Good Managerial Economics Essay Example

(Relational Contracting)
Reg. No.

Relational Contracting

Relational contracting has been defined as a form of contracting that is strongly anchored on a specific economic and social context on a currently existing trust relation between the parties concerned and whereby such a relation influence not only the scope but also the content of the contract. The principle of trust in the context of business relationship implies that each party stand to benefit from the relationship. However, trust is not a matter of trial and error but something built over repeated experiences. When viewed in the perspective of economic trust, cost is inversely proportional to trust. For example, lack of trust implies the need to create rules that shall ensure the parties in the relationship are in compliance with terms governing the relationship. Such rules and regulations have been found to result in higher costs incurred in the management, specification, monitoring and negotiation of contracts. An approach that is based on trust, however, is far much cheaper in terms of both transaction and compliance costs. Available evidence suggests that the role of trust is rapidly gaining ground in the building of sustainable business relationships. Studies have further revealed trust-based commercial relationships have been associated with significant economic and strategic benefits since they offer opportunities to lower the cost of doing business and in the process helps in facilitating businesses meet their strategic goals (Jye, 2005).
A reduction in transaction costs results in prospects of an improved economic efficiency of the firm. While some of these transaction costs are internal, others are external to the organization. Nevertheless, all involves transfer of goods or services from the one who is providing (the provider) to the one who is going to use (the user). Internal transactions taking place within an organization include management and monitoring of employees. It also involves procurement of various inputs as well as capital equipment. When a relational contract exists, such costs are eliminated and in the process the organization saves what is equivalent to what would have been used to process these transaction costs (Colledge, 2005). For example, money that would have been used to recruit and manage, maintain, and motivate employees would be saved. Similarly, when it comes to procurement, there are usually a cost element involved. The first cost is incurred by maintaining employees working in the procurement department. The associated costs required to maintain the personnel is also reduced. Although there could be some employees hired to oversee procurement transactions, the number would be less than the case when there were no relational contracting.
In a typical organization without relational contracting, purchase of a product or input from an external source usually involves a number of costs. Firstly, there is a cost of selection. This is where the company can prepare tender document, call for bids, select the best bid, and then award (Lingard, Hughes, and Chinyio, 1998). Besides incurring costs in the process, there is also the element of valuable time that is lost. Further loses of time would be incurred through delays. After the selection, then comes the contract management. It has been argued that for business relationships to prosper the parties require some sort of informality and flexibility. This argument is drawn on the premise that long, complex and highly detailed contracts are often inconsistent. As a result, business that operate mainly on trust have few contracts or tend to do away with contracts and they concentrate on relationships built not on legal force but mutual consent of trust and opportunities.
Contract management is big task that is highly engaging. It shall require a lot of paper work, contractual obligations, and the risks that are likely to occur due to the various clauses involved in contractual obligations (Mouzas and Blois, n.d.). Such risks can be costly at times and might lead to huge losses especially if the contract is not managed well. Furthermore, beyond contract management there is performance measure. This might involve monitoring and evaluation of the progress. This also has a cost element since resources must be allocated to ensure that there is effecting monitoring and evaluation throughout the contract period. If it is a project, it is until such a project is completed. Sometimes, everything goes well until the project is delivered or until the transaction is successfully executed. However, at times, some issues leading to disputes arise. Disputes can be costly to settle. The other party might require to be compensated. Even seeking the services of an arbitrator involves some costs. Basically, there are a lot of transaction costs associated with governance. With a relational contracting with a provider, a number of these transaction costs are avoid thus the recipient stand to benefit a lot from the savings made.
Sometimes, the acquisition of inputs to a firm is highly predictable. Such inputs include electricity, paper, milk, or even custom stationery. Whether they require long-term or short-term contract, the clauses can be adjusted accordingly to reflect the circumstances. However, sometimes, the goods and services to be supplied cannot be well defined in advance and this is where relational contracts is necessary. An example is the supply of special equipment for the production unit and which is rarely replaced. It could also involve supply of key equipment much weaponry used by the army. The focus in such contracts is more about the scope of work rather than the terms of relationship. When necessary, such might be terms might be renegotiated.
Relational contracts offer a lot of benefits such as efficiencies and effectiveness in doing business (MDL, 2010). Firstly when it comes to efficiency, there is a reduction in transactional costs over the short term since the parties rely on mutual expertise and information rather than each having its own setting. Efficiency also results in medium to long term reduction of transaction costs associated with uncertainty since trust reduces friction, opportunistic tendencies, and the likelihood of uncertainty. Issues of close specification, close monitoring and control, and are some of the compliance costs saved due to efficiency. There is also the chances of lighter control due to less dependence on regulations and compliance requirements between parties. The ease of working relationships leads to higher efficiencies thus further saving costs. In terms of effectiveness, relationship contracting facilitates the collaboration to exploit available scarce resources. It also helps create a bank of good will that is very important if one party fails to meet the objective at some point. Relationship contracting, through reference, further enhance the creation of networks that would have been created using expensive means such as marketing or advertisements (Diathesopoulos, 2010).
Relational contracts also provides an opportunity for two or more trust-bounded entities to co-exist in such a manner that they enjoy mutual benefits arising from cost-cutting measures. However, the may result in an arrangement where one of the parties invest a lot in assets specifically targeting the transaction. Although it might be based on trust, such a move is prone to risks and may lead to losses in the process of reducing transaction costs. For example, efficiency can be expressed in terms of cost: the more efficient a transaction, the less the cost involved. As such, efficiency of certain transactions can be greatly improved by investing in transaction-specific assets with an overall improvement in transaction efficiency. Such assets might be rendered useless if the relationship or relational contract breaks. For example, site/location specific assets involves a seller or buyer locating its facilities closer to the other to cut on inventory and transportation costs. Physical asset specific investment involve acquisition of a specialized equipment specifically for a specific customer, human capital asset investment involve a move by one or both parties to develop employee skills or knowledge specific to the currently existing relationship (it could be buyer-seller relationship). Dedicated capacity involves creation of a capacity to serve a particular customer whose relative market size is larger than it can serve so it would be difficult to get alternative customers if the relation breaks. Finally, there is brand name capital where the parties agree to maintain a shared reputation of shared brand name. In light of this, it is very important to assure the investing party that it stands to gain full value out of the transaction-specific investment intending to make. Such investments might include those made for the purposes of reducing production costs which if not made might end up resulting in high production costs for both parties.

References

Colledge, B. 2005. Relational Contracting: Creating Value beyond Project. Lean Construction Journal, 2(1), pp.30-45
Diathesopoulos, M. 2010. Relational contract theory and management contracts: A paradigm for the application of the Theory of the Norms. [Online]. Available at: http://mpra.ub.uni-muenchen.de/24028/1/MPRA_paper_24028.pdf [accessed 02 April 2014]
Jye, L.C. 2005. Trust & Relational Contracting. [Online]. Available at: https://eprints.usq.edu.au/478/1/LIMChuanJye-2005.pdf [accessed on 02 April 2015]
Lingard, H., Hughes, W. and Chinyio, E. 1998. The impact of contractor selection method on transaction costs: a review. Journal of Construction Procurement, 4 (2). pp. 89-102.
McKinlay Douglas Ltd (MDL). 2010. Trust & Relational Contracting. [Online]. Available at: http://www.mdl.co.nz/site/mckinley/files/resources/Relational_contracting.pdf [accessed 02 April 2015]
Mouzas, S. & Blois, K. n.d. Relational Contract Theory: Confirmations and Contradictions. [Online]. Available at: http://impgroup.org/uploads/papers/6417.pdf [accessed 02 April 2015]