On the determinants and consequences of informal contracting

• Date: 01 October 2018
• Published date: 01 October 2018
• Author: Ricard Gil,Giorgio Zanarone
• DOI: http://doi.org/10.1111/jems.12246

726 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jems J Econ Manage Strat. 2018;27:726–741.

Received: 2 July 2015 Revised: 27 November2017 Accepted: 28February 2018

DOI: 10.1111/jems.12246

ORIGINAL ARTICLE

On the determinants and consequences of informal contracting

Ricard Gil1Giorgio Zanarone2

1J.R. Smith School of Business, Kingston,

Canada (Email: rg73@queensu.ca)

2CUNEF, Madrid, Spain (Email: gza-

narone@cunef.edu)

Abstract

As documented by Macauley and others, informal contracts are pervasive in mod-

ern economies. Yet, systematic empirical evidence on them is still limited. In this

paper, we provide a framework to investigate the determinants and consequences of

informal contracting. First, we present an illustrative model that organizeskey predic-

tions from the theoretical literature. Next, we discuss selected empirical works that

shed light on the model's relevance and testability. Overall, we find combined sup-

port for most theoretical predictions from the model, and we observe that significant

progress has been made over time at measuring key determinants of informal contract-

ing such as the parties’ discount factor and fallbackoption. We conclude by discussing

strategies for testing theoretical predictions for which conclusive evidence is still

missing.

1INTRODUCTION

Thanks to scholars like Coase, Williamson, Hart, Holmstrom, and to the empirical works inspired by their theories, the impor-

tance of formal contracts as vehicles of commitment and exchange is now well understood in economics.1At the same time,

economists, sociologists and legal scholars alike have documented the existence and pervasiveness of informal contracts—that

is, contracts that are enforced by parties through the threat of terminating trade, rather than by courts.2For instance, managers

often rely on “hand-shake” agreements to support their deals (Macauley, 1963); firms include in their employees’ compensa-

tion both formal bonuses based on objective performance evaluation and informal ones based on subjective evaluation (Fast &

Berg, 1975); formally centralized companies and governments motivate employees (Foss, 2003) and bureaucrats (Xu, 2011) by

informally promising to delegate authority; and large corporations such as General Motors rely on informal, internally enforced

routines to manage their workers and suppliers (Helper & Henderson, 2014).

Inspired by these and other works, a rich theoretical literature has emerged in economics, investigating the conditions that

make informal contracts feasible (Bull, 1987; MacLeod & Malcomson, 1989), their dynamic patterns (Halac, 2012; Levin, 2002,

2003; Li & Matouschek, 2013; Ray, 2002), and the way formal contracts help sustain and enforce informal ones by reducing

the parties’ temptation to renege on their promises (Battigalli & Maggi, 2008; Baker, Gibbons, & Murphy, 1994, 2001; Klein,

1995, 2000; Klein & Murphy, 1988, 1997; Kvaløy & Olsen, 2009; Zanarone, 2013).3

Despite the ubiquitousness of informal contracts as documented by case studies, there is scarce systematicevidence on whether

existing economic theories correctly predict their determinants and consequences.4In a way, this is not surprising given that,

by definition, informal contracts are difficult to measure. However, direct data on the use of formal and informal contracts is

sometimes available because organizations keepinter nal records of, and optimize upon, these twocontractual forms (Gil, 2013).

We thank Pol Antras, Benito Arruñada, Jordi Blanes-i-Vidal, Alessandro Bonatti, Albert Choi, Oscar Contreras, Gillian Hadfield, Bob Gibbons, Fernando

Gomez, Desmond Lo, Kevin J. Murphy, Lorenzo Sacconi, Orie Shelef, Patrick Warren, Michael Whinston,and audiences at MIT, Pompeu Fabra University,

ISNIE and the AEA Meetings for useful comments and suggestions. This study received financial support from the Spanish Ministry of the Economy and

Competitiveness through grant ECO2014-57131-R.

GIL AND ZANARONE 3

727

Moreover, the existingtheor ies maypredict patterns t hat are uniqueto informal contracting environments, and hence can be used

to develop indirect empirical tests that may be performed using more conventional data on contracts and outcomes. Building on

these observations, in this paper we provide a framework to empirically investigate informal contracts, in the hope that it may

both shed light on the relevance of existing theories and guide future empirical research. To the best of our knowledge, this is

the first such study in the literature.

