenitisanequilibriumforthepartiestobeginthegamebycooperating,planningtocooperateuntileitherthepayoffschangeorthegameends.

Third,thepayoffsmightneitherbeconstantnorchangepermanently(asinthe

firstenrichment),butinsteadfluctuaterandomlyacrossperiods.Thatis,supposethatthepayoffsareindependentlyandidenticallydistributedovertimeandthatthepartiesobservethecurrentpayoffsbeforetakingactionseachperiod.Inperiodt,

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thecurrentpayoffsfromcooperationanddefectionareCtandDt,andtheexpectedfuturepayoffsfromcooperationandpunishmentareE(Ct)andE(Pt),so(1)becomes

(4) Ct 1

rE(Ct ) Dt

1

rE(Pt ) .

Inthissetting,ifthelong‐termgainofE(Ct)‐E(Pt)ineachfutureperiodoutweighsallpossiblerealizationsoftheshort‐runtemptationDt‐Ct,then(4)impliesthecriticalvalueofrbelowwhichthepartiescansustainpermanentcooperationdespitefluctuatingpayoffs.Alternatively,ifthereareextremerealizationsoftheshort‐runtemptationthatviolate(4)thencooperationwillendoncetheshort‐runtemptationhitsahighenoughvalue,butifthepartiesarenottooimpatientthenitisanequilibriumtobeginbycooperating,planningtocooperateuntileitheranextremetemptationarrivesorthegameends.

Finally,inthemostsophisticatedoftheseenrichments,wherethepartiesmust

repeatedlyadjusttheircollaborationoverthecourseoftheirrelationship,supposethattherearetwolevelsofcooperation(fullandpartial,withpayoffsC>candD>d,asabove)andthatthepayofffromdefectingonfullcooperationfluctuatesrandomlyacrossperiods(e.g.,Dtcanbeeitherhighorlow,DH>DL).Ifthepartiesareimpatientenoughthat

(5)C P

DH C r ,

thenthepartiescannotsustainfullcooperationinperiodswhenthedefectionpayoffishigh.Ontheotherhand,ifthepartiesarenottooimpatient,thenitisanequilibriumforthepartiestoachievefullcooperationinperiodswhenthedefectionpayoffislowandpartialcooperationwhenitishigh.Strikingly,thereisevidenceforthissophisticatedbehavior(aswellastheothersdescribedhere),aswediscussnext.

2.2 EvidencefromtheLabandfromRelationshipsBetweenFirms

Wenowbrieflyintroduceevidencethatmodelslikethesecaptureimportant

aspectsofbehavior.Webeginwiththebasicmodel,summarizedbyequations(1)and(2),afterwhichweturntotheenrichments,summarizedbyequations(3)through(5).Inthissection,werestrictourattentiontolabexperimentsandtofielddataonrelationshipsbetweenfirms,savingdiscussionofrelationshipswithinfirmsforSection3.Alltheevidencewedescribeisonlyillustrative;manyfurtherexamplescouldalsobegiven.

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Condition(1)predictsthatcooperationislesslikelyasthereturnstodefectionrise(i.e.,asDorPincreases).6Asevidenceinthisspirit,considerthefieldstudybyMcMillanandWoodruff(1999)andthelabstudybyBrownandSerra‐Garcia(2010).McMillanandWoodruffuseasampleoffirmsinVietnamduring1995‐97tostudytradecredit(i.e.,theextenttowhichabuyer’spaymentismadesignificantlyafterthesupplierdeliversthegoods).Theyfindthatsuppliersgrantbuyersmoretradecreditiftherearefewersimilarsupplierswithin1kilometerandifthesupplier’smaincompetitorislocatedmorethan1kilometeraway(i.e.,whenpunishmentpayoffsarelowerforbuyers).Turningtolabevidence,BrownandSerra‐Garciaconductanexperimentthatvariesaborrower’sabilitytoexpropriateloanedfundsbyallowing(ornotallowing)theborrowertoreinvestfundsfollowingdefault.Theyfindthatthevolumeoftradedecreasesandthatborrowersaremorelikelytodefault(ininitialperiods)whenexpropriationispossible(i.e.,whendefectionpayoffsarehigher).

Asdirectevidencefortheideathatcooperationismorelikelyinenvironments

withlowerdiscountrates,aspredictedby(2),considertheexperimentbyDalBo(2005),whoconductsarepeatedPrisoners’Dilemmaandvariestheprobabilitythatthegamewillbecontinued.DalBofindsthathigherprobabilitiesofcontinuation(whichimplylowervaluesofr)leadtohigherratesofcooperation.Engle‐WarnickandSlonim(2004)providearelatedexperimentalfinding.

Therearealsoindirectexamplesof(2),basedontheideathattheremaybe

morethantwopartiesavailableanddifferentpairingsofpartiesmayoccurovertime.Asableakbaselinecase,supposethattherearemanyparties,thatpairingsarerandomeachperiod,andthateachpartyknowsonlyitsownexperience(i.e.,thereisnoinformationaboutwhatotherpartiesdidwhileinotherpairings).Inthiscase,itislikelytotakemanyperiodsbeforeagivenpairmeetseachotheragain,sorishighandcooperationisunlikely.Buttherearevariousalternativestothisbleakbaselinecase,eachofwhichcanbeinterpretedasreducingrandsomaking(2)morelikelytohold,asfollows.

Inlabstudies,BrownandZehnder(2007)allowpartiestochoosetheir

partnerseachperiod,leadingtobothlong‐standingrelationshipsandimprovedcooperation,andDuffyandOchs(2009)findgreatercooperationinfixedpairsthaninrandompairs.Usingfielddata,RobinsonandStuart(2007)studybiotechnologyalliances,findingthatalliancepartnerswithcloserproximitytoeachotherintheindustrynetworkarelesslikelytouseequity(anduselessequitywhenitisinvolvedinthedeal)andusemorefundingpledgedupfrontratherthanfundingbasedonmilestones.Similarresultsholdwheneitherofthefirmsismorecentralintheoverallnetwork(asdistinctfrommoreproximatetoitspartner).Thesefindingsareconsistentwiththeideathatfirmsthataremoreproximate(andhencemore

6Forfixedparameters,either(1)holdsoritdoesnot,socooperationiseitherpossibleornot.Ifweimaginedatawith,say,heterogeneousvaluesofC,however,thenanincreaseinDorPcanbesaidtoreducethelikelihoodofcooperation,suchasinthesenseofaprobit.

