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Accounting, Organizations and Society 27 (2002) 213±238

Incentive issues in inter-®rm relationships$

Stanley Baiman *, Madhav V. Rajan
The Wharton School, University of Pennsylvania, Accounting Department, Philadelphia, PA 19104, USA

This paper discusses the incentive problems to which buyer-supplier transactions are subject and, by surveying the
incentives literature, discusses some of the inter-®rm design instruments that can be used to mitigate these problems.
Most of the literature discussed is based on the incomplete contracting model, which is better suited to analyzing inter-
®rm issues. We also discuss some of the managerial accounting issues which are raised by this literature and suggest
some managerial accounting issues for further research. # 2002 Elsevier Science Ltd. All rights reserved.

1. Introduction dealt with by negotiations between independent

®rms. If such externalities are large, they may not
With the recent increase in competition resulting be adequately dealt with through arm's-length
from deregulation, globalization, and the increased transactions. Rather, there may be value to
speed of technology innovation, ®rms have recog- the ®rm working out more elaborate relations with
nized the need to compete more e€ectively by its suppliers and thereby viewing itself, not in
reducing costs, improving quality and reducing the isolation, but as part of a supply chain or net-
time it takes to bring their products or services to work.1
market. To achieve these improvements, many Successful supply chain management is char-
®rms have restructured their internal operations, acterized by several features including: an earlier
often outsourcing activities which were formerly involvement of suppliers in the buyer's design
done internally. The claimed advantage of doing process, greater information sharing among the
so is that the ®rm can concentrate on doing only parties, and investments by all parties aimed at
what it does best (its so-called ``core competence'') reducing the supply chain's cost and improving the
and contract with independent suppliers to pro- quality of the supply chain's output. Successful
vide its non-core activities. The disadvantage is management of the supply chain requires ®rst that
that any externalities between the activities the members be able to identify which technologi-
retained and those outsourced, which were pre- cal changes will result in improved supply chain
viously internalized within the ®rm, must now be eciency. Second, it requires that the members be
willing to make these changes. The diculty is
that, without changing the contractual relations
Earlier drafts of this paper were presented at the AOS-
USC Conference in Los Angeles in November 1999 and the
between the supply chain members from that
EIASM Workshop On Accounting and Economics IV in
Copenhagen in June 2000. 1
Dell Computer is one of the ®rms most cited for making
* Corresponding author. this change. See Andrews (2000).

0361-3682/02/$ - see front matter # 2002 Elsevier Science Ltd. All rights reserved.
PII: S0361-3682(00)00017-9
214 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

which would characterize an arm's-length and other relevant issues can be addressed
relationship, an identi®ed technological change with complete contracting models and we will
may require one member to bear the cost of the discuss the relevant ideas from that literature as
change but another member to capture most of well.
the bene®t of the change.2 Thus, successful supply In the next section, we ®rst de®ne what we mean
chain management requires not only the ability to by a complete contract and then discuss some of
identify potentially valuable investments, but also the relevant insights from that literature for
the ability to design inter-®rm relations among understanding inter-®rm transactions. In Section
the supply chain members that mitigate buyer- 3, we introduce the idea of incomplete contracting
supplier incentive problems and thereby support and illustrate the basic incentive problem asso-
the implementation of those investments. ciated with it. In Section 4, we discuss the di€erent
The purpose of this paper is to discuss the ways in which the ineciencies created by that
incentive problems to which such buyer±supplier incentive problem can be mitigated. Section 5
transactions are subject and, by surveying the contains a discussion of the implications from the
incentives literature, to discuss some of the inter- previous discussion for managerial accounting and
®rm design instruments that can be used to miti- managerial accounting research.
gate these problems. Given that we are interested
in buyer±supplier transactions, we want to restrict
our attention to the literature which models such 2. Complete contracting
inter-®rm transactions, as opposed to that which
models intra-®rm transactions. Unfortunately, A contract is complete if: there are no restric-
there is no consensus on what distinguishes intra- tions on the feasible set of contracts from which
®rm from inter-®rm transactions.3 Therefore, we the contracting parties can choose; all information
will survey only those papers whose models and that will be jointly observed by the contracting
issues can most naturally be interpreted in terms parties can be speci®ed by them at the time of
of inter-®rm transactions. Issues which are more contracting and will be veri®able by a court; and
likely to arise in such transactions include: the role there are no out of pocket costs associated with
of observable but unveri®able information; the writing or enforcing contracts. Complete con-
misappropriation by one contracting party of tracting has several powerful implications. For
ideas and technology brought by the other con- example, with complete contracting, there is no
tracting party; and the interactive e€ect of the role for ®at or discretionary authority.4 It is at
contracting parties' outside opportunities and least as ecient to specify ahead of time the
their agreed-upon contractual relationship, imply- behavior that is required of an employee for each
ing the need to model rather than exogenously contingency than to rely on the discretion of the
assume those outside opportunities. We feel employer. Further, with complete contracting,
that most of these issues are better captured within asset ownership is irrelevant; any rights associated
incomplete contracting models and, hence, most with asset ownership can be assigned to others
of our discussion will be of the incomplete through the chosen contract.
contracting literature. However, some of these A convenient way of organizing the insights
from the complete contracting literature for the
See Baiman, Fischer and Rajan (in press) for a theoretical design of inter-®rm transactions is in terms of two
analysis of the redistributive e€ects of quality enhancing interrelated decisions which any buyer and sup-
investments within a buyer±supplier relationship. See Bradsher plier must make: allocating the tasks which must
(2000) for a discussion of the diculties associated with be accomplished between them (i.e. the sourcing
increasing information sharing within the automotive industry
because of its potential redistributive e€ects.
3 4
For di€erent views on the nature of intra vs. inter-®rm Fiat authority arises when, in return for a ®xed salary, one
transactions see Grossman and Hart (1986); Hart (1995); Wil- person agrees to behave as directed by another person, as long
liamson (1975, 1996). as the requested actions are within some set of actions.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 215

decision) and choosing the contractual arrange- hidden information and hidden action problems
ments which will govern their relations. which arise from outsourcing that particular task,
As noted above, the initial distribution of asset but the e€ect on the overall buyer±supplier rela-
ownership is irrelevant when contracts are com- tionship. For example, assume that the supplier is
plete. In such settings, the most basic question already producing a product or service for the
involving buyer±supplier relations has to do, buyer and the latter is considering whether to
instead, with the buyer's sourcing decisions. We retain or outsource a second task to the same
can divide the incentive e€ects of the outsourcing supplier. Allocating the second task to the supplier
decision into two types. If assigned the task, the of the ®rst task can a€ect how eciently the ®rst
supplier may not have the same incentive to work task is accomplished. Clearly, there may be pro-
as hard or as carefully in accomplishing the task as duction externalities between the two tasks, e.g. it
the buyer would if he retained the task (the hidden may be less expensive to do both tasks together
action problem). Secondly, the supplier may have rather than separately. But our main concern is
private information about the cost of accomplish- with incentive externalities, which can arise in
ing the task assigned to him or the value of the either of two ways.
work to the buyer.5 This private information gives In the ®rst case, assume that as a result of being
him an incentive to, for example, exaggerate his assigned the ®rst task, the supplier acquires pri-
cost of accomplishing the task, thereby giving him vate information about the cost to complete that
an ability to capture greater reimbursement from task. Likewise, the person to whom the second
the buyer (the hidden information problem). task is assigned will privately acquire information
This additional reimbursement which the supplier about the cost to accomplish that second task.
can earn as a result of his private information is There is both a direct and an indirect bene®t to the
called his informational rent. In this latter case, buyer retaining the second task. The direct bene®t
the buyer will usually ®nd it in his best interest is that any informational rent that would be
to distort the work demanded of the supplier in earned by the supplier on that second task, and
order to reduce the share of the surplus produced any resulting production ineciency, is elimi-
by the transaction which can be captured by the nated. The indirect bene®t is that the buyer will
supplier (i.e. reduce the supplier's informational observe the private information associated with the
rent). second task and, if it is informative about the sup-
The ®rst sourcing issue that the buyer must plier's private information about the ®rst task, the
consider is the incentive e€ects of outsourcing a buyer can incorporate it within the supplier's com-
task to a supplier versus doing the task himself. If pensation contract to better control the supplier's
multiple tasks are outsourced, the buyer needs to performance of the ®rst task.6 That is, statistical
consider the incentive e€ects of bundling the tasks, correlation between the cost of accomplishing the
that is whether to give all of the outsourced tasks two tasks makes it valuable for the buyer to retain
to one supplier or to di€erent suppliers. If multiple the second task. However, a negative correlation
suppliers are to be used, the buyer needs to con- between these two tasks' cost-state realizations
sider the incentive e€ects of di€erent ways of also makes assigning the second task to the sup-
organizing the suppliers. plier more valuable. In this case, the supplier's
normal incentive to exaggerate the costs of per-
2.1. Whether to outsource a task forming the ®rst task is mitigated because such
exaggeration implies that the cost of performing the
In considering whether to outsource a task to a second will be low and hence so will the supplier's
supplier, the buyer needs to consider not just the
In particular, the buyer can incorporate his announcement
The supplier may have come to the relationship already about the second task's private information realization. It is the
endowed with the information, or may have acquired it in the announcement of that realization, not the realization itself, that
process of carrying out the task. is contractible.
216 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

