The Value of Relationship-based and Market-based Contracting: Evidence from. Corporate Scandals in China. Abstract. This paper examines the economic. Product Market Threats and Financial Contracting: Evidence from Performance- sensitive Debt .. While previous studies have demonstrated a relationship between Dynamic Threshold Values in Earnings-Based Covenants. While informal contracts are widely used in modern economies, limited by more recent theoretical models that investigate how informal contracts are built over time, from the market, as under the medieval Law Merchant (Milgrom et al. , ). . of the future value of relationships between contractors and subcontractors.
In Section 5we describe the data. In Section 6we discuss our empirical methodology and present our results. Literature Review As this article focuses on the consequences of repeated interactions and long-standing relationships on firm performance in California highway procurement contracts, we believe that this article builds on and contributes to two strands of the literature. These are the literature on implicit and relational contracting and the literature on procurement and construction contracts specifically.
Despite this, the nature of informal agreements together with the existence of implicit and relational contracting has been an important subject of study for some time now. Klein and Leffler were among the earliest contributors on this topic followed by others, such as BullKlein and MurphyBaker et al.
This literature studies the emergence of informal contracting when formal contracting may yield suboptimal outcomes. These theories revolve around two main points. First, they approach the question of whether informal agreements and formal contracts are complements or substitutes as well as whether the latter will emerge when the performance of the former proves to be dissatisfactory see Poppo and Zenger ; Lazzarini et al.
Second, their sustainability hinges on the capacity of participating parties to enforce these agreements via gains derived from future interactions. The appeal of this latter idea has found applications in many different scenarios, and as a consequence, a literature surrounding the idea of future interactions sustaining informal agreements has developed.
Some examples include studies of topics as diverse as subjective pay performance Baker et al. A separate, related, literature focuses on prior interactions and their effect on contracting outcomes. Articles such as Banerjee and Duflo or Crocker and Reynolds use the number of prior interactions as reputational measure that allows for savings in ex ante contracting costs and defer any discussion regarding the role of continuation value of relationships.
Banerjee and Duflo in fact present a simple model of contracting that rules out explicitly any role of continuation value and highlights reputational effects. On the other hand, McMillan and Woodruff and Corts and Singh among others use the number of prior interactions as a measure of future interactions, which mixes the current cost of contracting with the continuation value of relationships. Our article differs from these two strands of the literature in that we focus our analysis on the role of continuation value with an exogenous measure with time and geographical variation while allowing the impact to differ according to prior interactions.
Ours, together with Macchiavello and Morjariais among the very few articles that account for variation in continuation value and the stock of prior interactions and exploit plausible exogenous sources of variation that allows for the study of the role and impact of relational contracting.
Examples of the former type are Guasch et al. Examples of the latter are Bajari and TadelisBajari and TadelisBajari, McMillan and Tadelisand Bajari and Lewiswho examine theoretically and empirically procurement in the construction industry.
In general, these analyses ignore the fact that bidders in these auctions have ongoing relationships with the public agency and reputations that leave room for some degree of ex post adjustment.
Similarly, subcontracting tends to be unobserved by the econometrician and is therefore omitted. Our article focuses on these two aspects specifically. A number of articles have examined California highway procurement auctions.
In particular, Bajari et al. Other articles examine the effect of preferential programs in these auctions on both auction participation and bidding behavior. Examples include Krasnokutskaya and Seim and Marion Our article differs from these and others in that it focuses on the subcontracting strategies for contractors bidding for highway construction projects and estimates the consequences of repeated interactions with subcontractors in affecting contractor performance in these auctions.
We also need to acknowledge, and differentiate from the current paper, two recent contributions that study closely related topics to ours. Miller estimates the cost implications of contractual incompleteness in subcontracting decisions for a set of bridge construction contracts procured by the California Department of Transportation.
Kellogg empirically examines the impact of past interactions on the productivity of well drilling in Texas. Our article differs from these in that we focus on the role of future contracting possibilities as a way to mitigate moral hazard problems.
