Scaffolding: Using Formal Contracts to Build Informal Relations to Support Innovation
Social Science Research Network
Is it still the case that formal contracts are largely remote from day-to-day management of transactional relationships? Using a preliminary series of 30 interviews we find that in traditional stable industries, much like Macaulay (1963) suggested, little is invested in detailed contracting and unexpected contingencies are handled with little reference to contract language. Contracting partners in these relationships do not resort to formal court enforcement, relying instead on informal
... ms such as reputation, repeat business, and norms to secure their agreements. We also found evidence, in contrast, that in industries with high rates of innovation, even though contracting partners continue to rely on informal rather than formal enforcement mechanisms, they make substantial use of formal documents and legal advice to plan and manage their relationships. To understand this twist on Macaulay's results, we develop a model that shows the relationship between formal contracting and informal enforcement mechanisms. We show that formal contracts and contract doctrine can serve as a mechanism by which, as the relationship evolves, classification of conduct as breach or not can be reached. With this common classification scheme, parties can use the simple set of strategies and a simple belief system to support an equilibrium in which breach is deterred through informal enforcement. We call this role for formal contracting scaffolding and claim that it provides a support system for the efficacy of informal enforcement mechanisms, including the endogenous development of trust, on which the relationship depends, precisely in settings subject to significant ambiguity and unpredictable change.