reimbursement for performing that task (this is to decide whether the R&D work should be fur-
referred to as ``countervailing incentives''). That ther developed should be given to the party whose
is, if the costs of accomplishing the two tasks are incentive problem distorts the overall eciency of
negatively correlated, allocating the second to the the entire relationship least.9
supplier may make eliciting the ®rst task's cost The above analysis is based on a supply chain in
realization less costly, thereby reducing the sup- which the buyer contracts for goods or services
plier's total informational rent. Of course, if the with an upstream supplier and sells the ®nished
private information signals associated with the product or service to a downstream ®nal custo-
two tasks are positively correlated, then allocating mer. In more realistic settings, the buyer must also
the second task to the supplier increases the lat- decide on his downstream marketing channels, e.g.
ter's informational rent from the ®rst task.7 whether to sell to an exclusive distributor or to a
The second way in which incentive externalities distributor who services others (i.e. a common
between the tasks can arise is if the second task is agency). This can be viewed as an outsourcing
subject to hidden action no matter to whom it is decision as well, except that the outsourcing is
assigned Ð the task will be chosen opportunisti- being done downstream rather than upstream.
cally no matter to whom it is assigned. For exam- Here again, incentive issues arise which will in¯u-
ple, assume that some basic R&D task is already ence the buyer's sourcing decision. Assume now
assigned to a supplier. Given the nature of the that whoever markets the buyer's ®nal product
R&D work, one will only know how successfully it privately learns information about the demand for
was accomplished if it is further developed (e.g. that product. The bene®t of marketing through a
prototyped). The supplier's compensation for the common agency is that, while each of the buyer
R&D work may, therefore, be contingent upon ®rms contracts with the common agency non-
whether the work is further developed and how cooperatively, they are still able to design these
successful the further development is. Because this contracts to coordinate their own production,
development decision is so complicated, it is thereby facilitating collusion. The cost of market-
usually left to the discretion of one of the parties ing through a common agency is that the common
and hence subject to moral hazard. The question is agency has private information of interest to all
who should be given the discretion to decide whe- buyer ®rms and is able to extract more informa-
ther and how to further develop the supplier's tional rent from them than would separate exclu-
R&D work. If this decision is given to the sup- sive dealers. Whether common agency or exclusive
plier, R&D work may be further developed which dealing dominates depends upon the a priori
should not be. If this latter decision is given to the uncertainty about the state and whether the pro-
buyer, R&D may not be further developed that ducts are substitutes or complements.10 Thus, the
should be, or it may be developed without attri- trade-o€ here is between improved coordination/
bution or compensation to the supplier.8 No mat- collusion and increased information rent.
ter to whom the development decision is assigned,
the fact that the development decision is subject to
moral hazard will distort the supplier's incentive
to perform the original R&D work. Thus the right This area of research falls within the general topic of dou-
ble moral hazard. See Wolfson (1985) for an empirical analysis
of this double moral hazard problem for limited partnerships in
the oil and gas drilling industry. See Baiman and Rajan (1995a)
and Aghion and Tirole (1997) for analyses of the task assign-
See Riordan and Sappington (1987) and Lewis and Sap- ment decision in these cases. Issues of ``trust'' naturally arise
pington (1989) for work in this area. when discussing discretion. The literature on trust will be
The buyer may further develop the results of the supplier's discussed more fully in Section 4. The ``in¯uence activities''
R&D work without informing the supplier, thereby denying the literature [eg. (Milgrom, 1988)] examines the externalities asso-
latter possible royalties. Given the nature of R&D work, it may ciated with the use of discretion versus rules.
be dicult for the supplier to prove that subsequent develop- See Martimort (1996) for an analysis of this common
ment work was based on his earlier R&D work. agency problem.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 217

2.2. Bundling of tasks disobedient equilibrium exists, then even without

communicating among themselves, the suppliers
If the buyer has already decided to outsource a will defect from the obedient equilibrium to the
number of di€erent tasks, he must decide how to disobedient equilibrium. The issue for the buyer,
bundle them, i.e. whether they should be assigned then, is how to design contracts which will give
to di€erent suppliers or whether some should be him the same utility he would have received if the
assigned to the same supplier. If the tasks to be suppliers had played the obedient equilibrium, but
assigned are correlated, the buyer needs to weigh eliminate the non-obedient equilibria.13
the bene®t of assigning multiple tasks to the same How one chooses to bundle tasks together has
supplier (arising from countervailing incentives other incentive e€ects. For example, tasks which
discussed above) versus the bene®t of assigning are dicult to measure (easy to measure) should
each task to a di€erent supplier (arising from be bundled with other tasks which are dicult to
relative performance evaluation).11 measure (easy to measure). Otherwise, if a supplier
Assigning the tasks to di€erent suppliers also is given both a dicult-to-measure task and an
raises the possibility of implicit collusion among easy-to-measure task, he will have a tendency to
them. For example, assume that the buyer has overinvest in the easy-to-measure task (and hence
several suppliers, each with some private informa- the task which is given the higher powered incen-
tion, working for him and that he has negotiated a tives) and underinvest in the dicult-to-measure
contract with each supplier. The buyer will choose task.14
the set of contracts such that there exists an equi- In the multi-task literature discussed so far, it is
librium in which his utility is maximized subject to usually assumed that the buyer's ability to moni-
the suppliers ®nding it in their best interest to work tor or measure each supplier's performance of his
for the ®rm and act obediently (send truthful task is exogenously given. However, this char-
reports to the buyer and implement the actions acteristic of a task is actually a function of the
requested by the buyer). With the contracts imple- design of the product produced by the supply
mented, the suppliers' actual behavior will be an chain. For example, in designing a product, one
equilibrium solution to the resulting simultaneous chooses: whether each function of the ®nal pro-
play non-zero sum game which they play among duct is produced by a single component (the
themselves. In general, such games have multiple function sharing decision); and whether a change
equilibria. One of them is the one preferred by the in one component requires a change in other
buyer; it maximizes his utility subject to the sup- components in order to maintain the performance
pliers acting obediently. However, for this same of the ®nal product (the coupling/decoupling).15 If
set of contracts there may be another equilibrium the components which make up a ®nal product are
in which the suppliers act disobediently but which
is Pareto preferred by the suppliers, while making 13
See Demski and Sappington (1984); Rajan (1992a,b) for
the buyer worse o€.12 If this Pareto-preferred analyses of this implicit collusion problem.
See Holmstrom and Milgrom (1991).
See Antle and Smith (1986); Baiman and Demski, (1980); 15
Decisions about function sharing and coupling a€ect the
Dye (1992); Holmstrom (1982); Janakiraman, Lambert and direct cost of manufacturing an item, but also a€ect the user
Larcker (1992); McMillan (1995) for discussions of relative eciency of the product. For example, with no function shar-
performance evaluation. ing and complete decoupling it is more likely that the product
Notice that this result does not contradict the Revelation can be produced with standard o€-the-shelf, components rather
Principle. The latter merely states that any equilibrium which than specially designed components. However, this will usually
can be achieved with a contract (say D) which induces the lead to a heavier, larger ®nal product which operates at a lower
suppliers to act disobediently, can be achieved by another con- level of eciency than one made up of specially designed com-
tract (say O) which induces them to act obediently. It does not ponents which share functions and are highly coupled. Laptop
say that the equilibrium solution to contract O is unique. Fur- computers achieve their reduced weight through the use of
ther, this issue of a disobedient equilibrium being preferred by components which share functions and are tightly coupled. See
the supplier to the obedient one does not exist when there is Ulrich (1995) and Ulrich and Eppinger (1996) for a discussion
only one supplier. of product architecture.
218 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

outsourced, the extent to which they are designed the reliability of the individual subassembly and
to share functions and the extent to which they are not how it interacts with other subassemblies. The
coupled will a€ect the extent to which product way in which a supply chain hierarchy is orga-
failures can be traced to a particular component nized a€ects who tests which parts and sub-
and hence supplier. For example, if two compo- assemblies, as well as the extent to which one can
nents are designed to share a function and be trace the source of a subassembly's failure.18 This,
highly coupled, a failure of that function can be in turn, can a€ect the amount of e€ort spent on
traced to those two components, but not to either testing, versus the amount spent making the indi-
one of them and hence not to a speci®c supplier. vidual parts reliable, versus the amount of e€ort
In this case, it is more incentive ecient to assign spent making sure that the parts interact in the
the production of both components to one sup- desired way (i.e. are robust). The advantage of a
plier rather than to assign their manufacture to multi-tiered supply chain in which the buyer buys
di€erent suppliers.16 an already fully assembled product from the high-
est level supplier is that the buyer can test the col-
2.3. Organizing suppliers lective robustness of the individual parts and the
overall reliability of the ®nal product and can
Associated with the task allocation decision is attribute its failure to (and hence assess a penalty
the decision as to how to structure the supply on) a single supplier. The disadvantage of this
chain. Should all the suppliers directly supply the architecture to the buyer is that the care with
buyer, who then does all of the assembly? Or which the parts are put together into the ®nal
should the suppliers be organized into hierarchies assembly is chosen by a supplier, introducing an
in which some suppliers act as buyers for other additional decision subject to moral hazard that
suppliers and the higher level suppliers do some of the buyer must deal with. The advantage of the
the subassembly work? The design of supplier two-tiered hierarchy in which the buyer does all of
hierarchies can have incentive e€ects in much the the assembly work is that he chooses the care with
same way as the product design can, as discussed which the parts are put together. The dis-
above. For example, assume a supply chain in advantage of the two-tier hierarchy is that the
which each supplier expends e€ort to choose the buyer can only test the overall quality of the ®nal
quality of his part. The quality of each part deter- product (including the robustness of the individual
mines:(1) the probability of it being defective and parts which he purchased) after he has put it
failing on its own, thereby causing the entire ®n- together. At this point, if the ®nal product fails the
ished product, or subassembly of which it is a quality test, the buyer cannot unambiguously
component, to fail; and (2) the probability of a attribute the failure to one of its suppliers as
non-defective part interacting with other non- opposed to himself, potentially reducing the e€ec-
defective parts in such a way that the entire ®n- tiveness of the incentives that it constructs for the
ished product, or subassembly of which it is a suppliers.
component, fails.17 In testing an individual part, As noted earlier, the role of discretion and asset
one can only test the reliability of that individual ownership in inter-®rm transactions cannot be
part, not how it interacts with other parts. Even addressed within a complete contracting world. To
when one tests subassemblies, one can only test address these and other issues, we must relax the
assumption of complete contracting, which we do
See Baiman, Fischer and Rajan (1998) for an analysis of next.
these issues. See Anderson, Glenn and Sedatole (1999) for some
empirical results.
17 18
An example of this occurs when parts that are drawn from Similar to the point made earlier about product design, if
populations which are within design tolerances are assembled some function of a subassembly fails and several of the parts
but the subassembly does not meet design speci®cations. See which make up the subassembly share in that function, it may
Taguchi, Elsayed and Hsiang (1989) for a discussion of this not be possible to uncover which individual part caused the
tolerance build-up e€ect. failure.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 219

