This study explores how the relationship specificity of an investment affects the ex-ante structure of contracts and the ex-post resolution of an ensuing hold-up problem.
Incomplete contracting theories have been a central building block for models in finance and economics for almost three decades. They build on the idea that when state contingencies cannot be perfectly observed, described or enforced, contracting parties are often left to settle contractual issues via ex-post renegotiations, which can lead to hold-ups for the parties that have made larger relationship specific investments.
However, despite the widespread use of contracting theories in organizational economics and corporate finance, very few empirical studies have directly tested the extent to which hold-up plays a role in explaining the ex-ante structuring of contracts and whether parties indeed resort to hold-up when the opportunity arises. This study seeks to bridge this knowledge gap, in addition to examining how contracts are renegotiated if one party does resort to hold-up. In addition, the study explores how the relationship specificity of an investment affects the ex-ante structure of contracts and the ex-post resolution of an ensuing hold-up problem, using a randomized-field experiment in the wholesale pen market in Chennai, Tamil Nadu.
The Indian wholesale market for pens was chosen as the venue for the audit study. In the first part of the experiment, auditors were randomly assigned to pose as small businessmen and visit wholesale stores. They negotiated a bulk order of pens with each wholesaler, with an average order size of around 600 pens. The orders consisted of either generic pens that are easy to resell in the market (“plain pens”) or customized pens on which the wholesaler was asked to print a specific logo, which could not be removed once it is printed (“printed pens”). In either case, the wholesalers were required to make relationship-specific investments by ordering the pens from a large distributor and paying upfront for the order. Printed pens required a greater relationship-specific investment from the wholesaler, since the printing charges were borne by the wholesaler, and that pens which were printed could not be used in any other sale. The wholesaler had some scope for hold-up, as they could, in theory, behave opportunistically and not provide timely delivery of the order or charge a higher price at the time of delivery. However, this was unlikely to happen, as it would damage the wholesaler’s reputation. Thus, the shopper had more bargaining power ex-post to renegotiate the price of the order. In the second stage of the experiment, the research team conducted an ex-post renegotiation of the contracts for 75 pen orders (half for plain and half for printed pens). The shoppers called up the wholesaler on the day of delivery to tell him that the order could not be honored in full due to cancellation by the shopper’s ultimate customer and offered to buy the order at a reduced price.
The results of the study show that there is clear support for the importance of relationship-specific investments in contracting. Further, the study reveals that the specificity of the investment affects the bargaining position of the wholesaler. When faced with an actual hold-up, wholesalers are more willing to renegotiate an order ex-post and accept lower prices when the order had been placed for printed pens. The results are surprising given that the salvage value for these printed pens is close to zero and therefore a deviation from the assumption that renegotiation leads to ex-post efficient outcomes.
The underlying cause for the unwillingness to negotiate by the wholesalers is most likely a rational calculation of the benefits of protecting their goodwill. If prevalent social norms were the trigger, then the wholesalers would remain indifferent to the economic impact of their actions. In addition, it is observed that wholesalers expected low hold-up probabilities even from shoppers with whom they have never interacted before, so the reputational Implications for them are minimal. Thus, the study shows how relationship specificity of an investment indeed affects the ex-ante structure of contracts and the ex-post resolution of an ensuing hold-up problem.