Copyright © 2012 by R. Gibbons and R. Henderson

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

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.

1

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

2

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.

3

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

4

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.

5

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

6

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

7

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

8

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,

9

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.

10

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.

11

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

12

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.

13

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.

14

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

15

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).

16

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.

17

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

18

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.

19

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.

20

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).

21

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.

22

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

24

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.

 

25

ReferencesAnand,B.N.,T.Khanna.2000.DoFirmsLearntoCreateValue?theCaseofAlliances.StrategicManagementJournal21(3)295–315.Aral,S.,P.Weill.2007.ITassets,OrganizationalCapabilities,andFirmPerformance:HowResourceAllocationsandOrganizationalDifferencesExplainPerformanceVariation.OrganizationScience18(5)763–780.Argote,Linda,1999.OrganizationalLearning:Creating,retainingandtransferringknowledge.Springer.Bachmann,R.,A.Zaheer.2006.HandbookofTrustResearch.EdwardElgarPublishing,NorthamptonMa.Baker,G.,R.Gibbons,K.J.Murphy.1994.SubjectivePerformanceMeasuresinOptimalIncentiveContracts.QuarterlyJournalofEconomics109(4)1125–1156.Baker,G.,R.Gibbons,K.J.Murphy.1999.InformalAuthorityinOrganizations.JournalofLaw,Economics,andOrganization15(1)56–73.Baker,G.,R.Gibbons,K.J.Murphy.2002.RelationalContractsandthetheoryoftheFirm.QuarterlyJournalofEconomics117(1)39–84.Baker,G.,R.Gibbons,K.J.Murphy.2011.RelationalAdaptation.WorkingPaper.Barney,J.B.1986.OrganizationalCulture:CanItBeaSourceofSustainedCompetitiveAdvantage?TheAcademyofManagementReview11(3)656–665.Barney,J.B.,M.H.Hansen.1994.TrustworthinessasaSourceofCompetitiveAdvantage.StrategicManagementJournal15175–190.

Bertrand,M.,A.Schoar.2003.ManagingwithStyle:TheEffectofManagersonFirmPolicies.”QuarterlyJournalofEconomics118:1169‐1208Blau,P.M.,W.R.Scott.1962.FormalOrganizations:AComparativeApproach.ChandlerPublishingCompany,SanFrancisco,Ca.Bloom,N.,J.V.Reenen.2007.MeasuringandExplainingManagementPracticesAcrossFirmsandCountries.theQuarterlyJournalofEconomics122(4)1351–1408.Bresnahan,T.,Greenstein,S.andR.Henderson,2011.SchumpeterianCompetitionandDiseconomiesofScope:IllustrationsfromtheHistoriesofMicrosoftandIBM.ForthcominginTheRateandDirectionofInventiveActivity,50thAnniversary

26

Volume,editedbyJoshLernerandScottStern,NBERandUniversityofChicagoPress.Brown,M.,M.Serra‐Garcia.2010.RelationalContractingUndertheThreatofExpropriation‐ExperimentalEvidence.EbcDiscussionPaper,2010‐181–65.Brown,M.,C.Zehnder.2007.CreditReporting,RelationshipBanking,andLoanRepayment.JournalofMoney,CreditandBanking39(8)1883–1918.Bull,C.1987.TheExistenceofSelf‐EnforcingImplicitContracts.TheQuarterlyJournalofEconomics102(1)147–159.Christensen,C.M.1997.TheInnovator’sDilemma.HarvardBusinessPress.Cockburn,I.M.,R.M.Henderson,S.Stern.2000.UntanglingtheOriginsofCompetitiveAdvantage.StrategicManagementJournal21(Fall)1123–1145.Cohen,W.M.,D.A.Levinthal.1990.AbsorptiveCapacity:ANewPerspectiveonLearningandInnovation.AdministrativeScienceQuarterly35(1)128–152.Crawford,VincentP.,Sobel,Joel.1982.StrategicInformationTransmission.Econometrica,Vol.50(6):1431‐51.CyertR.,MarchJ.1963.ABehavioralTheoryoftheFirm.Oxford,UK:Blackwell.DalBo,P.2005.CooperationUndertheShadowoftheFuture:ExperimentalEvidencefrominfinitelyRepeatedGames.AmericanEconomicReview95(5)1591–1604.Duffy,J.,J.Ochs.2009.CooperativeBehaviorandtheFrequencyofSocialInteraction.GamesandEconomicBehavior66(2)785–812.Dyer,J.H.1997.EffectiveInterfirmCollaboration:HowFirmsMinimizeTransactionCostsandMaximizeTransactionValue.StrategicManagementJournal18(7)535–556.Dyer,J.H.,andH.Singh.1998.TheRelationalView:CooperativeStrategyandSourcesofInterorganizationalCompetitiveAdvantage.AcademyofManagementReview23(4)660‐679.Eisenhardt,K.M.,J.A.Martin.2000.DynamicCapabilities:WhatAreThey?StrategicManagementJournal21(Fall)1105–1121.Engle‐Warnick,J.,R.L.Slonim.2004.TheEvolutionofStrategiesinARepeatedTrustGame.JournalofEconomicBehavior&Organization55(4)553–573.