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likelytoencountereachother)ormorecentral(andhencemorelikelytohavetheiractionsvisibletoothers)arelesslikelytodefect.

Turningfromcross‐sectionalevidencetolongitudinal,recalltheideathatan

increaseinthedefectiontemptationcaninducedefection,asdiscussedinconnectionwith(3)and(4).Inthisspirit,Guriev,Kolotilin,andSonin(forthcoming),studynationalizationsofforeign‐ownedoilassetsin161countriesfrom1960‐2006.Duringthisperiodtherewere98nationalizationsin42countries.Controllingforcountryfixedeffects,theyfindthatnationalizationismorelikelywhenoilpricesarehigh(i.e.,defectionpayoffsarehigh)andwhenpoliticalinstitutionsareweak(i.e.,punishmentcostsarelow,sothepayoffduringpunishment,Pdiscussedwith(3),ishigh).Theseindependentvariables—theoilpriceandpoliticalinstitutions—maybesomewherebetweenthepermanentchangeenvisionedin(3)andthetemporaryfluctuationenvisionedin(4).

Finally,asevidenceonthesophisticatedbehaviorin(5),wherethepartiesrepeatedlyadjusttheircollaborationoverthecourseoftheirrelationship,considerRotembergandSaloner(1986),whostudyvariationsintheextentofcollusionoverthebusinesscycle.Intheirmodel,fullcollusion(whereallfirmschargethemonopolyprice)producesmoderaterenegingtemptationsinlow‐demandperiodsbuthigherrenegingtemptationsinhigh‐demandperiods,sothecolludingfirmscanimplementonlypartialcollusioninthehigh‐demandperiods,asdiscussedinconnectionwith(5).Empirically,RotembergandSalonerstudybothprice‐costmarginsoverthebusinesscycleforavarietyofindustries,aswellasactualpricewarsinspecificindustries,andinbothcasesfindevidencebroadlyconsistentwiththeirtheory:marginsaresmallerinbooms(i.e.,cooperationisreducedatmomentswhendefectiontemptationsarehigher).

Toconcludethissection,werecaptheargumentwehavemadethusfar.First,

repeated‐gamemodelsofcollaborationpredictthatcooperationcanoccurifdefectioncanbemetwithsufficientpunishment(wherepunishmentoccursovertime,sotheprospectofpunishmenthasagreaterimpactonparties’currentdecisionswhentheycaremoreaboutthefuture).Second,inbothlabstudiesandfielddataonrelationshipsbetweenfirms,thereareempiricalfindingsthatareconsistentwithsuchmodels.Asnotedabove,however,boththemodelsandtheevidencewehavedescribedfocusontheproblemofcredibility(i.e.,whetheroneactorshouldbelieveanother’spromises)andignoretheproblemofclarity(i.e.,whetheroneactorcanunderstandanother’spromises).Theythusimplicitlyfocusonsteady‐staterelationships,wherethepartieshavesubstantialsharedexperienceabouttheiractionsandpayoffs,andavoidtheproblemofhowthesesteady‐staterelationshipscomeabout.

Inthenextsection,weaddtwoaspectstoourargument.First,weconsider

relationalcontractswithinfirmsratherthanbetween.Inparticular,wedescribethreeimportantmanagementpracticesthatweseeasrelyingcruciallyonrelationalcontracts.Second,weprovidesufficientlydetaileddescriptionsoftheserelational

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contractswithinfirmstosuggestthatitcannothavebeeneasytodevelopasharedunderstandingofexactlywhatthesecontractsentailed,thuslayingthegroundworkforamoreextendeddiscussionoftheproblemofclarityinsection4.

3) ManagerialPracticesandRelationalContracts

Wenowdescribeimportantmanagerialpracticeswithinthreeleadingfirms:

subjectivebonusesatLincolnElectric,theproductionsystematToyota,andscience‐drivendrugdiscoveryatMerck.Ineachofthesesettings,wefocusonkeyactionsthatwebelievecouldnotbemotivatedbyformalcontractsandthatwethushypothesizearethesubjectofrelationalcontracts.WetreatLincolnbriefly,becauseitcorrespondsreasonablywelltothemodelinSection2.1,whereonepartyreliesontheothertokeepitspromises,butwediscussToyotaandespeciallyMerckinmoredetail,becausetheyillustratethemoretypicalandmoreinterestingcasewhereeachpartyisrelyingontheother.

Inadditiontopresentingaplausiblecasethatcompetitivelysignificant

managerialpracticesrelyonrelationalcontracts,ourgoalinthesedescriptionsistobegintoillustratetheideathatbuildingarelationalcontractmayrequireaddressingproblemsofclarityaswellasofcredibility.Weshowthattheserelationalcontractsrequirenotonlyahighleveloftaskknowledge—i.e.,oftheactionsthatconstitutecooperation,butalsoagreatdealofrelationalknowledge—i.e.,ofthepayofftocooperationforeachparty,ofeachparty’sabilityandincentivetodefect,andoftheactionsandpayoffsthatconstitutepunishment.Section4buildsonthesedescriptionstoexploretheproblemsinherentinbuildingrelationalcontractsinmoredetail.

LincolnElectricmakesarcwelders.Theirproductivity,innovation,and

profitabilityhavemadethemarguablytheworld’sleaderintheirindustry,andtheirmanagementpracticeshavebroughtthemsubstantialscrutiny—fromFastandBerg(1975)throughHastings(1999)andbeyond.Forbrevity,wefocusonthefirm’sincentivescheme,whichinvolvesbothapiecerate(specifyingtherateofpaypertaskcompleted)andasubjectivebonus(basedonfactorsthatcanbedifficulttomeasure,suchasdependability,quality,andideas/cooperation).SeeMilgromandRoberts(1995)fordescriptionsofhowLincoln’sotherpracticescomplementthesubjectivebonuswedescribe.

