Relational Contracts, Firms and Reputation: An Experimental Study of Institutional Choice

"This study examines the choice between relational contracts and firms in an experimental market setting. The study uses a theoretical operationalization of Williamson's arguments that markets (contracts) feature 'high-powered' incentives, while firms offer better communication. The paper investigates the types of information flows that can sustain relational contracts, and how this influences the choice between contractual and firm allocation. Specifically, when information flows are good, buyers can identify cost distortions by sellers and reallocate business to sellers who do not extract rents through cost distortions. The equilibrium result is then a contract similar in spirit to Williamsonian 'relational contracts.' These contracts sustain low cost adjustment to cost shocks while preserving the strong incentives of residual claims compensation. The analysis shows that surprisingly weak information flows can sustain such relational contracting. When information flows become sufficiently weak, reputational incentives deteriorate, and firms are chosen over contracts. "An unexpected result is that the analysis identifies an important Keynesian average opinion problem in institutional choice. Specifically, subjects' prior beliefs about optimal reporting behavior, and beliefs about beliefs and so on, play an essential role in the equilibrium. These beliefs determine subjects' initial choices of institutional form when information treatments are changed. These beliefs can differ, and updates depend on the past history of the individual subjects. The result is heterogeneity in institutional choice that can persist as a market equilibrium. Hence the experimental results suggest that existing treatments of institutional choice, which typically ignore this potentially important problem may be seriously incomplete."
firm, contracts, institutions