Contract ineffectiveness in emerging markets: An institutional theory perspective⋆

• Published date: 01 September 2016
• DOI: http://doi.org/10.1016/j.jom.2016.07.004
• Author: Zhigang Shou,Xu (Vivian) Zheng,Wenting Zhu
• Date: 01 September 2016

Contract ineffectiveness in emerging markets: An institutional theory

perspective

*

Zhigang Shou

a

,

*

,

1

, Xu (Vivian) Zheng

b

,

1

, Wenting Zhu

c

,

1

a

Department of Marketing, Economics and Management School, Wuhan University, Wuhan 430072, PR China

b

Department of Marketing, College of Business, City University of Hong Kong, Tat Chee Avenue, Hong Kong

c

Department of Marketing, School of Business Administration, Southwestern University of Finance and Economics, Chengdu, PR China

article info

Article history:

Accepted 25 July 2016

Available online 12 August 2016

Accepted by: Mikko Ketokivi

Keywords:

Contract ineffectiveness

Information transparency

Legal enforceability

Efficiency pressure

Equity pressure

Social ties

abstract

The effectiveness of contracts is bounded by the institutional environment in which they are designed

and enforced. When firms form supply chain partnerships in emerging markets, they may experience

contract ineffectiveness, which is defined as a firm's perceived limits of contracts with respect to safe-

guarding interests and coordinating activities. Specifically, we identify two institutional factors that may

give rise to contract ineffectiveness, information transparency and legal enforceability, as they determine

how effectively a firm designs and enforces a contract. In addition, we reveal that contract ineffectiveness

prompts a firm to seek social ties, including business ties and political ties, to overcome the institu-

tionally induced limits of contracts. These efforts, however, are moderated by the type of predominant

pressure a firm bears. While equity pressure strengthens the relationship between contract ineffec-

tiveness and a firm's pursuit of social ties, efficiency pressure weakens this relationship, because seeking

social ties imposes an extra burden of efficiency. Tested by data collected from 187 distributors in China,

our study reveals the institutional causes and the consequences of contract ineffectiveness, which is a

common problem encountered by firms when forming sup ply chain partnerships in emerging markets.

©2016 Elsevier B.V. All rights reserved.

1. Introduction

The role of contracts in governing business transactions has

been well documented in the transaction cost theory (TCT)

framework (Williamson, 1996). By specifying the roles, rights, and

responsibilities of each party, the rules and procedures of trans-

actions, and the remedies for contingencies, contracts enable firms

to coordinate activities (Argyres et al., 2007; Lumineau and

Malhotra, 2011; Salbu, 1997) and safeguard against opportunism

(Poppo and Zenger, 2002; Zhou and Xu, 2012; Zhou et al., 2014).

This in turn helps firms achieve efficient and equitable transaction

outcomes (Poppo and Zhou, 2014;Ring and Van de Ven, 1994). This

formal governance mechanism, however, has its limits (Cannon

et al., 2000; Cao and Lumineau, 2015). For example, contracts are

inherently limited in adapting to environmental uncertainties, thus

allowing exchange partners to behave opportunistically in domains

unspecified by contractual agreements (Cannon et al., 2000; Poppo

and Zenger, 2002; Schepker et al., 2014). To overcome such

adaptability-related limits of contracts, firms may turn to remedial

governance mechanisms (Poppo and Zenger, 2002) such as dyadic

relational governance, which involves developing relational norms

and trust in governing transactions to enhance the capability of

joint problem solving and safeguard against opportunism upon

contingencies (e.g., Cannon et al., 2000; Poppo and Zenger, 2002).

Supply chain management research has paid considerable attention

to how contracts and relational governance substitute for or com-

plement each other (Cao and Lumineau, 2015), with empirical ev-

idence suggesting the possibility for both under different

conditions (e.g., Cannon et al., 2000; Huber et al., 2013; Zhou and

Poppo, 2010).