27

Fast,N.,N.Berg.1975.TheLincolnElectricCompany.HarvardBusinessSchoolCase376‐‐028.Fuchs,W.2007.ContractingWithRepeatedMoralHazardandPrivateEvaluations.TheAmericanEconomicReview97(4)1432–1448.Garicano,LuisandTimothyVanZandt.2012.“HierarchiesandtheDivisionofLabor.”ForthcominginR.GibbonsandJ.Roberts(eds.),TheHandbookofOrganizationalEconomics.Princeton,NJ:PrincetonUniversityPress.Geertz,C.1962.TheRotatingCreditassociation:A"MiddleRung"inDevelopment.EconomicDevelopmentandCulturalChange10(3)241–263.Geertz,C.1978.TheBazaarEconomy:informationandSearchinPeasantMarketing.TheAmericanEconomicReview68(2)28–32.Gibbons,R.2005.IncentivesBetweenFirms(andWithin).ManagementScience51(1),pp.2‐17.Gulati,R.,J.A.Nickerson.2008.InterorganizationalTrust,GovernanceChoice,andExchangePerformance.OrganizationScience19(5)688–708.Guriev,S.,A.Kolotilin,K.Sonin.2011.DeterminantsofNationalizationintheOilSector:ATheoryandEvidencefromPanelData.JournalofLaw,Economics,andOrganizationForthcoming.Halac,M.2011.RelationalContractsandtheValueofRelationships.AmericanEconomicReviewForthcoming.Hastings,D.F.1999.LincolnElectric’sHarshLessonsfromInternationalExpansion.HarvardBusinessReview77162–180.Henderson,R.1994.TheEvolutionofintegrativeCapability:innovationinCardiovascularDrugDiscovery.industrialandCorporateChange3(3)607–630.Henderson,R.,I.Cockburn.1994.MeasuringCompetence?ExploringFirmEffectsinPharmaceuticalResearch.StrategicManagementJournal15(S1)63–84.Henderson,R.M.,K.B.Clark.1990.ArchitecturalInnovation:TheReconfigurationofExistingProductTechnologiesandtheFailureofEstablishedFirms.AdministrativeScienceQuarterly35(1)9–30.HofferGittell,Jody,2002.TheSouthwestAirlinesWay,McGraw‐HillKaplan,SarahandRebeccaHenderson,2005.“BridgingOrganizationalEconomicsandOrganizationalTheory”,September‐October2005,Vol16.,No5.,pp509‐521.

28

Kochan,T.A.,H.C.Katz,R.B.Mckersie.1995.TheTransformationofAmericanIndustrialRelations.CornellUniversityPress.Kreps,D.M.1990.CorporateCultureandEconomicTheory.J.Alt,K.Shepsle,Eds.,PerspectivesOnPositivePoliticalEconomy.CambridgeUnivPr.Lazzarini,S.,G.Miller,T.Zenger.2004.OrderwithSomeLaw:Complementarityvs.SubstitutionofFormalandInformalArrangements.JournalofLaw,Economics,andOrganization,Issue20(2),261‐298.Levinthal,D.1997.Adaptationonruggedlandscapes.ManagementScience,vol.43:934‐950.Levin,J.2003.RelationalIncentiveContracts.AmericanEconomicReview93(3)835–857.Lincoln,JamesandArneKallebergCulture,ControlandCommitment,CambridgeUniversityPress,1990Macaulay,S.1963.Non‐contractualrelationsinbusiness:apreliminarystudy.AmericanSociologicalReview,28:55‐67.Macleod,W.B.,J.M.Malcomson.1989.ImplicitContracts,IncentiveCompatibility,andInvoluntaryUnemployment.Econometrica57(2)447–480.Malcomson,J.M.2012.RelationalIncentiveContracts.R.Gibbons,J.Roberts,Eds.,theHandbookofOrganizationalEconomics.PrincetonUniversityPress,Princeton,Nj,Forthcoming.March,J.G.,J.P.Olsen.1989.RediscoveringInstitutions:TheOrganizationalBasisofPolitics.FreePr,NewYork.Marschak,Jacob,andRoyRadner.1972.EconomicTheoryofTeams.NewHaven,CT:YaleUniversityPress.Mcmillan,J.,C.Woodruff.1999.InterfirmRelationshipsandInformalCreditinVietnam.QuarterlyJournalofEconomics114(4)1285–1320.Milgrom,PaulandJohnRoberts.1995.ComplementaritiesandFit:Strategy,Structure,andOrganizationalChangeinManufacturing.JournalofAccountingandEconomics,vol.19:179‐208.Mundlak,Y.1961.EmpiricalProductionFunctionFreeofManagementBias.JournalofFarmEconomics43:44‐56.