Our empirical findings demonstrate that in the setting of California procurement auctions, even though past repeated interactions are correlated with lower bids, it is the future value of projects in an area that drives down bids of contractors. These findings are consistent with the continuation value of ongoing relationships being the main factor that drives down those bids.
Finally, this article also relates to an economic literature on the construction industry proper. The first documents the loose nature of the boundaries of the firm that appear to sustain transactions in this industry, whereas the latter two focus on the fragmentation of this sector and how specialization may lead firms to rely on subcontracting and outsourcing more often than similar firms in other industries.
Our article adds to this literature in that we examine a channel through which contractors may benefit from their subcontracting strategies, and we provide evidence on how repeated subcontracting may enhance contractor performance. Bidding on California Highway Auctions The California Department of Transportation Caltrans awards road construction and repair contracts through sealed-bid first-price auctions.
Potential bidders are solicited through a newsletter that details the bid letting date and the specifics of the project.
A contractor can bid on any project in the category of work for which it has been prequalified. This prequalification is based on the firm's equipment, training, licensing, and past work history. In its bid, the contractor must list each subcontractor whose work accounts for at least 0.
Each subcontractor must be prequalified to do the listed work. The other important restriction regarding subcontracting that was in place through much of the period of our study regards affirmative action. Until for contracts using state funds and for federally funded contracts, contractors were often required to award a certain percentage of contract dollars to Disadvantaged Business Enterprises, namely subcontractors owned by minorities and women.
Although Caltrans attempts ex ante to specify the relevant details of the work, unforeseen contingencies often arise after contract award see Bajari et al. These changes to project specifications many times lead to costly renegotiation between the contractor and Caltrans.
Although we do not have direct evidence regarding this, we expect that these change orders also alter the scope or scale of the subcontractors' tasks in ways difficult to specify ex ante. Theory Discussion In this section, we discuss the theoretical underpinnings of our empirical work.
A more detailed model is contained in Appendix A. A road construction contractor potentially faces significant problems related to moral hazard and incomplete contracting when hiring a subcontractor to perform a portion of the project. A prime contractor may wish to induce the subcontractor to undertake actions that may be unobservable by a third party yet known to both the contractor and the subcontractor. Increasing the quality of the goods provided by the subcontractor, perhaps through the timeliness of completing her portion of the project, is one such action that could lower the cost of the prime contractor.
Since switching subcontractors in the middle of a contract is potentially costly, subcontractors have an incentive to provide suboptimal quality. To take advantage, the subcontractor can either lower its cost by reducing quality or demand extra payment from the prime contractor through a renegotiation. An additional complication with contracting in this industry is the need to cope with unforeseen circumstances.
Often, a construction project differs from the original design due to conditions that are unobservable at the time of the design of the project. If these circumstances are significant, it may require a renegotiation of the contract between Caltrans and the contractor, presumably as well as the contracts between the prime contractor and its subcontractors. This renegotiation is costly and in the presence of switching costs may lead to hold-up opportunities for the subcontractor.
An informal contract, enforced using the continuation value of the relationship, can be used to specify the correct action to be taken by the subcontractor. Since contractors recognize that subcontractors value future business opportunities, contractors use informal contracts that condition future streams of revenue to good performance in current projects. These informal contracts will then align incentives between a contractor and her subcontractors and solve or attenuate the moral hazard and hold-up problem presented above.
Leveraging the value of future contracts lowers the cost of subcontracting, which in turn leads to lower bids on auctions in which contractors participate. Similarly, since the choice of subcontractor and auction participation is not random, prime contractors will prefer to subcontract tasks to subcontractors with whom the continuation value of the relationship is highest. Finally, the cost of subcontracting influences the cost of completing a project, and therefore, the likelihood that the firm's expected profits exceeds the cost of entry into an auction.
As a result, in situations where the firm has a pool of available subcontractors with a high continuation value, the firm is more likely to enter the bidding for the auction.