3. Incomplete contracts: the basic model decide upon the total price (or transfer, t) and
quantity, q, for their transaction. If they cannot
For the rest of our paper, we address issues reach agreement, neither has any other opportu-
which arise in settings in which there is a restriction nities and, therefore, each receives zero.
on the information which can be incorporated in the Suppose that the gross revenue to the buyer
contract (e.g. a contingency based on some infor- from selling quantity q is given by V ˆ 80 3 q", while
mation which all parties know will become jointly the cost to the supplier of making and delivering q
observable in the future cannot be incorporated units is given by C ˆ 80 2 0:25
3 q s . Note that s redu-
within the contract negotiated today). That is, we ces the supplier's cost but does not a€ect the buy-
focus on settings in which contracts are incomplete. er's revenue. We begin by analyzing the ®rst-best
This is but one type of restriction which leads to solution in which the buyer and supplier act
incomplete contracting. Others include restrictions cooperatively, or alternatively, can contractually
with respect to: the form of the contract (e.g. only commit to their behavior. We start the analysis at
linear contracts are permitted) or the length of the the last stage after s has been chosen and " has
contract (e.g. only contracts spanning a single per- been realized. At this point, the buyer and supplier
iod are allowed even though the relationship among must agree on the quantity to be exchanged and
the parties takes place over multiple periods). Each the price at which the exchange will take place.
of these restrictions is usually rationalized in terms For any given pair ("; s), the ecient transaction
of either the cost of writing contracts, the cost of quantity is the one that maximizes the value of
enforcing contracts, or the existence of indescribable  ˆ …V C†. This yields the optimal quantity:20
future events.19 Contract incompleteness leads
directly to potential ineciencies in the buyer- q …"; s† ˆ 0:5"s0:25 …1†
supplier relation. In this section, we introduce a
simple example to illustrate this basic ineciency. In turn, this quantity choice leads to an ex post
In the next section we discuss inter-®rm design surplus (V C) of:21
choices which can mitigate that ineciency.
Our example (referred to as Example I) consists 20 2 0:25
 …"; s† ˆ …q …"; s†; "; s† ˆ " s …2†
of a single buyer, a single supplier and a single 3
period. The buyer and supplier can either transact
with each other or earn zero. The supplier can The ®rst-best, choice of s (i.e. s ) is the one that
make an investment, s, that will lower his cost of maximizes the expected ex post surplus, 43 net of
producing the part that he will sell to the buyer, investment … …"; s† s† i.e.: s ˆ 103 ˆ 4:98. The
but does not a€ect the value of the part to the above was the analysis of the ®rst-best solution in
buyer Ð this is termed a ``sel®sh'' investment. This which the buyer and supplier acted cooperatively.
investment is costly for the supplier to undertake. We next analyze the buyer±supplier relation under
Moreover, it represents an investment that is spe- the assumption of noncooperative behavior and
ci®c to the current relationship; i.e. it does not extreme contract incompleteness Ð the supplier
a€ect the supplier's outside opportunities because must make his investment choice before any con-
he can only transact with this buyer. Subsequent tract is agreed upon. Only when the investment
to the investment, a random variable ", which has been chosen and the random variable " has
a€ects the gains from trade, is realized. We assume been jointly observed will the buyer and supplier
that the support of " is a compact interval on the
positive real line and that both the mean and var-
Appendix A contains the detailed derivation of the results
iance of " are 1, and hence E "2 ˆ 2. After for all of the variations of Example I.
observing s and " the buyer and supplier jointly The term ex post surplus means the incremental surplus
generated by exchanging q rather than not e€ecting the
exchange. Notice that the original investment cost, s, is not
See Tirole (1999) for an analysis of indescribable events in included because, at this stage of the game, it is sunk and,
an R&D context. therefore, not a€ected by the decision to exchange or not.
220 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

agree on how much is to be produced and the  4

10 3
transfer payment for the production. Rather than sˆ : …4†
directly model the quantity-transfer price negotia-
tions, we adopt a bargaining approach under
which the supplier's bargaining power guarantees From (3) and (4), it is clear that, for any < 1,
him fraction of the ex post surplus generated by the supplier underinvests in the relationship. Under
the agreement. In other words, subsequent to the Nash bargaining solution, for example, (in
observing s and ", the buyer and supplier bargain which =1/2), the supplier invests only 1.98,
and jointly decide on a quantity and transfer price which is 60% lower than the ®rst-best investment
under which the supplier receives the ®xed fraction level. The reason is simple Ð the supplier bears
41 of the ex post surplus generated by the the entire cost of the investment (i.e. s) but can
exchange. Notice now that the supplier must only capture of the value which it creates. The
anticipate what the agreement as to quantity and buyer can threaten to not engage in trade, thereby
price will be at the time he chooses his cost redu- denying the supplier any return on his investment,
cing investment. Further, unlike the ®rst-best case unless the buyer gets (1 ) of the value created by
analyzed above, the supplier will now choose his the investment. This ability of the buyer to expro-
investment s, to maximize his own expected pro®t priate some of the surplus created by the supplier's
rather than total expected pro®t. investment weakens the supplier's ex-ante incen-
An important assumption of the incomplete tives to invest. Thus, at the time that the buyer
contracting literature which underlies the follow- and supplier negotiate the quantity and transfer
ing analysis is that, given symmetric information, price agreement, they have incorrect relative bar-
there is no deadweight loss associated with the gaining powers which a€ects the supplier's ex ante
bargaining that takes place between the buyer and investment incentives. This is the classic hold-up
the supplier.22 Therefore, despite the absence of problem which results when there is no initial
contracting, the buyer and supplier will always contract (we shall refer to this no-initial-contract
agree to choose the ex post ecient quantity level solution as the ``Williamsonian'' solution).
for each realized ("; s) pair [i.e. q …"; s† ˆ 0:5"s0:25
from (1)]. The reason is that this maximizes the
surplus going forward, i.e. the size of the pie that 4. Incomplete contracts: inter-®rm design choices
is available for the buyer and supplier to divide. available to mitigate the resulting ineciency
Each party's share of the ex post surplus (i.e. pie)
is ®xed, therefore, each is interested in choosing In the incomplete-contracting version of Exam-
the quantity that maximizes the ex post surplus ple I, the ineciency arises because the buyer has an
[ …"; s† ˆ …q …"; s†; "; s† ˆ 20 2 0:25
3 " s from (2)]. incentive to exploit his bargaining power and hold-
However, at the time that the supplier chooses the up the supplier at the time of renegotiation. Because
investment, he knows that, given any chosen s and the supplier cannot trust the buyer to not exploit his
subsequently realized ", he will receive only frac- bargaining power, the supplier's incentive to invest
tion 41 of the surplus,  …"; s† ˆ 20 2 0:25
3 " s : Ex is lessened. This ineciency can be mitigated if
ante, therefore, he chooses his level of investment either: the contracting parties somehow become
to maximize: [E‰  …q; "; s†Š s], or: more inherently cooperative and trustworthy; or
their bargaining powers can be manipulated such
that their self-interested behavior is less disruptive.
It is often claimed in the business press that the
enhanced eciency associated with supply chains,
There is symmetric information here because, at the time
as opposed to arm's-length transactions, comes
that the quantity and transfer price are agreed upon, both the
buyer and the supplier have observed s and ". With asymmetric from the increased information sharing among the
information, it is possible that an exchange that would have supply chain members. This increased sharing of
been ecient does not take place. information is, in turn, attributed to the increased
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 221

level of trust inherent in supply chains. However, ment the initial contract …q^; t^ †. Notice that even
there has been very little discussion in the press with incomplete contracting, this initial contract is
about exactly how that trust is achieved.23 enforceable because its enforcement does not
In the following sub-sections, we discuss some depend upon being able to discriminate between
of the inter-®rm design choices which can manip- di€erent future contingencies, ". Appendix A
ulate the amount of trust which the buyer and demonstrates that there exists a …q^; t^ † such that the
supplier have in each other. Notice that we are parties will renegotiate to the ®rst-best quantity
talking about manipulating a calculative type of and transfer given the observed " and the chosen s,
trust in which people are still assumed to act solely thereby inducing the supplier to choose the ®rst-
in their own self-interest. Behavior based on this best s. The initial contract which accomplishes this
type of trust can be thought of as behavior that is is: simple (consisting of just two numbers); inde-
promised but not stipulated in a contract, and pendent of the relative bargaining positions of the
hence not court-enforced, but rather, behavior parties [ ; …1 †]; and non-contingent.24
that is self-enforced by the parties' self-interest. The reason why this simple non-contingent
Within an incomplete contracting world, we can contract completely eliminates the hold-up pro-
think of inter-®rm design choices as a€ecting the blem, thereby achieving ®rst-best, is that it chan-
outside opportunities of the contracting parties ges the relative bargaining powers of the parties.
which, in turn, a€ects their relative bargaining Without the initial contract, the supplier's best
powers, which, in turn, a€ects their level of trust in alternative to not agreeing to negotiate with the
each other. Inter-®rm design variables which can buyer was to receive zero. By negotiating he
a€ect the contracting parties' outside opportu- receives  …"; s†. Therefore, he chose s to max-
nities include: the design of contracts; the alloca- imize his net share of the ex post surplus,
tion of asset ownership; and the organization of [  …"; s† s]. With the initial contract, the sup-
the market in which each operates. plier's best alternative to not renegotiating with
the buyer is to enforce the initial contract and
4.1. Trust and changing outside alternatives Ð receive t^ C…q^; "; s†, which therefore represents
initial non-contingent contracting his bargaining power or threat position. By rene-
gotiating he receives what he would have received
To see how non-contingent contracts can a€ect in the absence of renegotiation …t^ C…q^; "; s††, plus
one's outside opportunities, refer back to the his share of the surplus gained by renegotiating
incomplete-contracting version of Example I and … ‰ …"; s† …V…q^; "† C…q^; "; s††Š†.25 The suppli-
assume that the parties agree to an initial non- er's relative bargaining power can, therefore, be
contingent contract that speci®es a quantity to be manipulated by changing the initial contract
exchanged …q^† and a price at which the exchange will parameters …q^; t^†. Further, for this example, the
take place …t^†. Assume that the parties are free to supplier's bargaining power is now increasing in
renegotiate their relationship later if they choose to, s; …t^ C…q^; "; s† ˆ t^ 80 ^ 2 0:25 is increasing in
3 q "s
based on the realized value of ". However, if they s), while the buyer's bargaining power is constant
cannot agree on a new contract, they must imple-
This result forms the crux of the work in (Edlin & Reich-
See, for example: Johnston and Lawrence (1988); Powell elstein, 1996).
(1990); Tedeschi (1999); Templin and Cole (1994b). Achieving Notice that in the incomplete contracting literature, the
the trust required to share information is a non-trivial task in parties renegotiate to a contract which is di€erent from the
the automotive industry as is indicated by the following quo- initial contract in order to adjust to the noncontractible
tation in Bradsher (2000): ```The dealers have never wanted to demand realization E. This is in contrast to the complete con-
share pricing information with the manufacturer, and rightly tracting literature in which the parties can renegotiate after
so, because the manufacturers use it against them' in negotia- some actions have taken place. There, the initial contract will,
tions over the sharing of various costs, said J. David Power III, without loss of generality, always be one that will not be
founder of the consulting and consumer rating company that changed at the time of renegotiation. See Fudenberg and Tirole
bears his name.'' (1990) and Christensen, Demski and Frimor (2000).
222 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

