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FORMAL CONTRACTS AND RELATIONAL GOVERNANCE

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Strategic Management JournalStrat. Mgmt. J., 23: 707–725 (2002)Published online 1 May 2002 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.249DO FORMAL CONTRACTS AND RELATIONALGOVERNANCE FUNCTION AS SUBSTITUTES ORCOMPLEMENTS?LAURA POPPO1* and TODD ZENGER21Pamplin College of Business, Virginia Tech, Blacksburg, Virginia, U.S.A.2John M. Olin School of Business, Washington University, St Louis, Missouri, U.S.A.Relational exchange arrangements supported by trust are commonly viewed as substitutesfor complex contracts in interorganizational exchanges. Many argue that formal contractsactually undermine trust and thereby encourage the opportunistic behavior they are designed todiscourage. In this paper, we develop and test an alternative perspective: that formal contractsand relational governance function as complements. Using data from a sample of informationservice exchanges, we find empirical support for this proposition of complementarity. Managersappear to couple their increasingly customized contracts with high levels of relational governance(and vice versa). Moreover, this interdependence underlies their ability to generate improvementsin exchange performance. Our results concerning the d eterminants of these governance choicesshow their distinct origins, which further augments their complementarity in practice. Copyright 2002 John Wiley & Sons, Ltd.Transaction cost economics (TCE) has emergedas a common framework for understanding howmanagers craft governance arrangements. The gen-eral proposition of this literature is that managersalign the governance features of interorganiza-tional relationships to match known exchange haz-ards, particularly those associated with specializedasset investments, difficult performance measure-ment, or uncertainty (Williamson, 1985, 1991). Inresponse to exchange hazards, managers may craftcomplex contracts that define remedies for foresee-able contingencies or specify processes for resolv-ing unforeseeable outcomes. When such contractsare too costly to craft and enforce, managers maychoose to vertically integrate.Many have argued, however, that transactioncost economics overstates the desirability of eitherintegration or explicit contractual safeguards inexchange settings commonly labeled as hazardous.Key words: outsourcing; trust; transaction cost eco-nomics; IT; contracts; relational governance*Correspondence to: L. Poppo, Pamplin College of Business,Virginia Tech, Blacksburg, VA 24061, U.S.A.This view recognizes that in many industries man-agers engage in complex, collaborative marketexchanges that involve rather high levels of assetspecificity and that are characterized by otherknown hazards (Hill, 1990; Dyer, 1997). Rela-tional norms, such as trust, are viewed in this liter-ature as substitutes for complex, explicit contractsor vertical integration (Granovetter, 1985; Bern-heim and Whinston, 1998; Bradach and Eccles,1989; Dyer and Singh, 1998; Gulati, 1995b; Uzzi,1997; Adler, 2001). Based on this reasoning, trustand its underlying normative behaviors operate asa self-enforcing safeguard that is a more effec-tive and less costly alternative to both contractsand vertical integration (Hill, 1990; Uzzi, 1997).Indeed, some contend that formal contracts mayeven undermine a firm’s capacity to develop rela-tional governance. Formal contracts may signaldistrust of your exchange partner and by undermin-ing trust, encourage, rather than discourage, oppor-tunistic behavior (Ghoshal and Moran, 1996: 24,27; Macaulay, 1963: 64; Fehr and Gachter, 2000).Taken together, these critiques view relationalCopyright  2002 John Wiley & Sons, Ltd. Received 3 F ebruary 2000Final revision received 12 December 2001708 L. Poppo and T. Zengergovernance as a substitute for formal contracts. Inthe presence of relational governance, formal con-tracts are at best an unnecessary expense and atworst counter-productive.In this paper, we advance and test an alter-native argument: that formal contracts and rela-tional governance function as complements. Ratherthan hindering or substituting for relational gover-nance, well-specified contracts may actually pro-mote more cooperative, long-term, trusting ex-change relationships. Well-specified contracts nar-row the domain and severity of risk to which anexchange is exposed and thereby encourage coop-eration and trust. In addition, well-crafted con-tracts promote longevity in exchanges by increas-ing the penalties that accompany severing anexchange relationship. As discussed in the trans-action cost literature, contracts also provide cus-tomized approaches and mutually agreed uponpolicies and procedures for dealing with necessaryadaptations in an exchange (Williamson, 1991).This complementary relationship may also func-tion in reverse. The continuity and cooperationencouraged by relational governance may generatecontractual refinements that further support greatercooperation. Relational governance may heightenthe probability that trust and cooperation will safe-guard against hazards poorly protected by the con-tract. Finally, relational governance may help over-come the adaptive limits of contracts: a bilateralcommitment to ‘keep-on-with-it’ despite the unex-pected complications and conflicts.We empirically test whether relational gover-nance and formal contracts operate as comple-ments or substitutes using data on outsourcingrelationships in information services during theearly 1990s. The data were collected from sur-veys of senior managers regarding their sourc-ing of various information services, such as dataentry, software application development, data net-work design, and network maintenance. During thetime period of this survey, outsourcing of infor-mation services was escalating, accompanied byconsiderable debate in the popular press about themerits of outsourcing and the merits of various out-sourcing arrangements (Clemons and Row, 1991;McFarlan, 1990; McFarlan and Nolan, 1995; Lac-ity, Willcocks, and Feeny, 1995, 1996). Perhapsas a consequence of such debate and as a con-sequence of variation in the underlying exchangeconditions, the structure of outsourcing arrange-ments varied widely. Some managers developedlong-term supply relations with their vendors; oth-ers spent considerable time and money customiz-ing formal contracts. Still others appear to havedone both. Using this variation in the structureof outsourcing relationships, we empirically testthe relationship between formal contracts


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