Lincoln’sbonusisveryimportantforboththeworkersandthefirm:over

severaldecades,theaveragebonustoanindividualwasapproximatelyaslargeastheindividual’stotalpiece‐ratepay(dependingonthepersonandtheyear)andtheaveragebonuspoolwasabouthalfofthefirm’spre‐tax,pre‐bonusearnings(againwithsubstantialvariationacrossyears).Crucially,however,neithertheindividualbonusreceivedbyaworkernortheaggregatepoolpaidbythefirmisdeterminedbyaformula(i.e.,anobjectiveweightattachedtoanobjectiveperformancemeasure).Instead,botharediscretionary.

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InthelanguageofSection2,Lincoln’sworkersmayearnhighpayoffsfromworkinghard,asbonusescanapproachhalfoftotalcompensation,butsincepaymentofthebonusisdiscretionary,Lincoln’smanagementcaninprincipledefectbypayingtoosmallabonusornoneatall.Severalformalmodelshaveexploredtheconditionsunderwhichsuchadiscretionarybonusplansatisfiesacredibilityconstraintsuchasequation(1)above.7Butthesemodelsignorethedegreetowhichsuchcontractsmustalsosolveapotentiallysevereclarityproblem:Lincoln’srelationalcontractrestsonanumberofsharedunderstandingsthatmaywellbedifficulttoimitate.Forexample,thesizeofthebonusiscontingentnotonlyontheproductivityofanemployee,butalsoontheemployee’s“dependability,”the“quality”oftheirworkandthedegreetowhichtheycontributednewideasand“cooperated”intheimprovementoftheproductionprocess—noneofwhichiseasytodefineormeasure.

Asimilarrelianceonrelationalcontracts—andanassociatedrelianceonthe

developmentofanextensivesharedunderstandingofconceptsthatareintrinsicallyhardtodefinewithoutsharedexperience—isevidentinournextexample,fromToyota’sproductionsystem(TPS).

ManyresearchershavedocumentedthattheTPSreliesoninnovative

contributionsbytheworkforcethroughshop‐floorproblem‐solving(see,forexample,Ohno,1995andWomack,JonesandRoos,1991).Thekindsofbehaviorsaskedoftheworkforceinclude“raiseproblemswhenyouseethem”and“beaneffectivememberofproblem‐solvingteams.”AswiththeaspectsofworkerperformancethatarerewardedinLincoln’ssubjectivebonus,weconjecturethatthesedesiredbehaviorsinToyota’sproductionsystemcannotbespecifiedpreciselyenoughtobemeasuredandrewardedinaformalcontract.

Asoneexample,akeydiscretionarybehavior(bybothworkersand

supervisors)involvesthe“andoncord”(aropeontheassemblylinethat,whenpulledbyaworker,sendsanalerttosupervisorsthattheremaybeaproblemontheline).Ifthesupervisorfailstoresolvethepotentialproblem,thenpullingtheandoncordmayresultinstoppingtheline—anenormouslydisruptiveeventinmanycontinuous‐flowproductionsystems.Buildinganeffectiverelationalcontractaroundtheuseoftheandoncord—andaroundparticipationinproblemsolvingmorebroadly—requiresnotonlysolvingthecredibilityproblem,butalsodevelopingasharedunderstandingofahostofsubjectiveideas.Forexample,bothemployeesandmanagersmustdevelopasharedunderstandingofquestionssuchaswhichtypesofproblemsareworthpullingthecordforandhowsupervisorsshouldrespondinthosecasesinwhichthecordhasbeenpulledinappropriately.Theymustalsolearnatwhatpoint,ifany,willsupervisorspenalizeworkers(financially

7SeeBull(1987),MacLeodandMalcomson(1989),andLevin(2003)forrepeated‐gamemodelsofsuchrelationalincentivecontractsandBaker,Gibbons,andMurphy(1994)foratwo‐partpayplanlikeLincoln’s,combininganobjectivepieceratewithadiscretionarybonus.

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orsocially)formistakesinpullingthecord,andwhatkindsofrewardsareappropriatewhenthecordhasbeenusedwell.

Noticethateventhissimplifieddiscussionoftheuseoftheandoncordraises

animportantissuenotpresentintheTrustGameinSection2orinourdiscussionofLincoln’sbonus.IntheTrustGame,Player1chooseswhethertotrustPlayer2,whothenchooseswhethertohonor/cooperateorbetray/defect.Likewise,inLincoln’sbonus,theworkerissubjecttothefirm’sdiscretionoverwhatbonustopay.Withtheandoncord,however,eachpartyisbeinggivendiscretionbytheother:theworkertostopthelineandthemanagertoimplementworkersuggestionsandtosupportproblemsolvingin“appropriate”ways.Wesuspectthatsuchmutualdependenceismoretherulethantheexception.Butinsuchsettings—wherebothpartiescancooperate,defect,andpunish—evenmoreknowledgemustbeheldincommoniftherelationalcontractistobesustainable.Toillustratethismutualdependence,andmorebroadlythecomplexityoftheknowledgeonwhichrelationalcontractsoftenrely,Table1sketchessomeofthepotentialactionsbyworkersandmanagersthatmustbemutuallyunderstoodinordertobuildarelationalcontractaroundtheuseoftheandoncord.

Table1:Cooperation,Defection,andPunishmentintheuseoftheAndoncordatToyota. Cooperate Defect PunishWorker Actions:

1.Pulltheandoncordwhenyouseeaproblem2.Offersuggestionsonimprovementstotheproductionprocess(thatmightmakeyourjobredundant)

Actions:1a.Neverpulltheandoncord(outoffearofbeingpunished)1b.Pulltheandoncordtostopthelineandavoidworkwhenthereisnotrueproblem2.Keepimprovementshiddenfromco‐workersandmanagers

Actions(inresponsetoperceiveddefectionbymanager):1.Sabotagethemanufacturingline2.Pullandoncordfrequently3.Engageinabsenteeism

Supervisor Actions:1.Recognizepotentialproblemwhenandoncordpulledandaidinproblem‐solving2.Implementimprovementswithoutnecessarilycuttingjobs3.Acceptauthorityofworkteamstomakesomeshop‐floordecisions

Actions:1.Punishworkersforpullingandoncord(evenappropriately)2.Cutworkforceoncetheydiscoverpotentialinnovations3.Interfereinworkteamsandoverridetheirdecisions

Actions(inresponsetoperceiveddefectionbyworker):1.Penalizeworkers(financiallyorsocially)forpullingandoncord2.Removetheandoncord

JustasourdiscussionofLincoln’sbonusignoredahostofcomplementary

practicesthatsustainperformanceatLincoln,hereourdiscussionofToyota’sandon

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cordfocusesononlyonesmallaspectoftheTPS.Nonetheless,eventhissmallaspectillustratestherangeofknowledgethatmayberequiredtobuildthenecessaryrelationalcontract.Furthermore,whiletheseissuesareimportantinmanufacturingsettingssuchasLincolnandToyota,theyareperhapsevenmoreimportantinknowledge‐worksettings,whichweillustratenextbydiscussingscience‐drivendrugdiscoveryatMerck.