in s (V…q^; "† t^= 80 3 q

^" t^ is constant in s). There- parties can renegotiate to a new contract. In
fore, the supplier has an incentive to increase his Appendix A we demonstrate that, in this case of
investment s, merely to increase his bargaining cooperative investments, the presence of a non-
power. Finally, it is easy to show that the suppli- trivial initial non-contingent contract, …q^; t^†;
er's marginal return to investing in s is increasing results in a lower level of investment and a less
in q^. Therefore, one can choose a strictly positive ecient outcome than that achieved without the
q^ such that the ®rst-order condition with respect initial contract. Stated di€erently, with coopera-
to s is satis®ed at the ®rst-best s.26 Notice that in tive investments, the buyer and supplier can never
this example, there is no role for contractible do better than the Williamsonian outcome by
information, such as provided by an accounting signing an initial non-contingent contract; i.e. it is
system. optimal to have no initial contract. The reason for
The result that an initial non-contingent con- this is that, in the cooperative investment case, the
tract can eliminate hold-up problems resulting supplier's bargaining power is decreasing in q^ but
from renegotiation is unfortunately not very gen- constant in s, while the buyer's bargaining power
eral. It applies primarily to investments that are, is increasing in both q^ and s. Therefore, with the
as in the example above, ``sel®sh'' in nature in that initial contract, the supplier has an incentive to
they help the supplier lower his own cost of sup- further decrease his investment in s, from the
plying the product, but do not a€ect the value of already too small level induced with no initial
the product to the buyer. In many situations, contracting. An alternative way of stating is that
however, the e€ect of the supplier's investment is with cooperative investments and an initial con-
to increase the value of the intermediate product tract …q^; t^†, the supplier's marginal return from
to the buyer, i.e. investments which are termed investing in s is decreasing in q^. Unlike in the self-
``cooperative''. In these cases, initial contracts turn ish investment case, there may now be value to
out to be worthless. going to contingent contracts which incorporate
To illustrate this latter point, consider a varia- contractible information such as accounting
tion of the above example with cooperative information.
investments, where C= 80 2 80
3 q , V= 3 q" s
, and the From the two extreme scenarios laid out above,
speci®cation of " is unchanged. Notice now that it is clear that a general (and realistic) setting in
the investment s increases the value of the product which a supplier (and/or buyer) has the possibility
to the buyer but has no e€ect on the supplier's of making investments that are both sel®sh and
cost. In this case, the ex post ecient quantity is cooperative is fairly complex. To illustrate this
given by q …"; s† ˆ 0:5" s0:25 , while the ex post sur- situation, consider yet another extension of our
plus is now 20 0:5
3 " s : The ®rst-best level of invest- basic example.27 In particular, we leave " as before
ment thus maximizes the expression, …20 3 s
E and let C= 80 2 0:25
3 q s and V= 80
3 q" s
: Note that
2  400
…" † s†; implying s = 9 : The second-best Wil- higher levels of s both add to the value (coopera-
liamsonian solution in which contracting is una- tive) and lower the cost of production (sel®sh). The
vailable, on the other hand, has the supplier ®rst-best quantity level q is then given by
maximizing his share of the ex post surplus q …"; s† ˆ0:5 " s0:5 and the ex post surplus by
20 0:5 2 W 400 2 20 2 0:75
3 s E…" † s by choosing s = 9 . Again, 3 " s : The ®rst-best investment level therefore 
20 0:75
we have underinvestment by the supplier relative maximizes the expression 3 s E…"2 † s ;
to ®rst-best. implying s =104. The no-initial-contract or Wil-
As in the sel®sh investment case studied above, liamsonian solution,  on the other hand, maximizes
consider a default contract, …q^; t^†. As before, after 20
3 s
E…"2 † s ; leading to the lower invest-
s has been chosen and " has been realized, the ment level of sW =(10 )4. While the ®rst-best sur-

However, it is not in general the case that the optimal
non-contingent contract …q^; t^† is the ®rst-best quantity and 27
Che and Hausch (1999) analyzes this general case of an
transfer. investment that is both sel®sh and cooperative.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 223

Fig. 1. A Ð Surplus under ®rst-best; B Ð Surplus under initial contracting; C Ð Surplus with no initial contract.

plus level is 13 (104), the Williamson game yields best (since the supplier captures all the rents from
(10)4 3 43 ; which is lower for any < 1. bargaining and so invests the ®rst-best quantity up
Does a non-trivial, non-contingent default con- front) and, hence, the no-contract Williamsonian
tract, …q^; t^†; increase eciency in this case? In solution is preferred to the solution with a non-
Appendix A we show that for very small , we can contingent default contract. Fig. 1 illustrates these
choose …q^; t^† such that the ®rst-best solution can results for the sel®sh/cooperative example and the
be achieved. However, as becomes larger, the restriction that q4180.
non-contingent quantity q^ grows unbounded. So far we have focused on the ability of con-
Therefore, if there are capacity or demand restric- tracts to achieve eciency, given that the contracts
tions, then it is only for values of less than are incomplete and that the buyer and supplier
some ^, that the ®rst-best outcome can be have an unlimited ability to renegotiate ex post.
achieved with an initial non-contingent contract.28 An alternative approach is to study the role of
For higher values of , there is still value to having contracts in the presence of explicit restrictions on
an initial contract (relative to the Williamsonian the renegotiating ability of the parties. For exam-
solution), but the surplus generated no longer ple, in our simple example in which only the sup-
equals ®rst-best. Eventually though, as nears 1, plier invests, assume that the initial contract has
the Williamsonian solution itself approaches ®rst- the following provisions: it gives the supplier the
ability to make a take-it-or-leave-it o€er to the
The speci®c value of ^ will depend on the capacity or buyer after " is observed; if the buyer rejects that
demand restrictions. o€er then there is no trade. Further, assume that
224 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

the parties cannot renegotiate out of this initial tionship and allows us to study how other design
contract. In this case, the initial contract gives all instruments can be used to mitigate the under-
of the bargaining weight to the supplier and he is lying ineciency which arises from incomplete
able to extract the full surplus resulting from his contracting.
investment. Anticipating this, he will make the
®rst-best investment. More generally, in the pre- 4.2. Trust and changing outside market conditions:
sence of a commitment to not renegotiate (Che & asset ownership
Hausch, 1999) demonstrates that ®rst-best can be
implemented even with sel®sh and/or cooperative When an uncontracted-for contingency arises in
investments.29 an incomplete contract, the appropriate use of the
In the absence of limits on renegotiation, there asset is left to the owner's discretion. If the most
are other ways to structure the buyer±supplier ecient use of the asset involves trade, the owner
relation to mitigate ineciency resulting from and the potential trading partner will negotiate
hold-up behavior. One solution involves the buyer over the terms of trade. As noted earlier, the inef-
taking an equity stake in the supplier.30 This ®ciency arises because each party will try to hold-
arrangement has parallels to the Japanese keiretsu up the other party, trying to extract as much of the
ownership structure.31 However, Riordan (1991) surplus created by the ecient trade, while still
points out that this has both merits and demerits. assuring that the trade takes place. Who owns the
The bene®t is that it reduces the impetus for the asset will a€ect the relative bargaining positions of
buyer to act opportunistically by lessening his the negotiating parties and hence the share of the
incentive to extract rents from the supplier. This surplus which each can obtain.32 In turn, each
has to be balanced against the downside which is party will anticipate the subsequent negotiations,
that the supplier now owns a smaller stake in his as well as the division of surplus, and will choose
own ®rm and so has less incentive to invest in cost- his ex ante relationship-speci®c investment to
reducing activities. maximize his own share of the surplus, rather than
In the previous section, we saw that the source the surplus itself.33
of ineciency arising from incomplete contracting To illustrate these and subsequent points, we
is that, subsequent to the investment, neither party introduce Example II and several variations on it.34
could trust the other to refrain from trying to use Assume a single supplier, a single buyer, and a sin-
the renegotiations to extract more of the surplus gle period. The buyer sells a good that is manu-
resulting from the investment. In this section we factured by the supplier. We will refer to the good
showed that for sel®sh (sel®sh/cooperative) invest- manufactured by the supplier as the intermediate
ments, this ineciency can be eliminated (mitigated) product. To manufacture the intermediate product
with an initial non-contingent contract. However, requires an asset. The value of the intermediate
notice that this non-contingent contracting does product to the buyer depends on the intermediate
not eliminate or mitigate the investment ine- product's quality, which depends on the care
ciency by causing either party to refrain from try- taken by the supplier in manufacturing it. In par-
ing to fully exploit the renegotiation phase. ticular, the supplier takes two actions in the
Rather, it merely changes their incentives to do so. manufacturing process, a1 and a2 . The probability
In the next section, we will introduce a new
example which expands the buyer±supplier rela- 32
For example, in the incomplete contracting literature, it is
usually assumed that the parties will negotiate to the Nash
bargaining solution, in which case each will receive his no-trade
For more work on the power of imposing restrictions on status plus one-half the gains from trading. One's no-trade
renegotiations see: Aghion, Dewetripont and Ray (1994); status will depend upon the ex ante ownership of the assets.
Demski and Sappington (1991); Noldeke and Schmidt (1995). 33
See Grossman and Hart (1986); Hart and Holmstrom
This changes the parties' relative bargaining power by (1987); Hart and Moore (1990), Hart (1988, 1989).
essentially changing the a parameter in Example I. 34
This example is adapted from Baker, Gibbons and
See Dyer (1997) for empirical evidence on this. Murphy (1997).
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 225