29

Nooteboom,B.1996.Trust,OpportunismandGovernance:AProcessandControlModel.OrganizationStudies17(6)985–1010.Ohno,T.1988.ToyotaProductionSystem:BeyondLarge‐ScaleProduction.ProductivityPress.Ostrom,E.1990.GoverningtheCommons:TheEvolutionofinstitutionsforCollectiveAction.CambridgeUniversityPress.Pil,F.K.andJ.P.MacDuffie.1996.TheAdoptionofHigh‐InvolvementWorkPractices.IndustrialRelations.35(3),423‐455.Poppo,L.,T.Zenger.2002.DoFormalContractsandRelationalGovernanceFunctionasSubstitutesOrComplements?StrategicManagementJournal23(8)707–725.Reinganum,J.F.,1989,"TheTimingofInnovation:Research,DevelopmentandDiffusion",inSchmalensee,R.andR.Willig,eds.,HandbookofIndustrialOrganization,Volume1,Amsterdam:NorthHolland.Rivkin,J.W.2000.ImitationofComplexStrategies.ManagementScience46(6)824–844.Robinson,D.T.,T.E.Stuart.2007.FinancialContractinginBiotechStrategicAlliances.JounalofLawandEconomics50(3)559–596.Rotemberg,J.J.,G.Saloner.1986.ASupergame‐theoreticModelofPriceWarsDuringBooms.TheAmericanEconomicReview76(3)390–407.Rousseau,D.M.1989.PsychologicalandImpliedContractsinOrganizations.EmployeeResponsibilitiesandRightsJournal2(2)121–139.Rousseau,D.M.1995.PsychologicalContractsinOrganizations:UnderstandingWrittenandUnwrittenAgreements.SagePublications,inc,LondonUk.Rousseau,D.M.,S.B.Sitkin,R.S.Burt,C.Camerer.1998.NotSoDifferentAfterAll:ACross‐DisciplineViewofTrust.AcademyofManagementReview23(3)393–404.Selten,ReinhardandMassimoWarglien.2007.“Theemergenceofsimplelanguagesinanexperimentalcoordinationgame.”ProceedingsoftheNationalAcademyofSciences104:7361‐66.Senge,Peter.1993.TheFifthDiscipline:Theartandpracticeofthelearningorganization.CrownBusinessPress.

30

Spence,A.Michael.1973.Jobmarketsignaling.QuarterlyJournalofEconomics,87:355‐374.Stewart,J.1993,July26.Takingthedare.TheNewYorker34‐39.Syverson,C.2011.WhatDeterminesProductivity?JournalofEconomicLiteratureForthcoming.Teece,D.J.,G.Pisano,A.Shuen.1997.DynamicCapabilitiesandStrategicManagement.StrategicManagementJournal18(7)509–533.Tripsas,M.,G.Gavetti.2000.Capabilities,Cognition,andInertia:EvidencefromDigitalImaging.StrategicManagementJournal21(Fall)1147–1161.Watson,J.(1999),‘Startingsmallandrenegotiation,’JournalofEconomicTheory,85,52–90.Watson,J.(2002),‘Startingsmallandcommitment,’GamesandEconomicBehavior,38,176–199.Weber,RobertoandColinCamerer.2003.“"CulturalConflictandMergerFailure:AnExperimentalApproach.”ManagementScience49:400‐15.

Wernerfelt,B.1984.AResource‐BasedViewoftheFirm.StrategicManagementJournal5(2)171–180.Williamson,O.E.1993.Calculativeness,Trust,andEconomicOrganization.JournalofLaw&Economics36(April)453–486.Winter,S.G.1987.KnowledgeandCompetenceasStrategicassets.HandbookOnKnowledgeManagement.Ballinger,159–184.Winter,S.G.1988.OnCoase,Competence,andtheCorporation.JournalofLaw,Economics,andOrganization4(1)163–180.Womack,J.P.,D.T.Jones,D.Roos.1991.TheMachineThatChangedtheWorld:theStoryofLeanProduction.Harperbusiness,NewYork.Yamagishi,T.,M.Yamagishi.1994.TrustandCommitmentintheUnitedStatesandJapan.MotivationandEmotion18(2)129–166.Zaheer,A.,N.Venkatraman.1995.RelationalGovernanceasAninterorganizationalStrategy:AnEmpiricalTestoftheRoleofTrustinEconomicExchange.StrategicManagementJournal16(5)373–392.

31

Zaheer,A.andN.Venkatraman,“Relationalgovernanceasaninterorganizationalstrategy:Anempiricaltestoftheroleoftrustineconomicexchange”,StrategicManagementJournal,16(5),(1995),pp.373‐392.