Contractors and their subcontractors utilize relationships to enforce contracts, but relationships may also have value in other dimensions. The productivity of a given contractor—subcontractor match is likely to depend in part on the degree of prior interactions. Coordinating the efforts of members of the supply chain is important, as workflow is important in the highway construction industry. As firms work together more, coordination costs decline through learning-by-doing.
Also, the contractor and subcontractor may learn about each other's productivity over the course of working together.Managing Contracts and Relationships in Procurement and Supply
One challenge in formulating testable implications is that the continuation value may alter outcomes in the current period for reasons unrelated to enforcing informal contracts.
Since the continuation value of a relationship is correlated with expected future contracting opportunities, it may be associated with firm entry, which potentially lowers the equilibrium price charged for road construction services Furthermore, firms may invest in relationships when future business is anticipated to be significant. For the reasons just described, both past interactions and future business opportunities may affect bidding, auction participation, and subcontractor choice in the current period through channels aside from informal contract enforcement.
Rather than examine the effect of the stock of relationships or future opportunities separately, our focus will be on the interaction of the two.
We will investigate whether existing relationships are more valuable in the presence of future contracting opportunities. The interactive effect is sensible since, as we argued above, repeated interactions between firms and their suppliers lead to greater productivity, perhaps due to lower coordination cost.
This suggests that in future projects, a firm is more likely to hire a subcontractor with which it has a relationship, and this match is more likely to both win future auctions and earn higher profits on those projects it wins. Thus, the continuation value is highest when there are both more future contracts and when a firm has more relationships established with its suppliers.
The two issues described above, those of future opportunities inviting entry and encouraging relationship investment, are silent regarding the coefficient on the interaction term between past relationships and future business. The first story regarding an increase in competition offers no prediction about whether the effect should differ across contractors that hold different relationships with their subcontractors.
Similarly, the second story regarding stronger incentives to invest in their current subcontracting relationships has no implications for the correlation between the interaction of past interactions and continuation value and bids posted.
Data Description The data used in this study include the universe of road construction and repair contracts put up for bid by Caltrans between May and October The CBO administrators expressed dismay that the track records and accomplishments of their organizations did not factor into the selection process, causing reviewers to overlook bidders with a history of performing well in favor of those with lower costs.
As this participant suggested, the operating assumption of client need and vendor expertise under the BV-PIPS minimized the complexity of the human services context, which required pragmatism based on familiarity with local dynamics and trust of agencies providing services. Threat to home visitation EBI and other evidence-based programs Participants felt that the blind review process undermined the status of EBIs in the service system. As indicated earlier, adherence to the BV-PIPS prohibited the child welfare agency from specifying any particular EBI in the solicitation notice to encourage bidders to present innovative practices.
This requirement weakened the prioritized status of the home visitation EBI, which most participants praised for producing measurable outcomes including family and service system improvements.
Although participants supported moving into new directions, the identity and research-base of interventions proposed under the BV-PIPS were unknown to the initial reviewers, making it impossible to judge whether they met criteria for what other child welfare officials knew worked locally. In fact, three applicants recommended program initiatives that failed to meet the basic EBI criteria.
One government administrator stated, In the [solicitation], it said it had to be an evidence-based practice that they had experience with and could show their success with. We had people from both within and without the [study system] that brought practices to the table that were not evidence-based at the level that we requested. Interestingly, nearly all of the administrators who cited themselves as having the greatest amount of involvement in the initial procurement and selection processes admitted to having very little knowledge of the home visitation EBI.
This suggests a disconnection between the stated need for evidence-based services locally, and the knowledge of those involved in procurement processes.
In contrast, the CBO administrators were extremely concerned about the potential loss of a successful and established EBI. If I was a decision maker at the [local government] level, that would be really scary to me that this new process got us really close to tossing out something that works and spending a lot of money on something that was unproven.