that the intermediate product is of high quality giving him ownership of the asset increases his
and can be sold by the buyer for QH ˆ 3 is 0.4a1 . incentive to invest, thereby improving eciency.
The probability that the intermediate product is of In the above example, the ineciency associated
low quality and can be sold by the buyer for with incomplete contracting results in ex ante
QL ˆ 1 is 1 0:4 a1 .35 The supplier's disutility underinvestment. This example also illustrates the
associated with taking actions a1 and a2 is 12 a21 ‡ point that, in general, it is better for the person
1 2
2 a2 : The supplier's e€ort is not observable. Given making the investment to own the asset. However,
these parameters, the ®rst best solution is a1=.8 while assigning the asset to the supplier rather
and a2=0, and the ®rst-best surplus is 1.32.36 than the buyer improves eciency, there are
In Example II, the source of the contract potential costs to doing so. First, one can only
incompleteness is that, while the quality of the grant the supplier control rights by taking them
intermediate product is jointly observable to the away from the buyer. Although the buyer did not
buyer and the supplier, it is not contractible. This have a relationship-speci®c investment to make in
means that the parties cannot commit to a con- this case, if he had, then giving the asset ownership
tract which is contingent on the quality realiza- to the supplier would have reduced the buyer's
tion. Instead, the supplier must invest in a1 and a2 , incentive to make that investment.37
anticipating what the buyer will o€er to pay for the Another potential ineciency arises by giving
product ex post. We assume that ownership of the the asset ownership to the supplier, the party
asset implies ownership of the intermediate pro- choosing the ex ante investment. To illustrate this
duct. Thus, if party i owns the asset, party i has we modify Example II by assuming that there
the right to dispose of the intermediate product in exists a market for the intermediate product. For
whatever way he wants. Regardless of who owns simplicity assume that the price for a high (resp.,
the asset, we assume that the end result of any low) quality intermediate product on this alter-
successful renegotiation will result in each party native market is PH =0.9 (resp., PL =0.1), so that
receiving one-half of the surplus achieved from the buyer is still the most ecient user of the
exchanging the asset Ð the Nash bargaining solu- intermediate product. As before, whoever owns
tion (i.e. =1/2). the intermediate product decides how to use it.
If the supplier owns the asset, the buyer and the Finally, assume that because the other potential
supplier will bargain over the intermediate pro- users of the intermediate product (represented by
duct after its quality has been realized and split the the alternative market) are using it for purposes
surplus gained from selling it to the buyer rather that are di€erent from the buyer's, they de®ne
than doing nothing with it. In this case, the opti- quality di€erently than does the buyer. In parti-
mal solution is a1 =0.4 and a2 =0, and the surplus cular, the intermediate product will be of high
is 1.24. On the other hand, if the buyer owns the quality for the purposes of the market with prob-
asset, he can expropriate the good after its quality ability a2 and low quality with probability (1 a2 ).
has been realized without splitting the surplus with In this case, if the buyer owns the asset, the opti-
the supplier. Clearly, in this case the supplier's mal investments will be a1 =0 and a2 =0, and the
optimal investment choices are a1 =0 and a2 =0 surplus is 1 as before. If the supplier owns the
and the surplus is 1.00. The ineciency arises in asset, the optimal investments will be a1 =0.4 and
both cases because the supplier, who is bearing the a2 =0.4 and the surplus is 1.16. Again, it is more
entire cost of the ex ante investment, will be ecient for the supplier than the buyer to own the
unable to fully recoup that cost. For this case, asset. However, as a result of the supplier owning
giving the supplier additional bargaining power by the asset, not only is he still underinvesting in the
relationship-speci®c investment (a1 ) as before, he
is now also overinvesting in the non-relationship
S's investments in a1 and a2 represent cooperative invest-
ments using the terminology introduced in Section 4.1. speci®c investment (a2 ). That is, while asset
Appendix B summarizes the progression of the variations
of Example II as well as the solutions to those variations. 37
See Grossman and Hart (1986) for an example of this.
226 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

ownership by the person making the ex ante buyer's use, the intermediate market becomes
investment may enhance eciency because it irrelevant to the buyer and supplier in their nego-
improves his incentive to invest in relationship tiations.
speci®c investments, it may also reduce eciency The above variations on Example II illustrate
(as in this case, from 1.24 to 1.16) because it that asset ownership has a direct e€ect on the
increases his incentive to make socially useless incentives of the contracting parties via its e€ect
investments.38 The supplier invests in a2 not to on their relative bargaining power. Asset owner-
improve the eciency of the good in its ®nal use, ship also has indirect e€ect on the incentives of the
but to improve his bargaining power when he and contracting parties via its e€ect on the range of
the buyer negotiate over how to split the surplus.39 behavior that can be self-enforced through implicit
Notice that in this case introducing a competitive contracts.41 To illustrate this, consider the varia-
market for the intermediate product actually tion of Example II in which the supplier produces
exacerbates the buyer±supplier hold-up problem an intermediate good used by the buyer, but that
and results in a decrease in the eciency of that intermediate good has a di€erent use and can be
relationship. sold to a market. In the single period setting exam-
Now assume that the buyer and the supplier ined earlier, it was more ecient for the supplier to
jointly own the asset. In this case, neither party own the asset (as opposed to the buyer owning it).
can unilaterally decide how to dispose of the Now consider the case in which this same game is
intermediate product. For the intermediate pro- repeated in®nitely. By going to a multi-period set-
duct to be used, they must jointly agree on it. Now ting, no additional information is added for use
the optimal investments are a1 =0.4 and a2 =0 and within explicit contracts; however, we can now
the surplus is 1.24. Notice that, contrary to con- allow for implicit contracts. The parties can now
ventional wisdom, joint ownership may be more agree to the following implicit contract:
ecient than single ownership.40 In this case, the
1. The buyer and the supplier agree that the
reason is that joint ownership eliminates the
supplier will choose some jointly observed
socially wasteful investments whose sole purpose
(a1 ; a2 ).
is to a€ect bargaining power. Further, this solu-
2. If the supplier does so, the buyer will pay the
tion is the same as in the original example in which
supplier a three part compensation consisting
there was no alternative market for the inter-
of: (i) a constant, plus (ii) an additional pay-
mediate good. The reason for this is that with joint
ment based on the quality realization which
ownership and with the alternative use of the
is speci®c to the buyer, plus (iii) an addi-
intermediate good being less ecient than the
tional payment based on the quality realiza-
tion which is speci®c to the alternative use of
A somewhat similar point is made in (Rajan & Zingales, the intermediate good.
1998b). However, they are concerned with the case in which 3. If the supplier does not choose the obedient
making an investment in a relationship-speci®c asset can reduce (a1 ; a2 ), then the buyer will refuse to honor
the outside value of that asset. In this case, it may be optimal the payment, and the buyer and the supplier
for the non-owner to decide on the investment because the lat-
ter will not internalize the non-relationship-speci®c loss of the
will revert to the one-period game previously
investment. studied.
The idea of the supplier choosing a2 to improve his bar-
gaining power, rather than to improve the eciency of the
The above contract is implicit because the sup-
intermediate product in its eventual use, is similar to Milgrom plier's choice of (a1 ; a2 ), while jointly observable,
and Robert's notion of in¯uence activities. For references to is not contractible. The only way in which the
the latter, see: (Milgrom, 1988; Milgrom & Roberts, 1988; implicit contract will be implemented is if there
1990, 1992). In their analysis, however, non-owners of the asset exist payments that make this behavior self-enfor-
usually do the in¯uencing.
An important reason for this result is the assumption that cing; i.e. payments that satisfy both the buyer and
with complete and symmetric information the parties will
always agree to the ecient use of the resources. See Halonen (1995), Klein (1996), Baker et al. (1997).
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 227

the supplier's incentive compatibility constraints.42 it within the supplier's information system and
For our example, such payments do exist. If the making those reports available to the buyer.
buyer owns the asset, then there exists an implicit Ignoring the cost of doing so, it seems intuitive
contract such that the optimal actions are a1 =0.6 that one can do better by making the supplier
and a2 =0, and the surplus is 1.3. If the supplier action information contractible than by using it
owns the asset, then the optimal actions are within an implicit contract. However, this is not
a1 =0.50762 and a2 =0.11698, and the surplus is necessarily the case.43 To illustrate this point,
1.27. Notice that allowing for multiple periods and assume that the supplier observes some cost/qual-
implicit contracts improved the eciency asso- ity information before choosing his action and
ciated with either the supplier or the buyer owning that the most ecient action varies with that
the asset. However, while in the one-period game, information. Assume that the supplier's action
it was more ecient for the supplier to own the choice is contractible but that the cost/quality
asset, in the repeated game it is more ecient for information, while jointly observable, is not con-
the buyer to own the asset. The advantages to the tractible. Contracting on the supplier's action
buyer owning the asset in the multi-period setting choice means that a particular action must be
are: (1) the outside opportunity use of the asset is speci®ed before the most appropriate choice is
irrelevant, hence the supplier has no incentive to known. This induces a loss of ¯exibility (i.e. the
invest in a2 and (2) it is easier to satisfy the buyer's ability to match actions to cost/quality realiza-
incentive compatibility constraints when the buyer tions), which induces a loss of eciency. On the
owns the asset because the cost of the buyer rene- other hand, not contracting on the supplier's
ging now includes the loss of the relationship in action choice allows the buyer to o€er an implicit
the future. Thus, the implicit contract has elimi- contract which (as in the previous variation on
nated the buyer's incentive to extract all of the Example II), threatens to withhold future business
surplus from the investment at the renegotiation from the supplier if the buyer observes that the
stage. supplier chose an inappropriate action given the
As a ®nal point, assume that the asset is owned observed cost/quality realization. If the supplier
jointly by the supplier and the buyer. Then, for the and the buyer's relationship is such that the buy-
given parameters, it can be shown that there exists er's threat is credible, then it may be more ecient
no implicit contract that can improve on the one- to use the supplier's observed input choice as the
period solution with joint ownership. Thus, the basis for threats or promises rather than as a con-
eciency of implicit contracts, as well as the tingency in an explicit contract.44 What is impor-
resulting behavior based on trust, is a€ected by tant in this example is that the supplier's action is
the identity of the owner of the assets. contractible, but his action strategy is not. Con-
In the above variation, we used the jointly tractual provisions restrict actions rather than
observed, but noncontractible, supplier action strategies. Therefore, the eciency loss from using
information within an implicit contract Ð as the information in contractual provisions (thereby
foundation on which the buyer could base his reducing ¯exibility) may be more than the e-
threat/promise strategy. That is, we used the ciency loss from using the information within an
observed supplier behavior within an implicit implicit contract.
contract to partially complete the incomplete con-
tract. Another alternative is to make the supplier's 43
See Boot, Greenbaum and Thakor (1993) and Bernheim
action contractible, for example by incorporating and Whinston (1998) for a rigorous analysis of conditions
under which it is optimal to not include veri®able contingencies
in explicit contracts. See Klein (1996) for a more intuitive
42 44
That is: (1) given the promised payments, the supplier Two observed features of the Japanese auto industry are
®nds it optimal to make the obedient investments; and (2) given the high rate of contract renewals and the incompleteness of
that the supplier makes the obedient investments, the buyer contracts between auto manufacturers and their suppliers. The
®nds it optimal to make the promised payments. above analysis implies that these two features are complements.
228 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