Yet the limits of contracts may also arise from the institutional

environment in which contracts are designed and enforced, which

*

The authors would like to thank the editors and the three reviewers for their

insightful comments on the earlier versions of this manuscript. The authors also

acknowledge the financial support from the National Natural Science Foundation of

China (Grants No. 71372128, 71172210, and 71532011) and the support from Phi-

losophy and Social Sciences Research, Ministry of Education of P. R. China (Grants

No. 14JZD017).

*Corresponding author.

E-mail addresses: mkshou@whu.edu.cn (Z. Shou), xuzheng@cityu.edu.hk

(X. Zheng), zwt0322@gmail.com (W. Zhu).

1

The three authors contributed equally.

Contents lists available at ScienceDirect

Journal of Operations Management

journal homepage: www.elsevier.com/locate/jom

http://dx.doi.org/10.1016/j.jom.2016.07.004

0272-6963/©2016 Elsevier B.V. All rights reserved.

Journal of Operations Management 46 (2016) 38e54

has received scant attention in previous research. According to

institutional theory (Grewal and Dharwadkar, 2002; Scott, 2001,

2014), the institutional environment in which a firm operates has

a profound impact on the organizational structure and the func-

tionality of contracts. In emerging markets where the legal and

cultural commitment to the use of contracts has yet to be estab-

lished, the effectiveness of contracts may be discounted (Peng,

2003; Zhou and Poppo, 2010; Zhou and Xu, 2012). For example,

the Business Confidence Survey (European Chamber in China and

Roland Berger, 2013) indicates that 76% of European companies

lack confidence in the effectiveness of contracts in China, and they

all regard the improvement of institutional environment as a key

driver of the Chinese economy. In our study, we define contract

ineffectiveness as a firm's perceived limits of contracts with respect

to safeguarding interests and coordinating activities. When forming

supply chain management partnership with different entities, firms

may experience varied levels of contract ineffectiveness, which

renders contract ineffectiveness a relationship-level construct.

However, factors at other levels may also affect contract ineffec-

tiveness. In our study, we take an institutional theory perspective

and aim to examine the impact of institutional factors on contract

ineffectiveness, which in turn prompts firms to seek remedial

governance mechanisms (i.e., social ties). To do so, we need to

overcome the following three limitations of extant research.

First, it is not clear what institutional factors may give rise to

contract ineffectiveness. Specifically, because a contract is most

effective when carefully designed and legally enforced (Argyres and

Mayer, 2007; Zhou and Poppo, 2010), the institutional factorsthat

may affect contract design, enforcement, and thus ineffectiveness

are worth examining. Although a few studies have paid attention to

the role of the institutional environment (e.g., legal environment

hostility) (Cavusgil et al., 2004) in determining the effectiveness of

governance mechanisms in general, they do not explain the rise of

contract ineffectiveness directly. In addition, most have focused on

factors that influence contract enforcement, and thus far, few

studies have identified the institutional factors that may give rise to

contract ineffectiveness by affecting a firm's ability to properly

design a contract.

Second, few studies have investigated how firms respond to

institutionally induced contract ineffectiveness by selecting

different governance mechanisms. If, because of institutional voids,

contracts cannot perform their intended functions of safeguarding

interests and coordinating activities, what do firms do? Top man-

agers' social networking with the business community and gov-

ernment officials is a widely spotted phenomenon in emerging

markets. By providing additional market- and supplier-specific

information and helping enforce contracts, social ties (including

business and political ties) help firms overcome the limits of in-

formation factor markets and legal systems, protecting them

against unlawful and opportunistic behaviors (Sheng et al., 2011;

Xin and Pearce, 1996). To date, surprisingly few studies have dis-

entangled the relationship between contract ineffectiveness and

firms' efforts to seek social ties.