Formanydecades,pharmaceuticalresearchfirmsattemptedtodiscovernew

drugsthroughalarge‐scaleprocessoftrialanderror.Forexample,severalsuccessfulpsychotropicdrugswerediscoveredbyputtinglargenumbersofpotentiallybiologicallyactivecompoundsintodistressedratsandchemicallytinkeringwiththefewcompoundsthatseemedtohavesomeeffectontherats’behavior(Henderson,1994).Thisprocessofdrugdiscoveryreliedprimarilyontheskillsofhighlytrainedmedicinalchemistswhocoulddesignandconstructchemicalcompoundsthatwerelikelytohavepharmacologicaleffects.Evenforverysuccessfuldrugs,however,thespecificbiochemicalmechanismsresponsibleforthedrug’stherapeuticeffectswereoftennotwellunderstood.

Beginninginthe1980s,advancesinthescientificliteratureofferednew

understandingsofthebiochemicalmechanismsunderlyingmanydiseases,makingitpossiblefordrugcandidatestobetargetedatspecificmechanisms.Pharmaceuticalfirmsseekingtochangefromtheoldprocessofdrugdiscovery(large‐scaletrialanderror)toanewone(basedonthemechanismsofdisease)neededtoundergoseveralsignificantchanges(Henderson,1994).First,completelynewkindsofscientistshadtobehired,suchasmolecularbiologists.Second,thenewprocessrequiredrichcommunicationacrossscientificdisciplinesandtherapeuticareas,whereastheoldprocesshadperformedwellwhenconductedindisciplinaryandfunctionalsilos.Finally(andmostimportant,forourpurposes),thenewprocessrequiredthefirm’sscientistsnotonlytostaycurrentwiththepromisingmechanismsbeingdiscoveredintheacademicliteraturebutalsotoconductsuchleading‐edgesciencethemselves,in‐house.

Perhapsnotsurprisingly,stayingcurrentwiththeacademicliteratureinvolved

morethansittinginthefirm’slabandreadingthejournals.Forexample,therewasgreatvalueinalsoattendingconferences,butonetypicallycouldnotfullyunderstand(or,insomecases,evenbeinvitedto)manyconferenceswithouthavingone’sownactiveresearchinthearea—aclassicinstanceof“absorptivecapacity”(CohenandLevinthal,1990).Asaresult,somepharmaceuticalfirmsencouragedtheirscientiststopublish—eventhoughofcourseanultimategoalwastosecurepatentsondrugcandidates.HendersonandCockburn(1994)callafirm“PROPUB”ifanindividualscientist’scareerinsidethefirmdependedonthescientist’sstandingintheoutsidescientificcommunity,andtheyfindthatpatentoutputissignificantlygreaterinPROPUBfirms(evenwithdummyvariablesfortherapeuticareaandfirm).

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Thisnewprocesshasbeenlabeled“science‐drivendrugdiscovery”(Cockburn,Henderson,andStern,2000).Notethatitisnotthemerepresenceofmoreordifferentscientistswithinpharmaceuticalfirmsthatpromptsthislabel;forexample,thereweremanysyntheticchemistsinvolvedintheoldprocess.Rather,thelabelreflectsthefactthatthenewprocesswithinthefirmreliessoheavilyoninteractionswithandassessmentsfromtheoutsidescientificcommunity.Itisthisroleforthescientificcommunity(andthepossibletensionofthisrolewiththefirm’sgoalofpatentsondrugcandidates)thatweexploreasafinalexampleofboththepresenceofrelationalcontractsunderlyingkeymanagerialpracticesandthedifficultiesinbuildingarelationalcontract,asfollows.

Firmspursuingscience‐drivendrugdiscoveryneededscientiststobehave

almostasiftheywereacademicscientists—toexplorequestionsoffundamentalscientificinterest,topublishintherefereedliterature,andtoattendacademicconferences.Atthesametime,however,thesescientistscouldnotactcompletelylikeacademics.Theyhadtoalsotakeactionsthatincreasedthelikelihoodofthediscoveryofnewdrugs.Makingamajorscientificbreakthrough—evenwinningaNobelprize—withoutsimultaneouslygeneratingknowledgethatcouldbequicklyappliedtothesearchfornewdrugswouldnotconstitutefullsuccess.Thosefirmsthatsuccessfullydevelopedthissharedunderstanding,ofwhomMerckisthemostwellknown,introducedmore“significant”drugsandgrewfasterthananyoftheircompetitors,butthepracticewasrelativelyslowtodiffuseacrosstheindustry(Cockburn,HendersonandStern,2000).

Weseescience‐drivendrugdiscoveryasacomplexmanagerialpracticethat

cannotbesustainedwithoutarelationalcontract.Nomechanisticformulacouldtellaresearchsupervisorwhetheraparticularscientistwasappropriatelystraddlingthefinelinebetweenbehavinglikeanacademicscientistandbehavinglikeacommerciallyorienteddrughunter,andthusnoformalcontractalonecouldensurethatresearcherswerebehavingasthefirmdesired.Stayingconnectedtotheacademicworldrequiredpublishinginthejournalsandattendingconferences—butnoonecouldspecifyhowmanypapersascientistshouldpublishandwhichconferencesheorsheshouldattend,particularlywheneveryscientist’sresearchtrajectorywaslikelytobedifferent.Whenwasgoingtoconferencesvitaltotheresearch,andwhenwasitconsumption?Andonthemanager’sside,whenascientisthadpublishedextensivelyinavitalnewfieldbutfailedtoreceiveanincreasedresearchbudget,washermanagerrenegingontherelationalcontractorrespondingappropriatelytothefactthatthescientist’slabstillhadnotproducedanyplausibledrugcandidates?