Notice that there are two important implica- invest ex ante and improves the eciency of the
tions to this result. First, when this result is true buyer-supplier network. Notice that the buyer will
for a buyer±supplier network, the governance choose the number of suppliers to reduce
structure of the network will appear to an outsider (although not necessarily eliminate) his incentive
to be very incomplete Ð because much of the to extract the surplus from the suppliers' invest-
governance is in the implicit contract. Second, this ments.
insight provides one possible explanation for the However, if the buyer has to make a relation-
empirical fact that contracts often do not include ship-speci®c investment as well, reducing the num-
provisions for information which is contractible. ber of suppliers will reduce his incentive to do so.
Thus, committing to a number of suppliers is a way
4.3. Trust and changing outside market conditions: for the buyer to commit to the amount of surplus
organizing suppliers which he will appropriate at the time of renegotia-
tion and to endogenize the credible amount of trust
We have so far looked at the case in which the in the buyer-supplier network.45 This arrangement
buyer has a single task to outsource and there has obvious parallels to the Japanese auto indus-
exists one potential supplier for that task. More try, which is characterized by long-term relation-
generally, there may exist several potential suppli- ships between the automobile manufacturers and
ers who can carry out that task; moreover, the the few suppliers on which they rely.46 Notice also
buyer may have more than one task to outsource. that this analysis suggests that the size of the sup-
Note that, regardless of the number of tasks and plier base should be decreasing in the importance
the number of suppliers with whom the buyer of the suppliers' investments, and increasing in the
chooses to deal, the problem remains the same: the importance of the buyer's investment.
suppliers must be motivated to make the ecient Reducing the number of suppliers can have
relationship-speci®c investments, and the buyer another incentive e€ect. In the above analysis of
must be motivated to reward them for doing so. supply chain design, no mention was made of the
However, the number of suppliers with whom a role of monitoring in controlling incentives. When
buyer chooses to deal, as well as the way in which the buyer reduces the number of suppliers with
the buyer organizes them, can have a signi®cant whom he deals and then organizes them into a
impact on the range of self-enforcing behaviors of supply network, it is reasonable to assume that it
both the buyer and the suppliers. becomes easier for the suppliers to monitor how
For example, assume as before that the buyer the buyer deals with each of them. In this case, if
outsources a single task, and there are no explicit the buyer reneges on an implicit agreement with
contracts. However, now suppose that there are one supplier, the others will observe it and may
many di€erent identical suppliers with whom the ®nd it in their best interest to end their relation-
buyer may deal. As before, after the suppliers make ship with the buyer, thereby denying him the
their investments, the suppliers and the buyer will ongoing rents from that relationship. That is, by
bargain over the quantity of intermediate products reducing the number of suppliers and organizing
to transfer and the price of those goods. In order them into a supply chain, the buyer actually
for the buyer to induce the suppliers to make makes it easier for his suppliers to observe his
relationship-speci®c investments, it is necessary to behavior with respect to the other suppliers,
convince them that the buyer will not appropriate,
during the bargaining, all of the surplus produced
by the investments. By reducing the number of 45
See Bakos and Brynjolfsson (1993) for a discussion of this
suppliers with whom he deals, the buyer gives each idea. This basic idea here is similar to that in McMillan (1995).
See Dyer (1997) for an empirical analysis which supports many
of the remaining suppliers increased bargaining
of McMillan's assertions.
leverage for the negotiations, and hence assures 46
See Dyer (1997) for empirical evidence on the use of a
each a larger fraction of the surplus from their smaller supplier base in supporting trust within Japanese buyer-
investments. This increases their incentive to supplier relationships.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 229

thereby increasing his cost of reneging on his con- out cross-monitoring by the suppliers, the buyer
tract with any individual supplier, thereby making negotiates a separate implicit contract with each
it easier for him to make credible promises. This, supplier. Each implicit contract satis®es an incen-
in turn, increases the eciency of the buyer-sup- tive compatibility constraint which assures that
plier network. The extent of the eciency e€ect of the buyer will ®nd it optimal to act obediently and
this monitoring will depend on whether the sup- carry out the behavior promised in the implicit
pliers' inputs are substitutes or complements.47 contract. Because the suppliers are di€erent, the
To illustrate the above point, refer to the repe- opportunity cost to the buyer of not reneging on
ated play variation of Example II. Assume that his promised action is higher for one of the sup-
there are now two di€erent suppliers, one the same pliers (say SH ) than for the other (say SL ). By
as before (call him S1) and a second supplier (S2) allowing the suppliers to cross-monitor, the buyer
who chooses actions a21 and a22 . Supplier 10 s pro- is able to impose on himself the higher opportu-
duction function is the same as before with his nity cost associated with reneging on SH , even if
action choices now referred to as a11 and a12 . The he reneges on SL . This makes the opportunity cost
probability of supplier 2 achieving a high (resp. to the buyer of reneging higher, and self-enforce-
low) quality intermediate output which can be ability easier to achieve.
sold by the buyer for Q2H =4 (resp. Q2L =3) is a21 , Reducing the number of suppliers and organiz-
while the probability of supplier 2 achieving a high ing them into a supply network may, however,
quality (resp. low) intermediate output which can come with a cost. Doing so makes it easier for the
be sold to the intermediate market for P2H =2.5 suppliers to observe each others' behaviors, and
(resp. P2L =2) is a22 . If the buyer writes separate therefore easier for them to collude against the
contracts (referred to as bilateral contracting) with buyer.
the two suppliers, the optimal action choices are: Let us now take as given that the buyer decides
a11 =0.50762, a12 =0.11698, a21 =1.00, and a22 =0, to use a ®xed number of suppliers. In the section
and the surplus is 4.77. Now assume that each on complete contracting, we noted that the design
supplier can observe whether the buyer reneges on of supplier networks could have incentive e€ects.
his agreement with the other supplier and that each The design of networks has additional incentive
will revert to the single period behavior if the buyer e€ects when contracting is incomplete.
reneges on either agreement (referred to as multi- For example, to the extent that suppliers who
lateral contracting). The new optimal action choices are higher in the supplier hierarchy are asked to
are: a11 =0.6103, a12 =0.0759, a21 =0.92413, and do work which requires more skill and private
a22 =0.07588, and the surplus is 4.793. Thus, to the information, they will tend to earn higher infor-
extent that the buyer can reduce the number of mational rents.49 The buyer can therefore use the
suppliers and organize them so that they can more promise of promotion to higher levels as an incen-
easily observe his interactions with each, the tive device to motivate suppliers at lower levels of
buyer-supplier network eciency is increased.48 the hierarchy, both in order to perform well at
The basic reason for this result and why it depends that level, as well as to invest in the skill and
on having di€erent suppliers is as follows. With- information which will be necessary to perform at
higher levels of the hierarchy. In essence, the buyer
constructs a tournament by organizing the sup-
See Levin (1998). pliers into hierarchies and choosing the depth of
One of the roles of enterprise software is to reduce the
cost of these types of observations. See Baker (1999). An
important feature of Toyota's supply system is its supplier
associations, which one can view as facilitating such cross- 49
Ahmadjian and Lincoln (1999) reports that it was Denso's
monitoring and enhancing the use of implicit contracts. See increasing informational rent as a result of prior investments
Dyer (1997) for empirical evidence on the use of smaller which recently caused Toyota to start producing in-house some
supplier base and communication in supporting trust within of the electronics parts which were previously outsourced to
Japanese relationships with suppliers. Denso.
230 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

the hierarchies.50 Toyota's supply chain has often to the others in the network, the more ecient
been viewed in this light.51 A complication with their relationship-speci®c investments can be.
this analysis arises, however, because promotion However, the more access a ®rm gives to the oth-
decisions tend to be discretionary. Therefore, these ers in the network, the greater the potential loss
supply chain hierarchies must be designed not from the recipients misappropriating this proprie-
only to provide incentives to the suppliers to work tary information.54 It is reasonable to assume that
hard and invest in skill and information, but also the higher a supplier is in the buyer's hierarchy
to provide incentives to the buyer to actually pro- (®rst-tier vs. second-tier, etc.) the more access that
mote in the way promised.52 Further, for this supplier has to the buyer's proprietary informa-
model to be viable over time, the buyer must be tion. Thus, in determining whether a supplier
growing in order for the hierarchy to grow and should be ®rst-tier or second-tier, say, the buyer
provide additional tiers into which the suppliers must trade-o€ the e€ect on the supplier's invest-
can be promoted. If the buyer stops growing, fur- ment in relationship-speci®c assets versus the
ther promotion eventually becomes impossible e€ect on the supplier's incentive to misappropriate
and the supply chain loses this incentive e€ect. the proprietary information.55
One can argue that the recent changes in the As noted above, one of the costs of increasing
structure of the Japanese inter-®rm relations, in the depth of a supply chain hierarchy is that sup-
which keiretsus are either being abandoned or pliers at lower tiers have less access to the buyer's
are merging, is a result of the prolonged down- technology and thus make fewer ecient relation-
turn in the Japanese economy and the resulting ship-speci®c investments. If these suppliers also
inability to use hierarchical promotion to motivate have their own private information, and the con-
suppliers.53 tract incompleteness is of the form that requires
Part of the eciency gained by setting up a each supplier to contract only with those one level
tightly-woven buyer±supplier network is that each above or below them (rather than directly with the
party may give the others access to his own pro- buyer), then arranging the suppliers in a hierarchy
prietary information. The more access a ®rm gives has an additional cost. In this case, any private
information held by supplier Si can reach the buyer
only by traveling through all suppliers in the hier-
See Drago and Heywood (1989), Lambert, Larcker and archy between Si and the buyer. But each inter-
Weigelt (1993), and O'Reilly III, Main and Crystal (1988) for a
vening supplier will take an informational rent
discussion of the tournament literature.
In the Toyota system there are two types of suppliers:
from passing on the information. Hence, the e-
Design Supplied (DS) and Design Approved (DA). The former ciency of the hierarchy is decreasing in its depth.56
receive the blueprints and speci®cations for the products which
they are producing directly from Toyota. They, thus bring little
design skill or specialized information to the relationship. In 5. The role of accounting in inter-®rm relationships
contrast, the Design Approved suppliers are given the func-
tional characteristics of the parts, but do the design work
themselves. DA suppliers to Toyota are typically higher in the The incentives literature discussed in this paper
supply hierarchy and earn higher pro®ts than DS suppliers. The has two important implications for accounting
higher pro®ts earned by DA arise from the informational rents research into supply chains. The ®rst has to do
that accrue to them. Thus, promotion to DA from DS ®ts this with understanding the rich environment in which
tournament model. See Asanuma (1985, 1995) and Richardson
(1993) for a discussion of the Toyota supply chain hierarchy. accounting information system choices for supply
See Prendergast (1993) for an analysis of this problem.
Related to the issue of making discretionary promotion
promises self-enforcing is that of making discretionary bonus Templin and Cole (1994a) discusses the problem of mis-
promises self-enforcing. See Baiman and Rajan (1995b) and appropriation of ideas within buyer±supplier networks.
Malcomson (1986) for an analysis of when to grant one party See Rajan and Zingales (1998a) for a fuller discussion of
the discretion to pay a bonus to another party. this trade-o€.
53 56
See Ahmadjian and Lincoln (1999), Shirouzu (1999), See McAfee and McMillan (1995). This e€ect is similar to
Strom (1999a,b) for a discussion of this phenomenon. the double marginalization result of Melumad et al. (1992).
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 231

