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Forgiveness in Vertical Relationships: Incentive and Termination Effects

Vanneste, BS; Frank, DH; (2014) Forgiveness in Vertical Relationships: Incentive and Termination Effects. Organization Science , 25 (6) pp. 1807-1822. 10.1287/orsc.2013.0861. Green open access

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Two types of contractual solutions have been proposed for resolving incentive conflicts in vertical relationships: formal and relational (i.e., enforceable or not by third parties). Much is known about the optimal structure of formal contracts, but relatively little is known about the structure of relational contracts. We study a core feature of the latter: the conditions leading to continuation of the relationship, whose prospect gives relational contracts their force. We build a formal model of a vertical relationship between two parties that endogenizes the choice of the minimum performance necessary for continuation as a function of the values of contractibles, noncontractibles, and outside options. The model highlights a basic trade-off between providing strong incentives for the present (incentive effect) and safeguarding relationships for the future (termination effect). The stable relationships that follow from a more forgiving contract are more important under certain conditions (when a lot of value is jointly created by exchange partners, i.e., high contractible value, high noncontractible value, or unattractive outside options); however, strong incentives from a less forgiving contract are more important under other conditions (when a formal contract is insufficient and a relational contract is most important, i.e., high noncontractible relative to contractible value). We discuss implications for the choice of governance of interorganizational relationships.

Type: Article
Title: Forgiveness in Vertical Relationships: Incentive and Termination Effects
Open access status: An open access version is available from UCL Discovery
DOI: 10.1287/orsc.2013.0861
Publisher version: http://dx.doi.org/10.1287/orsc.2013.0861
Language: English
Additional information: This work is licensed under a Creative Commons Attribution 3.0 United States License. You are free to copy, distribute, transmit and adapt this work, but you must attribute this work as “Organization Science. Copyright 2013 INFORMS. http://dx.doi.org/10.1287/orsc.2013.0861, used under a Creative Commons Attribution License: http://creativecommons.org/licenses/by/3.0/us/”
Keywords: Relational contracts, forgiveness, vertical relationships, shadow of the future, formal contracts
URI: http://discovery.ucl.ac.uk/id/eprint/1406354
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