Third, as identified by prior research, achieving efficient and

equitable transaction outcomes are two predominant goals firms

pursue when selecting different governance mechanisms (Ari~

no

and Ring, 2010; Ring and Van de Ven, 1994). Yet again, few

studies have investigated how, in emerging markets where the

effectiveness of contracts is discounted due to institutional de-

ficiencies, efficiency and equity pressure may affect firms' efforts to

seek alternative governance mechanisms. Under considerable ef-

ficiency pressure, for example, firms may be reluctant to continu-

ously invest resources in establishing and maintaining ties with

other business partners and government officials, because doing so

may incur an extra burden of efficiency. Because prior literature on

governance mechanisms has mainly taken an efficiency-based

approach, as reflected in the TCT framework, empirical studies

that consider how equity pressure, in particular, affects a firm's

choice of governance mechanisms are lacking.

Our study attempts to address the aforementioned research

gaps by answering the following two questions: (a) What notable

institutional factors in emerging markets give rise to contract

ineffectiveness? (b) How does the level of contract ineffectiveness,

by itself and in combination with efficiency and equity pressure,

affect firms' efforts to seek business ties and political ties? Inte-

grating TCT and institutional theory, we build a conceptual frame-

work that examines the impact of institutional factors of

information transparency and legal enforceability on contract

ineffectiveness, which in turn affects their efforts to seek social ties,

with and without efficiency and equity pressure, in emerging

markets (see Fig. 1 for the conceptual model). We test our hy-

potheses using primary data from 187distributors in China, and the

results provide strong support for our hypotheses.

Our study aims to offer the following contributions to supply

chain management research. First, our study reveals a common

concern of firms entering into a contractual relationship in

emerging markets (i.e., contract ineffectiveness) and empirically

tests its impact on firms' efforts to seek social ties. Based on prior

research on the functionality of contracts, we formalize the

conceptualization of contract ineffectiveness and provide the

measurement for it. Second, we have identified two specific insti-

tutional factors that may give rise to contract ineffectiveness, in-

formation transparency and legal enforceability, which are defining

characteristics of emerging markets and display significant vari-

ance across a country's regions and industries (Hoskisson et al.,

2000; Luo, 2007; Meyer et al., 2009; Park and Luo, 2001). Third,

our study delineates the boundary condition of developing social

ties by showing how firms' efficiency and equity pressures, in joint

consideration with contract ineffectiveness, affect firms' efforts to

seek social ties. To our best knowledge, the current study repre-

sents one of the first efforts to empirically investigate the different

roles of these two types of pressure in affecting firms' efforts to

pursue social ties.

2. Theoretical underpinnings

2.1. Contract ineffectiveness and institutional causes

Signing a contract constitutes making a promise regarding the

delineated obligations, duties, and responsibilities to the other

party. By making such legally accountable promises, contracts

enable firms to protect individual rights (Bolton and Dewatripont,

2005; Smith, 2004), safeguard against opportunism (Lumineau

and Henderson, 2012; Zhou and Xu, 2012), and coordinate firms'

activities to achieve desired goals of both parties (Lumineau, 2015;

Reuer and Ari~

no, 2007). This viewpoint is echoed by transactional

cost theory, which argues that contracts can minimize transaction

costs through enabling greater administrative efficiency and de-

terring opportunism (Williamson, 1996).

Despite the importance of contracts, theyare inherently limited.

For example, incomplete contracts may fail to adapt to contin-

gencies (Poppo and Zenger, 2002) and thus become “inefficient

mechanisms of governance in the face of uncertainty”(Cannon

et al., 2000, pp. 182e183). Moreover, in an institutional environ-

ment in which the legal and cultural commitment to the use of

contracts has yet to be established, the intended functions of con-

tracts may not be fully realized. For example, Zhou and Poppo

(2010) found that the lower the perceived legal enforceability, the

lower the credibility of contracts in safeguarding one's interest.

Consequently, firms may encounter contract ineffectiveness, the

Z. Shou et al. / Journal of Operations Management 46 (2016) 38e54 39