A second CBO administrator acknowledged the importance of innovation while resisting the implication of bias towards the home visitation EBI: I feel like it really is something that we believe in and support. Others agreed that previous efforts of government administrators to systemically support the home visitation EBI as a premiere program were at risk because of the BV-PIPS. Review team in expertise Along with concerns about disregarding local expertise, preexisting government-CBO relationships, and the importance of identifying proposed EBIs during the blind review, the CBO administrators also universally criticized insufficient knowledge about child welfare services, in general, and EBIs, in particular, among the BV-PIPS reviewers who vetted the proposals during the Selection phase.
A second CBO administrator stated, To me it was confusing. In the end, the chosen contractors were staffed by home visitors certified to implement the EBI. Yet, this outcome was not considered inevitable. One CBO administrator said, We were literally on the edge and it could have tilted away from us.
In fact I think it was probably already heading in that direction. Other CBO administrators similarly speculated that the eventual involvement of an individual who was especially knowledgeable about child welfare EBIs during the Clarification phase helped to steer the reviewers back toward the home visitation EBI, because it had already delivered clear positive family and workforce outcomes in the service system.
For example, the majority of CBO administrators reported a weakening of staff morale, which, in some instances, resulted in significant turnover. It definitely dampened morale around here. People were going and finding other jobs. Changes and adjustments on the financial side included more accurate budgeting for service delivery costs and CBO control over expenditures. On the monitoring side, changes and adjustments centered on enhanced tracking of EBI provision, referrals, and family progress and outcomes.
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Although these changes and adjustments could have been instituted independent of the BV-PIPS, the CBO administrators were enthusiastic about the increase in flexibility they experienced in relation to CBO operations and the constructive effects of having stronger reporting requirements. Interagency relationships The three local CBOs had a history of productive working relationships to deliver the home visitation EBI as well as a broader array of child welfare services, including exchanging information about recruiting qualified staff, salary levels, and maintaining an organizational infrastructure for EBI delivery under their contracts with the local government.
Despite being pitted against one another during the bidding process, the CBOs took steps to preserve their collaborative relationships under the new contract to address pending challenges. For example, the CBOs had proposed to expand their services to additional sites in the study system when they submitted their bids and two CBOs did so upon receipt of the award, while one lost sites it had previously served.
These changes presented challenges for all the CBOs, including the need to quickly hire staff to cover new regions and the threat of financial losses. These challenges were managed through subcontracts between the one CBO that had not gotten a contract and the two that had, an uncommon practice within the study system, though not unprecedented.
This arrangement ensured both continuity of service to the community and, for the short term, buffered one CBO from major financial hardship.
Several CBO administrators felt that this kind of interagency support was essential in a market where only a small number of local CBOs possessed capacity to deliver EBIs on a large scale, and was necessary to mitigate the threat of out-of-state agencies being awarded contracts.
One CBO administrator explained, We had the conversation about out-of-state agencies being very competitive. We were basically hedging our bets. Although the administrators of the subcontracting CBO voiced some unhappiness with their loss of control, most CBO administrators felt that strong interagency relationships were preserved.
Greater CBO control over decision making within the inner context Contract awardees appreciated that the performance-based contracts reduced the micromanagement of services by the local government. The CBO administrators spoke favorably about the system increasing the control of CBOs over service provision by instituting a daily rate payment model and disallowing contract changes by the child welfare agency.
Even in the larger CBOs that provided a wider spectrum of services beyond the home visitation EBI, the shift toward more risk-based payment mechanisms engendered by the BV-PIPS represented a relatively recent development. As one CBO administrator with four decades of experience in the non-profit sector explained, Everything is moving into these unusual different kinds of payer methods where the provider assumes greater risk….
Thus, the BV-PIPS was viewed as providing the opportunity for CBOs to better prepare themselves to adapt to changes in the economic landscape of public-sector contracting. Until the BV-PIPs had been implemented, the dominant form of payment for services funded by the child welfare system was based on the cost-reimbursement model versus a fee-for-service model.