Table2sketchesourconceptionofcooperation,defection,andpunishmentfor

thescientistandthemanagerintherelationalcontractunderlyingscience‐drivendrugdiscovery.AswithLincoln’sbonusandToyota’sproductionsystemourdescriptionhereisnecessarilypartial,butitnonethelessillustratestheextentandcomplexityoftheinformationthatmustbeunderstoodbyallpartiesifthenecessaryrelationalcontractistobeself‐enforcing.

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Table2:Cooperation,Defection,andPunishmentinScience‐DrivenDrugDiscovery Cooperation Defection PunishmentScientist Action:behavealmost

likeanacademicscientist,butbesuretodevelopusefulknowledgefordiscoveringnewdrugs.

Action:eithershirk(representlackofresultsasunluckyresearch)orbehavelikeanacademicscientist(pursueproblemsfortheirownsake,buildexternalreputation)

Action(inresponsetoperceiveddefectionbymanager,andperhapsdependingonnatureofthatdefection):behavelikeanacademicscientist,orignoreresearchandbecomeadrughunter

Manager Action:rewardthescientistwhodisplayshigh‐sciencebehaviorevenifnonewdrugsresult.

Action:failtoincreaseresourcesforscientistswhopublish;rewardonlythosewhoproducedrugs

Action(inresponsetoperceiveddefectionbyscientist,andperhapsdependingonnatureofthatdefection):firethescientist,orcutfunding

4) BuildingandRefiningRelationalContracts OurdescriptionsofsomeoftherelationalcontractsinplaceatLincolnElectric,ToyotaandMerckhavehighlightedboththatmanysignificantmanagerialpracticesmayrelyonrelationalcontractsandthatthe“relationalknowledge”thatisrequiredtosustainthesecontractsmaybeveryextensive.

Inthissectionwebuildonthesetwoideastofocusmoresquarelyonthekeyquestionofwhyrelationalcontractsmaybehardtobuildandrefine—andhencehardtoimitate.Thethreecasesinsection3constitutesamplingonsuccess,inthesensethatthoserelationalcontractsdidgetbuilt.Forasharperviewofthedifficultiestheclarityproblemcancreate,wenowsamplefromtheotherendofthedistribution,whenfailuretocommunicateandtheresultinglackofsharedunderstandinginhibitedthedevelopmentorrefinementofrelationalcontracts.4.1 BuildingClarity:TaskandRelationalKnowledge

InourdescriptionsofLincoln,Toyota,andMerck,wesawthatdevelopingasharedunderstandingofthedesiredbehaviorswasnoteasybecausetherewasuncertaintyaboutbothappropriateactionsand(althoughwedidnotemphasizeitasmuch)associatedpayoffs.WecanstatethesedifficultiesabstractlyusingFigures1and2.ToparticipateintherelationalcontractinvolvingthoseFigures,player1needstoknow(a)whatbehaviorsconstitutecooperationbyher(TrustratherthanNotTrust),(b)whatbehaviorsarethenavailabletoplayer2ascooperationordefectionbyhim(HonorandBetray,respectively),(c)whatpayoffsplayer2wouldreceivefromthoseavailablebehaviors(1versus2inFigure1,orCversusDin

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Figure2),and(d)whatpayoffsplayer1wouldreceiveifeveryonecooperatesversusnot(1versus0inFigure1).8

Ofalltheactionsandpayoffsdescribedin(a)through(d),only(a)seemstous

akintowhatissometimescalledtaskknowledge(i.e.,howoneshouldbehaveintheorganization),sowehereaftercall(b)through(d)theadditionalrelationalknowledgeneededtoparticipateinarelationalcontract.AsnotedintheIntroduction,otherresearchtraditions(e.g.,Winter(1987,1988)ontacitknowledgeorLevinthal(1997),MilgromandRoberts(1995)andRivkin(2000)oncomplementarities)havemadeimportantstridesexploringthedifficultiesoflearningandcommunicatingtaskknowledge.Ashardasitmaybetolearnorcommunicateone’sowntaskknowledgein(a),however,itmustbeatleastashardandpresumablyhardertolearnsomeoneelse’staskknowledgein(b),butplayer1cannotparticipateintherelationalcontractwithoutthisunderstandingofplayer2’savailablebehaviors,aswellastheassociatedpayoffsin(c).Inthissense,thereissimplymore(anddifferentandprobablyharder)knowledgetolearnandcommunicateinthecaseofarelationalcontractthaninthecaseofone’sowntaskknowledge.Notice,too,thatthetaskmaybefurthercomplicatedbythefactthatifallgoeswellandbothpartiescooperatewitheachother,eventsofftheequilibriumpath—i.e.,thebehaviorsandpayoffsassociatedwithbothdefectionandpunishment—cannotbeobservedbutmustbeinferred.

Asonestrikingexampleofthedifficultyofcommunicatingrelational

knowledge,wereconsiderLincolnElectric.AfterdecadesofhighproductivityandapparentlyappropriatebonusesintheirClevelandoperations,Lincolnexpandedoverseas,withinitiallyverynegativeresults(Hastings,1999).Infact,earningsinClevelandwereatrecordlevels,butoverseaslossesweresolargethatthecompanyasawholewasinthered.Anewquestionthusaroseaboutwhatconstituteda“fair”bonusforClevelandworkers:shouldthebonusbebasedonClevelandprofitsoronthoseofthefirmasawhole?Naturally,whenthefirmhadoperationsonlyinCleveland,thisdistinctionneverarose,butithadsuddenlybecomecrucial.Formally,therewasnowdeepambiguityaboutwhichofmanagement’sactionswouldbeconsidered“cooperation”.