chains take place. The second has to do with types of information for performance metrics
modeling choices which can enhance the questions a€ected by product and supply chain architecture
which can be addressed. characteristics; or how is the demand for decision-
One implication which is common to the results facilitating information a€ected by product and
of most of the papers discussed is the idea of supply chain architecture characteristics. Second,
incentive complementarities; the choice of the given the operations management literature, there is
information system adopted by any one member data available so that these trade-o€s can be
of the supply chain or by the supply chain itself is empirically studied. Another issue which can be
but one of many inter-®rm design choices which studied both empirically and analytically is the rela-
a€ect the eciency of the supply chain. Any deci- tionship between the distribution of information
sion about accounting information must take into within the supply chain (and the cost of gathering
consideration the decisions about these other inter- that information as a€ected by innovations in
®rm design variables. As an extreme example, supply chain management information software)
when renegotiation is unfettered and the invest- and the ownership of assets. This work could
ment is sel®sh, there is no demand for contractible provide additional insight into the outsourcing
information Ð ®rst-best can be achieved with a and restructuring which was mentioned in the
simple non-contingent initial contract. More gen- introduction of this paper.
erally, the literature shows that the demand for A second implication of the literature which was
(contractible and non-contractible) accounting discussed is that some subtle informational e€ects
information will depend on: the distribution of asset on supply chains can only be studied within an
ownership, the product architecture (component incomplete contracting perspective. However to
function sharing and component coupling), the date, little research in managerial accounting has
supply chain architecture (task allocation, number utilized this point of view. Complete contracting
of suppliers, the way in which suppliers are orga- research has emphasized information's direct role
nized), the types of investments required by suppli- in in¯uencing behavior through contracting pro-
ers (whether they are complements or substitutes), visions. In particular, accounting information that
the use of common vs. exclusive dealerships, the is contractible can directly a€ect the eciency of
extent to which the members of the supply chain can buyer±seller relations by a€ecting the extent to
renegotiate contracts after uncontracted Ð for which court-imposed sanctions can be used to
contingencies are observed, the ability of the sup- encourage obedient behavior. The incomplete
ply chain members to write initial contracts, etc. contracting literature discussed here emphasizes
That is, this literature points out quite forcefully information's indirect role in in¯uencing behavior
that accounting information is just one of the through its in¯uence on relative bargaining power.
inter-organizational design instruments which The literature shows that even if the accounting
must be simultaneously considered. information is non-contractible, it can increase
Some of the determinants of the demand for eciency by being used within the implicit con-
supply chain accounting information such as pro- tract itself. More interestingly, the literature also
duct architecture and supply chain architecture are points out that, sometimes it is more valuable to
particularly interesting. First, while there is a large keep the jointly observable information non-con-
operations management literature on product tractible. In the above discussion, the accounting
architecture and supply chain architecture, it information was incorporated within the explicit
emphasizes out-of-pocket cost issues and, by and or implicit contracts which are enforced at the end
large, ignores incentives issues. Thus, there is a of the transaction. When renegotiations between
great deal of analytical research which can be the buyer and seller are allowed, accounting
done to understand the trade-o€s among these information can also play a valuable role in de®n-
variables and supply chain information choices ing initial contracts even if the initial contracts are
arising from incentive as well as out-of-pocket cost subsequently renegotiated (as illustrated in Fig. 1,
issues. For example: how is the demand for certain for example).
232 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

Notice however that while we motivated our research is how the content of accounting infor-
analysis and discussed the literature in terms of mation might change as a function of these new
buyer-supplier networks, the literature discussed arrangements.58 For example, the use of new non-
does not examine a major advantage claimed by ®nancial performance measures, such as supplier
networks- the improved sharing of information ratings, has grown with the shift away from arm's-
between the contracting ®rms. None of the papers length transactions to supplier networks and hier-
surveyed address this issue because essentially all archies. As noted earlier, the design of the supplier
of the literature assumes symmetric information hierarchy can a€ect the extent to which product
both at the time of production and exchange. In failure information can be ascribed to particular
order to address the issue of information sharing, suppliers. Thus, the design of the supplier hier-
we have to allow for asymmetric information, and archy can be seen as a substitute for accounting
there are very few papers which do so.57 The pro- information about product quality and process
blem with allowing for asymmetric information in performance. In a similar vein, the design of the
an incomplete contracting model is that there is no product produced by the supply chain can be
asymmetric information analog of the Nash bar- viewed as a substitute for accounting information.
gaining solution. In the presence of asymmetric In addition, given the previously mentioned
information, one must explicitly model the nego- arrangements to enhance trust within supply
tiation process between the parties (e.g. single bid, chains, one would expect that supply chains would
informed bid only, uninformed bid only, alternat- feature greater dissemination of both detailed
ing bids, etc.). ®nancial and non-®nancial information than
However, once we do so, we can address ques- would arm's-length transactions. This increased
tions such as: what a€ects the ability of a buyer disclosure amongst supply chain members might
and supplier to rationally exchange the informa- also increase the demand for standardization of
tion necessary to form a network versus take part that information. One can view the movement
in a market-mediated transaction; how does toward ISO approved measures of performance as
investing in supply chain management informa- an example of this.
tion systems a€ect the relative bargaining power In summary, the recent changes in inter-®rm
of the supply chain members and their incentive to relations have highlighted new and interesting
make sel®sh or cooperative investments; how does area of research in accounting. There already
investing by one supply chain member in infor- exists a literature which has implications for the
mation to which only he will have direct access design of supply chain information systems.
a€ect the relative bargaining power of the supply However, a number of interesting substantive and
chain members and the resulting eciency of the technical issues remain to be addressed.
supply chain; how does the ability to incorporate
some but not all of the future contingencies that
will be jointly observed at the time that production Acknowledgements
and exchange take place into the initial default
contract a€ect the eciency of cooperative invest- We thank Shannon Anderson, Miles Gietzmann
ments? and the other workshop participants for their sug-
In the above, we have focused on how account- gestions. In addition, we thank Arijit Mukherji,
ing information may facilitate new inter-®rm James M. Patton and two anonymous referees for
arrangements. An interesting future line of detailed comments on earlier drafts of this paper.

Two exceptions in the accounting literature are Vaysman
(1998) and Baldenius (2000). However, both of these papers
exploit the fact that the negotiations are being conducted by We thank one of the anonymous referees for suggesting
two divisions within the same ®rm. this line of research.
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 233

Appendix A 20 2 0:25
 …"; s† ˆ " s …A2†
In this Appendix we provide additional details
on the analysis of the examples discussed in Sec- Next, s must be chosen anticipating that it will
tion 3. The timing of the ®rst problem is: (1) the a€ect q …"; s† and  …"; s† as indicated in (A1) and
supplier invests in s, (2) " is jointly observed, (3) (A2). Given that we are analyzing the ®rst-best
the buyer and supplier jointly agree on the quan- solution, s will be chosen to maximize the expected
tity to be produced and transferred, q, and the surplus, net of investment; i.e. s satis®es:
price at which the transfer is to take place, t.
Because there is no ability to commit to these s ˆargmax
s50 ‰E …"; s† sŠ
decisions, the problem is solved by dynamic pro-
gramming, i.e. the last stage is solved ®rst, then 40 0:25 10
the next to last stage, etc. First, the optimal quan- ˆargmax
s50 s s ˆ  4:98 …A3†
3 3
tity and price are chosen for each possible (s, ")
combination. This determines the optimal quan-
tity and price rules, contingent on the previously Next we analyze the second-best solution,
chosen s and the previously realized ". Finally, the assuming that the supplier's bargaining power
optimal s is chosen given the above optimal guarantees him fraction of the value generated
quantity and price functions. by the agreement. As before, subsequent to obser-
The gross revenue to the buyer from selling ving s and ", the buyer and supplier jointly decide
quantity q is given by V= 80 3 q"; while the cost to upon a quantity and transfer. Note that, as in the
the supplier of making and delivering q units is ®rst-best case, it is sequentially rational for the
given by C= 80 2 0:25
3 q s . Because the buyer and buyer and supplier to always agree to choose the
supplier jointly choose q and t after s has already ex post ecient quantity level for the given ("; s).59
been chosen and " has already been observed, The reason is that this maximizes the surplus
(q; t) must be chosen to maximize, for any given going forward, i.e., the size of the pie that is
pair ("; s), the total revenue less value of available for the buyer and supplier to divide.
 ˆ …V C†. Notice that the cost of s is irrelevant Therefore, the quantity function chosen will be the
in this decision problem; it is a sunk cost. Further, same as in (A1), q …"; s†. Further, the ex post sur-
notice that price is irrelevant as well. Given that plus will be the same as in (A2),  …"; s†. However,
the buyer and supplier must jointly choose (q; t) when the supplier chooses s, he knows that, given
and given that both the buyer and supplier are risk any ("; s), he will receive fraction of the surplus,
neutral, the choice of t has a redistributive e€ect i.e.  …"; s† ˆ 20 2 0:25
3 " s : Therefore, in this sec-
but no production e€ect. Let us begin by ®nding ond-best setting, the supplier chooses his level of
the ®rst-best solution, i.e. the solution in which the investment to maximize [E‰  …"; s†Š s], or:
buyer and supplier act cooperatively. The quantity  
chosen is: argmax 20 0:25 2
s ˆs50 s E…" † s
q …"; s† ˆargmax ‰…q; "; s†Š 40 0:25 10 3
q50 ˆargmax
s50 s s ˆ …A4†
3 3
q50 ‰V…q; "; s† C…q; s†Š
80  Next, we analyze the case in which the buyer
q50 3 q…" qs 0:25
† ˆ 0:5"s0:25 …A1† and supplier are able to agree on an initial non-
contingent contract, which speci®es a default

