Working Paper: CEPR ID: DP10490
Authors: David Hemous; Morten Olsen
Abstract: Do contractual frictions matter when firms are engaged in repeated interactions? This paper argues that long-term relationships, which allow firms to (partly) overcome the static costs associated with low contractibility, will under certain circumstances create dynamic inefficiencies. We consider the repeated interaction between final good producers and intermediate input suppliers, where the provision of the intermediate input is noncontractible. A producer/supplier pair can be a good match or a bad match, with bad matches featuring lower productivity. This allows us to build a cooperative equilibrium where producers can switch suppliers and start cooperation immediately with new suppliers. Every period, one supplier has the opportunity to innovate, and in the baseline model, innovations are imitated after one period. We show that (i) innovations need to be larger to break up existing relationships in the cooperative equilibrium than in either a set-up where the input is contractible or when we preclude cooperation in long-term relationships, (ii) the rate of innovation in the cooperative equilibrium is lower than in the contractible case, and may even be lower than in the non-cooperative equilibrium and (iii) cooperation may reduce welfare. Next, we assume that the frontier technology diffuses slowly to suppliers (instead of after one period). In that case, for sufficiently slow diffusion, the innovation rate in the cooperative equilibrium may be higher than even in the contractible case. Finally, we show that cooperation may also increase relationship specific innovations.
Keywords: contractibility; innovation; relational contract; repeated game
JEL Codes: C73; K12; L14; O31; O43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| relational contracts (L14) | rigidities in existing relationships (L14) |
| rigidities in existing relationships (L14) | hinder economic growth (F69) |
| relational contracts (L14) | dynamic inefficiencies (D61) |
| dynamic inefficiencies (D61) | reluctance to switch partners (J12) |
| reluctance to switch partners (J12) | risk of entering a bad match (C78) |
| good and bad matches (C78) | influence on dynamics (C69) |
| good and bad matches (C78) | affect investment levels (F21) |
| good and bad matches (C78) | affect innovation rates (O39) |
| size of innovation (O35) | barrier to switching suppliers (D43) |
| rate of innovation in cooperative settings (O36) | lower than in contractible cases (D86) |
| cooperation (P13) | reduce overall welfare (D69) |
| static gains from relational contracts (L14) | outweighed by dynamic inefficiencies (D61) |