WeprovidetheresolutionofLincoln’sstoryinthenextsub‐section.Fornow

wesimplynotethatevenalongstandingrelationalcontractmaynotentailsharedunderstandingofallthedesiredbehaviorsinallthepossiblecircumstancesthatcouldarise.Inasimilarspirit,EllisonandHolden(2009)analyzeamodelwhereaprincipalattemptstoteachanagenthowtorespondtofluctuatingcircumstances.Formally,thetimingofeachperiodis:(1)theagentobservesthestateoftheworld,(2)theagentchoosesanaction,(3)theprincipalobservesthestateandsendsamessagetotheagent,and(4)bothpartiesreceiveacommonpayoffthatispositiveiftheagentchoosetheappropriateactionforthestateandzerootherwise.The8RecallfromSection2.1thatplayer1needstoknow(b)and(c)toassesswhetherplayer2willcooperate;ifso,player1thenneedstoknow(a)and(d)todecidewhethertocooperateherself.

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novelassumptionintheEllison‐Holdenmodelisthattherearesomestatesoftheworldthatthepartiescannotdiscussuntiltheyhaveexperiencedthemtogether.Inthissetting,therecanbemoreorlessusefulearlyrealizationsofthestate,allowingmoreorlessusefulinstructionsfromtheprincipaltotheagent.Tothedegreethatthisphenomenonisrealitsuggeststhatthedevelopmentofrelationalcontractsmaybesignificantlypath‐dependent,withsomestatesoftheworldenablingthecreationofmuchmorerobustcontractsthanothers;seealsoourdiscussionofChassang(2010)below.

Asasecondcaseaboutlackofsharedunderstanding,considerStewart’s

(1993)accountofhowCreditSuisse,alargeEuropeanbank,boughttheUSinvestmentbankFirstBoston,takingthecompanyprivateunderthenameCSFirstBoston(CSFB).Roughlyspeaking,inthefirsttwoyearsthatCreditSuissecontrolledCSFB,allfirmsintheinvestment‐bankingindustryperformedpoorlyandemployeesreceivedbonusesthatwerelowerthanthehistoricalaveragebutcomparabletobonusespaidatotherinvestmentbanks.Inthethirdyear,however,CSFBperformedbetterthanpreviouslyandyetworsethanitscompetitors,andCreditSuissepaidbonusesthatwereabovebonusesatCSFBinthefirsttwoyearsbutlowerthanthoseatotherfirmsinthethirdyear.Acrisisensued.Inbrief,CSFBassertedthatthebonuspolicyintheirindustrywasmatch‐the‐market,meaningthatbonusesshouldbecompetitivewithbonusesatothertop‐bracketfirms.Incontrast,theSwissassertedthatintheirindustrythebonuspolicywaspayforperformance,meaningthatabanker’sbonusdependedonhowheandhisbankperformed.Notethatthesetwopoliciesmakeidenticalpayprescriptionswhenallfirmsintheindustryhavethesameperformance,aswasbroadlytrueinthefirsttwoyears.Moregenerally,partieswithdifferentunderstandingsmaynotappreciatethatthisdifferenceexistsuntilkeyeventsoccur—withthefurthercomplicationthatbehaviorbyonepartyduringsuchaneventmaybeintendedascooperationbutnonethelessbeviewedbytheotherasdefection.

Forinspiringevidencethatdifferentgroupscanindeedreachdifferentshared

understandingsinsimilarenvironments,considerthelabstudiesbyWeberandCamerer(2003)andSeltenandWarglien(2007).Bothexplorecommon‐interestgames,wheretwoplayersreceivethesamepositivepayoffiftheysuccessfullycoordinate,buttheyreceivenopayoffiftheyfailtocoordinate.Morespecifically,theplayersareattemptingtobuildasharedlanguageduringrepetitionsofagamelikethefollowing:(1)player1observesthestateoftheworld,sS;(2)player1sendsacostlessmessagetoplayer2,mM;(3)player2choosesanactionaS;(4)payoffstoeachplayerareU(s,a)=1ifa=sandU(s,a)=0otherwise;(5)player2observess.Thus,player1wouldliketosendamessagem(s)thattellsplayer2thatthestateiss(sothatplayer2willthenchoosetheactiona=s).Theproblemisthat,atleastintheearlygoing,player2haslittlebasisforunderstandingplayer1’smessages.

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Bothpapersfindthatdifferentpairsofplayersdevelopdifferentlanguages,eventhoughthesepairsareplayinginthesameenvironment(exceptfortherandomrealizationsofthestatesoftheworldovertime).Becausethesearecommon‐interestgames,weinterprettheknowledgebeingcommunicatedastaskknowledge,notrelationalknowledge.Inparticular,thereisnoconcernwithdefectionorpunishmentinacommon‐interestsetting.Nonetheless,consistentwiththelargeliteratureonthedifficultiesofcommunicatingtacitknowledge,differentpairsofplayerstakedifferentlengthsoftimetodevelopasharedunderstanding,anddifferentpairsholddifferentsharedunderstandingsoncetheyreachthem.Fromthislabevidence,wefinditonlyasmallstretchtoimaginethatsimilarforcescouldcausereasonablepeopletoholddifferentunderstandingsinsituationslikethoseatLincolnorCSFB.Ofcourse,theissueatthesetwocompaniesinvolvedbonuses,sothesewerenotcommon‐interestsettings;rather,theproblemofcredibilityalsoarose,aswediscussnext.4.2 TheDynamicsofCredibility

Beyondthefactthatimplementingarelationalcontractrequirescommunicatingnotonlytaskknowledgebutalsorelationalknowledge,thereisanotherdifficultythatcomplicateslearningandcommunicatingarelationalcontractcomparedtolearningandcommunicatingtaskknowledge:relationalcontractsarerelevantonlywhengoalalignmentisimperfect.9Thus,whatevertheinformationthatneedstobecommunicated(taskand/orrelational),itmaynotbeinsomeone’sinteresttorevealthatinformation.Instead,informationmightbewithheldordistorted.Thereisofcourseanenormouseconomicsliteratureontheseissues,andwenotethatdiscussionalongtheselinesstartedinorganizationtheorybeforeinformationeconomicsororganizationaleconomicsexisted,suchasinCyertandMarch(1963).10Thequestionweface,however,ishowimperfectalignmentofinterestsaffectsparties’effortstobuildarelationalcontract(aspartofamanagerialpractice).