Substituting q …"; s† into …q; "; s† leads to an ex 59

Sequential rationality nmeans that, at each stage of the
post surplus of: game, each person will act in his own best interest.
234 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238

quantity and a default transfer, …q^; t^†; but are free Note that the expression on the left-hand side of
to renegotiate this later if they so choose. Given (A5) decreases everywhere in s, and hence there is
sequential rationality on the part of the buyer and a unique s which satis®es (A5).
supplier, regardless of the chosen default contract, Finally, let the default quantity q^ be chosen such
they will always renegotiate to the ex post ecient that the following equality holds:
quantity level, q …"; s†, generating ex post surplus    
 …"; s†. The supplier's ex post payo€ is given by: 20 2  1:25 10  0:75
q^ …s † ˆ …s † ; …A6†
3 3
t^ C…q^; "; s† ‡ ‰ …"; s† …V…q^; "† C…q^; "; s††Š
    where s is the ®rst-best investment level identi®ed
80 2 20 in (3). Substituting the value of q^ speci®ed by (A6)
ˆ t^ …1 † q^ s 0:25
‡ "
3 3 into (A5) implies that the unique solution to (A5)
  is s . Thus, the ability to negotiate an initial non-
 "s0:25 4q^
contingent contract …q^; t^† eliminates the hold-up
problem and assures the ®rst-best solution.
To understand the above, recall that if the buyer Next, consider the cooperative variation of the
and supplier do not renegotiate, they will implement above example in which C= 80 2
3 q and V= 3 q" s
80 0:25
the default contract, generating ex post surplus of The speci®cation of " is unchanged. Using the
‰V…q^; "† C…q^; "; s†Š, of which the supplier will same analysis as above, the ex post ecient quan-
receive t^ C…q^; "; s†. If they do renegotiate, they tity is given by q …"; s† ˆ 0:5 " s0:25 , as before,
will renegotiate to the ex post ecient solution given while the ex post surplus is now 20 2 0:5
3 " s . The ®rst-
("; s), resulting in ex post surplus of  …"; s†. The best level of  investment thus
 maximizes the
incremental surplus from renegotiating is therefore expression, 20 3 s 0:5
† s ; implying s ˆ 400
9 .
‰ …"; s† …V…q^; "† C…q^; "; s††Š, of which the sup- The second-best solution (de®ned as the outcome
plier will receive ‰ …"; s† …V…q^; "† C…q^; "; s††Š: when no initial contract exists),  on the other hand, 
The supplier's ex post payo€ is therefore his has the supplier maximizing 20 3 s 0:5
E…"2 † s:
default payment plus his share of the surplus This implies a ®rst-order condition of:
created by renegotiating, t^ C…q^; "; s† ‡ ‰ …"; s†
…V…q^; "† C…q^; "; s††Š. At the ®rst stage of the 20 0:5 400 2
s ˆ 1 ) sW ˆ : …A7†
game, the supplier maximizes the expected value 3 9
of this expression, net of his investment. Thus, his
choice of s is: Now consider a default contract, …q^; t^†: As before,
the parties will renegotiate to the ecient
exchange given the previously chosen s and pre-
s ˆargmax
s50 E" ‰t^ C…q^; "; s† ‡ ‰ …"; s† …V…q^; "† viously observed ", giving the seller an ex post
C…q^; "; s††Š sŠ ˆargmax
s50 E" ‰t^ 80 ^ 2 0:25
3 q s
payo€ of:
‡ ‰20 2 0:25
3 " s …80
3 q
^" 80 ^ 2 -0:25 †Š sŠ
3 q s
ˆargmax ‰t^ 80 ^ 2 -0:25 ‡ ‰ 40 0:25 t^ C…q^; "† ‡ ‰ …"; s† …V…q^; "; s† C…q^; "††Š
s50 3 q s 3 s    
80 2 20 0:25  0:25 
3 q
^ 80 ^ 2 -0:25 †Š sŠ
3 q s ˆ t^ …1 † q^ ‡ " s "s 4q^ :
3 3

Taking the ®rst derivative of the above with This in turn implies the following ®rst-order con-
respect to s gives the following ®rst-order condi- dition on the supplier's investment choice:
20 0:5 20 0:75
  s q^s ˆ1 …A8†
…1 † 20
3 q^ 2 s 1:25
‡ 10
3 s 0:75
ˆ 1: …A5† 3 3
S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238 235
But note that for any default quantity q^ > 0, the 2 2 200
…1 † q^ 104 q^ ˆ 0: …A10†
expression on the left in (A8) is lower than the cor- 3 3
responding expression on the right hand side of the
®rst-order condition corresponding to the second- where (A10) is derived by substituting in the ®rst-
best solution without contracting, [see (A7)]. In best value of s (i.e. s =104) into (A9) and simpli-
other words, the marginal returns from investment fying.
are uniformly lower with initial contracting. Given For < 1, (A10) is a quadratic equation with a
that the expression in (A7) is strictly decreasing in unique positive solution in q^:
s, and that the marginal cost of investing stays  q
constant (at 1), the implication is that, with an 50
q^ ˆ ‡ 2 ‡ 6…1 †2 : …A11†
initial contract, the supplier optimally chooses an …1 †
investment level lower than sW . Given the con-
cavity of the social welfare function in s, this By using (A11) to set the default quantity, the
implies an even greater eciency loss; i.e. it is buyer±supplier relation can therefore be made
optimal to have no contract. ecient despite the presence of both cooperative
Finally, we consider the last variation in which and sel®sh investments.60 However, as becomes
we leave E as before and let C= 80 3 q s
2 0:25
and large, the default quantity grows unbounded, as
80 0:25
V= 3 q" s : Using the same analysis as above, the denominator approaches 0. In the presence of
the ®rst-best quantity level q is given by q …"; s† ˆ restrictions on capacity or market demand, (A11)
0:5" s0:5 and the ex post surplus by 20 3 " s
2 0:75
: The is thus not applicable for large values of . To
®rst-best investment level, therefore,  maximizes capture this aspect, let us assume that the speci®ed
20 0:75
the expression 3 s E…"2 † s ; implying value and cost functions are valid only for quan-
s ˆ 104 . The second-best solution without  con- tities not exceeding q=180, say. This implies,
tracting maximizes 20 3 s0:75
E…" 2
† s ; leading to using (A11), that for values of 40:49, the ®rst-
a lower investment level of sW ˆ …10 †4 . While the best outcome can be achieved by the buyer and
®rst-best surplus level is 13 104 ; the second-best supplier through the use of an initial contract. For
solution without  contracting game yields higher values of , there is still value to having an
…10†4 3 43 ; which is lower for any < 1. initial contract (relative to the second-best no
With a default contract in this setting, the sup- contracting solution), but the surplus generated
plier's ex post payo€ ^

80 2 0:25

20 0:25
 is0:5given  by: t …1 † no longer equals ®rst-best. Eventually though,
3 q s ‡ " 3 s "s 4q^ . This in turn when nears 1, note that the second-best no-
implies the following ®rst-order condition for the contracting solution itself approaches ®rst-best
supplier's choice of s: (since the supplier captures all the rents from
bargaining and so invests the ecient quantity
  up front).61 Therefore, the value of having an
20 2 1:25
Z…s† ˆ …1 † q^ s initial contract disappears for very large values
  …A9† of . In our example, it can be shown that this
‡ 10 s 0:25 q^s 0:75 1 ˆ 0: happens for 50.76. To summarize then, having a
3 contract leads to ®rst-best for low levels of , has
some value for levels beyond some threshold,
Suppose that the supplier's bargaining power is and has no value at all once reaches a higher
relatively low, i.e.  0. Then, from (A9), only threshold. Fig. 1 illustrates these results for the
the ®rst term in Z…s† is relevant. We could there- 2 parameters of our example.
fore choose the default quantity to satisfy 20 ^
3 q 60
 1:25 Note that the default quantity now varies as a function of
…s † ˆ 1; and ensure that the supplier would
the supplier's bargaining power, unlike in the case of sel®sh
choose the ®rst-best investment level, s . More gen- investments studied earlier.
erally, requiring Z…s † ˆ 0 necessitates being able 61
This is also evident from (A9) since, as a ! 1,
 setting the
to ®nd a q^ that satis®es the following equation: default quantity to 0 would result in Z…s †=Z 104 ˆ 0.
236 S. Baiman, M.V. Rajan / Accounting, Organizations and Society 27 (2002) 213±238
Appendix B

Model Section in paper a1 a2 Joint welfare

First-best 4.2 0.8 0.0 1.32

One period 4.2 0.4 0.0 1.24
One market
S owns asset
One period 4.2 0.0 0.0 1
One market
B owns asset
One period 4.2 0.4 0.4 1.16
Two markets
S owns asset
One period 4.2 0.0 0.0 1
Two markets
B owns asset
One period 4.2 0.4 0.0 1.24
Two markets
Joint ownership
Repeated 4.2 0.5076 0.11697 1.27
Two markets
S owns asset
Repeated 4.2 0.6 0.0 1.3
Two markets
B owns asset
Repeated 4.3 a11 =0.50762 a21 =1 4.77
Two suppliers a12 =0.11698 a22 =0
Bilateral contracting
Repeated 4.3 a11 =0.6103 a21 =0.92413 4.793
Two suppliers a12 =0.0759 a22 =0.0759
Multilateral contracting

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