In the first part of the paper, we present a simple economic model that illustrates how informal contracts can be optimally

combined with formal contracts to provide incentives, and whose predictions can be easily generalized to contractual problems

other than moral hazard, such as adaptation to change (e.g., Baker, Gibbons, & Murphy, 2011; Williamson, 1991). The model

generates three testable predictions. The first is that formal contracts are more likely to be used when self-enforcement of

informal agreements is imperfect—that is, when a low discount factor or an attractive outside option limit the parties’ interest

in preserving their ongoing collaboration. The second, and related, prediction is that a high discount factor, or an unattractive

outside option, increase the parties’ ability to generate surplus under an informal contract. The third prediction is that when

informal contracts are available, parties will not perform as dictated by formal contract terms even though they may sign such

formal contracts to facilitate self-enforcement.

In the second part of the paper, we discuss recent empirical works testing the theoretical predictions from the model. By doing

this, we are not aiming to comprehensively review the empirical literature on informal contracting, but rather to draw inferences

on how to measure and identify key variables that may be replicated by future studies. Hence, wedeliberately focus on selected

works that offer systematic econometric evidence based on strong identification and accurate measurement of variables and/or

promising datasets. Accordingly, we do not discuss purely anecdotal evidence and case studies.

The empirical works we discuss span a variety of industries and contractual settings, including CEO compensation (Gillan,

Hartzell, & Parrino, 2009), movie exhibition (Barron, Gibbons, Gil, & Murphy, 2017; Gil, 2013), procurement (Chassang &

Ortner, 2017; Corts & Singh, 2004; Gil & Marion, 2013; Johnson, McMillan, & Woodruff, 2002), supply chains (Macchiavello

& Miquel-Florensa, 2017), international trade (Macchiavello & Morjaria, 2015), transportation (Jackson & Schneider, 2011;

Gil, Kim, & Zanarone, 2017), and politics (Shelef, 2013).

Overall, we find combined support for most theoretical predictions from the model, and we observe that significant progress

has been made over time at measuring key determinants of informal contracting such as the parties’ discount factor and fallback

option. At the same time we notice that a few theoretical questionsthat naturally emerge from our basic model—mainly,whether

formal and informal contracts are substitutes or complements and how the presence of informal contracts affects the design of

formal ones—are still awaiting clear supportive evidence. In the final part of the paper, we briefly discuss empirical strategies

that may allow researchers to investigate these untested theoretical questions. We also notice that more complex models of

informal contracting than the one analyzed here, such as those in Halac (2012) and Li and Matoushek (2013), generate additional

predictions on the evolution of contractual relationships over time that future empirical researchers may attempt to test. We

discuss some possible strategies for testing those dynamic informal contracting models in a companion paper (Gil & Zanarone,

2016).

The rest of the paper is organized as follows. Section 2 presents our illustrative model and derives testable implications.

Section 3 draws empirical lessons on how to test the model's predictions from selected empirical works on informal contracting.

Section 4 discusses opportunities for future research. Section 5 concludes.

2AN ILLUSTRATIVE MODEL

In this section, we adapt the agency model in Baker et al. (1994), as extended by Gibbons, Li, Li, and Venables (2012), to derive

testable implications that will help us organize the empirical studies on informal contracting discussed in Section 3.5We als o

use the model as a basis for our discussion of future research opportunities in Section 4.

2.1 Model setup

There are a principal and an agent, denoted as P and A, who are both risk-neutral, live forever,and discount next-period payoffs

by the common factor 𝛿∈[0,1]. Time evolves in discrete periods.

At the beginning of any given period, P offers A an incentive contract (hereafter simply a contract), 𝑤(𝑦,𝑝)≡𝑠+𝑏𝑝 +𝐵𝑦,

where 𝑠is a fixed salary, 𝑏and 𝐵are outcome-contingent bonuses, and 𝑝and 𝑦are outcomes to be defined momentarily. If A

rejects the offer, P and A take their outside options, receiving payoffs 𝜋≥0and 𝑢≥0, respectively, such that the joint outside

option is 𝑣≡𝜋+𝑢. If A accepts the offer, he simultaneously chooses a productiveaction,𝑎1∈ℝ+, and an unproductive action,