ReturningtoouraccountsofLincolnElectricandCreditSuisseFirstBoston,we

findtwodifferentscenariosunfoldingafteralackofsharedunderstandingwasdiscovered.AtLincolnElectric,wherethequestionwaswhetherCleveland’sbonusesshouldbebasedonClevelandprofitsoronthoseofthefirmasawhole,thefirmultimatelydecidedinfavoroftheformerprinciple(eventhoughdoingso

9 Thepartoforganizationaleconomicscalled“teamtheory,”initiatedbyMarschakandRadner(1972),canbeinterpretedasexploringinformationacquisition,communication,anddecision‐makingwhenallpartieshavethesameinterests(butgatheringandcommunicatinginformationarecostlyactivities).SeeGaricanoandVanZandt(2012)forarecentdiscussionofapproachesinthisvein. 10Forexample:“Where different parts of the organization have responsibility for different pieces of information relevant to a decision, we would expect some bias in information transmitted due to … attempts to manipulate information as a device for manipulating the decision. … [But] we cannot reasonably introduce the concept of communication bias without introducing its obvious corollary – ‘interpretive adjustment’” (pp. 79 and 85, Cyert and March, 1963).

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requiredthefirmtoborrowinordertopaythebonus).AtCSFB,incontrast,CSstucktoitspolicyofpayforperformance(ratherthanthebankers’preferredpolicyofmatchthemarket),leadingtothedepartureofmanyprominentbankers.

Therearemanywaystorelatethedynamicsofthesecasestotheoriesofthe

kindwehaveconsideredinthisessay.Ourpointhereisnottoendorseparticulartheoreticalinterpretationsofthesetwocases,butrathertosurfacethegeneralissuethatthesecasespresent:howwillpartiesrespondwhenapossiblemisunderstandingsurfaces?Wenowsketchthreecomplementaryapproachestothisissue,inthehopethatfurthertheoryandevidenceonthedynamicsofrelationshipswillensue.

Oneapproach,inthespiritofSection2.1,istoimaginethatthecritical

momentsinthesecasescorrespondtosuddenchangesinpayoffs.Forexample,CreditSwissemayhavereachedapointwherethedefectiontemptationpermanentlyincreasedfromDtoD,alongthelinesof(3),causingthebanktodefect.(Toputthispointlessabstractly,itmaybethatwhattheSwisswantedallalongwasaglobalfinancialsupermarket,forwhichitneededaninvestmentbank,butnotnecessarilyatop‐bracketinvestmentbank,sotheygaveuponthelatterwhenitspriceincreased.)ButthisandanyotheranalysisfromSection2.1assumesthatthepartieshaveasharedunderstandingofwhatactions(inwhatstates)constitutecooperationintheirrelationship,whereasthebankersatCSFBandtheirSwissownersapparentlydidnothavesuchasharedunderstanding.Wethereforeturntomodelswherethepartieshavesomethingtolearn.

ManyauthorshaveenrichedthecredibilitymodelsfromSection2.1toinclude

privateinformationaboutplayers’payoffs,sothatpartieslearnabouttheirpartnersasanequilibriumprogresses;seeMacLeodandMalcomson(1988),Watson(1999,2002),andHalac(2011),forexample.Asanillustration,inFigures1and2,supposethatplayer1isuncertainaboutplayer2’sdiscountrate,whichplayer1believescouldbehigh(rH)orlow(rL).Inmodelslikethese,itcanbeoptimaltoterminatearelationshipafterlearningenoughbadnewsaboutone’spartner’stype(perhapsasatCS).Likewise,itcanbeoptimaltoenricharelationship,suchasmovingfrompartialtofullcooperation,afterlearningenoughgoodnewsaboutone’spartner’stype.Asaresult,onecouldimagineplayer2searchingforwaystosignalthatsheisthepatient(or“hightrust”)type,rL,soastoinducegreatercooperationfromplayer1.

Modelsoflearningaboutone’spartneroftensuggestempiricalapproaches

basedonunmeasurablemanagerialattributes.Suchempiricalworkhasastrongtradition,fromatleastMundlak(1961)throughatleastBertrandandSchoar(2003).Butthereisanalternativeapproachthatalsoshedslightonperformancedifferences,basedonpath‐dependenceratherthanunmeasuredheterogeneity.Chassang(2010)offersonemodelinthisalternativespirit,inwhichaPrincipalandanAgentbuildarelationalcontract,asfollows.

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In each period, the Principal first chooses whether to invest or not, whereinvestingimposesacostkonthePrincipalbutdeliversabenefitbtotheAgent(andnot investing delivers zero to both parties and ends that period). If the PrincipaldoesinvestthendifferentactionsfromthefeasiblesetArandomlybecomeavailablethatperiod,andbothpartiesobservewhichactionsareavailablethatperiod.

In the feasible set A there are two kinds of actions, unproductive and

productive.AnunproductiveactioncostsnothingfortheAgenttotakebutproducesno output for the Principal, whereas a productive action costs c to take andproducesagivenpositiveoutputwithprobabilityqandzerowithprobability1‐q.Itiscommonknowledgewhat thenumberofproductiveactions isandwhatagivenproductiveactionproduceswhenitproducespositiveoutput,butinitiallyonlytheAgentknowswhichactionsaretheproductiveones.

In the first period, to induce theAgent to take a productive action (if one is

available)insteadofanunproductiveaction,thePrincipalthreatensnottoinvestinseveralfutureperiodsifthisperiod’soutputiszero.Notethatthispunishmentwilloccur on the equilibrium path, because a productive action could produce zerooutput. In this sense, learning (i.e., identifying a new action as productive) isexpensive.Ontheotherhand,laterinthegame,ifanactionhasalreadyproducedapositive output then the Principal knows that the action is productive, so if theAgentnowtakesthisactionanditproduceszerooutputthenthePrincipaldoesnotneedtopunishtheAgent.

Because learning is expensive (in the sense of punishments, and also in the

senseofopportunitycostafteratleastoneproductiveactionhasbeenidentified),itcanbeoptimaltostoplearningbeforeallproductiveactionsareidentified.Becauseopportunitiestolearnarriverandomly,otherwiseidenticaldyadsmaystoplearningafteridentifyingdifferentsetsofproductiveactions.Thatis,eachdyadconvergestoa steady‐state relational contract, but different dyads can converge to differentrelationalcontracts thatproducevaryingdegreesofcooperation.Thus,Chassang’smodel can produce persistent performance differences among otherwise similardyadsbecauseofpath‐dependenceinbuildingarelationalcontract—verymuchinthespiritoftheadministrationproblemthatanimatedthisessay.

5) Conclusion

Anextensiveliteraturehassuggestedthatorganizationalcapabilitiesare

difficulttoimitatebothbecausetheyrequirethecommunicationoftaskknowledgethatisoftendeeplyembeddedinorganizationalroutinesandbecauseproblemsofcomplementarityandlocalsearchmeanthattheprocessesofincrementallearningthatcharacterizemanyorganizationsmakeitdifficulttocommunicatethisknowledge.Herewehaveattemptedtodevelopacomplementaryexplanationfortheoftenslowdiffusionofcompetitivelysignificantcapabilitiesbyfocusingonthefactthatmanykeymanagerialpracticesrelyonrelationalcontracts,andby

23

suggestingthatbuildingtheserelationalcontractsrequiresmovingbeyondtaskknowledgetothedevelopmentof“relationalknowledge.”Wesuggestedthatrelationalknowledgemaybesubstantiallymoredifficulttodevelopthantaskknowledgebothbecausethereismuchmoreofitandbecauseitsacquisitioniscomplicatedbyincentiveproblems.

Whilewehopethatthisargumentiscompellingasahypothesis,thereis

clearlymuchthatremainstobedonetoproveitsvalidityanddetermineitsboundaryconditions.Forexample,whileitiswellestablishedthatorganizationsarerepletewithrelationalcontracts,andwhilewebelievethatmanycompetitivelysignificantmanagerialpracticesrelyonrelationalcontracts,carefulempiricalworkthatputtheseideastothetestwouldclearlybeuseful.Similarly,empiricalworkthatexploredthedevelopmentofrelationalcontractsovertimeasanintegralpartofthedevelopmentofmanagerialpracticeswouldalsobeofsignificantvalue.Oneapproachmightbetobeginwithcarefulqualitativestudiesandthenprogresstomoresystematic,potentiallysurvey‐basedworkthatcouldenablecomparisonsacrossfirmsovertime.

Wealsosuspectthattheseideas,iftheydoindeedproverobusttocareful

empiricalinvestigation,mayhavesignificantimplicationsformanagerialaction.Aconsiderableliteraturehasexploredtheprocessesthatenablefirmstobecome“learningorganizations”(see,forexample,Argote,1999andSenge,1993).Onecouldimagineacomplementaryfocusontheprocessesthatenablefirmstobuildrelationalcontracts.Extensiveandcrediblecommunicationisalmostcertainlyimportant,andwesuspectthatinmanycircumstancestheabilitytocommunicateconvincinglythatoneisa“hightrust”typewouldbeveryuseful.Anotherpossibilityisthatmanagerswhoexcelinthedevelopmentofrelationalcontractstakeadvantage—orperhapsevencreate—situationsthattestthelimitsofthecurrentcontracttothentakeactionsthatrefinethecontract,suchasbycommunicatingcrediblyaboutotherwiseunrevealedpayoffsandpreferences.Similarlyitmightbethecasethatsuccessfulmanagersdeveloptheabilitytochangerelationalcontractswithouttriggeringtheperceptionthattheyarerenegingonexistingagreements;KaplanandHenderson(2005)suggestthatthelatterperceptionmaybeasignificantbarriertoorganizationalchange.

Anotherpotentialextensionoftheseideasistoexploretheirimplicationsfor

theroleoforganizationalcultureandritual.Onepointofconnection,forexample,mayflowfromthefactthataneffectiverelationalcontracttendstoachievecooperation,ratherthandefection.Asaresult,itmaybeeasytoforget(orfornewcomersnevertohaveobserved)whatsomeoneelse’sopportunitiesfordefectionmightbe,orhowtemptingtheseopportunitiesmightbe,orwhatsomeoneelse’sopportunitiesforpunishmentmightbe,orhoweffectivethesepunishmentsmightbe.Thissituationisakintoonewhere“meansbecomeends,”whereapersonorgroupforgetswhyitdoessomething,andinsteadremembersonlywhatitiscurrentlysupposedtodo,thusleavingitselfunpreparedtorespondtofluctuating

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circumstances.Partiestoarelationalcontractthereforemighttellstories:toremindeachotherofwhatcouldoccur,andtosketchappropriatebehaviorifitdoes.

Morebroadlywebelievethatourframingopensupsomeintriguingissuesas

totherelationshipbetweenthedynamicsofconventionalrelationalcontracts(i.e.,purely“calculative”trust)andotherformsofsocialcapital.Astheextensiveliteratureontrusthasdemonstrated,organizationsareshotthroughwithbeliefsandexpectationsderivedfrompersonalandsocialdynamicsthatgiverisetomanydifferentkindsoftrust.Wehopethatourattempttoclarifytheroleofrelationalcontractsmaycontributetothedevelopmentofabroaderunderstandingoftherelationshipamongdifferentformsoftrustandtheirrolewithinthefirm.Withinthefirm,forexample,arecalculativeandaffectiveand/orsocialtrustcomplementsorsubstitutes?Mightitbethecasethatfirmscharacterizedbyhighlevelsofpersonaltrustfinditsignificantlyeasiertobuildandrefinenewrelationalcontracts?

Organizationalresearchershavelongsuggestedthattheinformalstructuresof

firmsarecriticallyimportanttotheirperformance—andthatinsomecircumstanceshigh‐commitmentworkpracticesortheabilitytosustainhighlevelsoftrustmaybeverypowerful.Ourhopeisthatbylinkingtheseideastotheanalyticalconstructofarelationalcontractwewillbeabletocatalyzefurtherresearchintheareaand,ultimately,tosupportpracticingmanagersinbuildingeffectiveorganizations.Ifbuildingrelationalcontractsisasimportantaswebelieveittobe,researchthatyieldsinsightintothemechanismsbehindtheirdevelopmentandthestrategicchoicesonwhichtheyrestcouldmakeanimportantcontributiononawidevarietyoffronts.

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