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Industrial Marketing Management 33 (2004) 513 526

Relationship marketing and contract theory

Sudhi Seshadria,*, Randhir Mishrab

School of Business, Singapore Management University, Bukit Timah Road, Singapore b Business Development, Satyam Computers, Hyderabad, India Received 5 January 2004; accepted 8 March 2004 Available online

Abstract The theoretical foundation of contracts and their limitations in governing exchange between firms is a current area of research in economics and business. The relationship marketing approach in business-to-business markets focuses on aspects in interfirm exchange that contracts cannot deal with efficiently. However, the ability to use contractual forms of governance where possible is crucial to the enhanced scope of relationship marketing management. We argue that contracts and relationships are complementary and that contracts provide an evolving governance structure for relationships. We examine the evolution of interfirm exchange theories in this framework and illustrate the convergence between contract theory and relationship marketing management, with examples from procurement in the supply chain, capacity reservation contracts, and program management. D 2004 Elsevier Inc. All rights reserved.
Keywords: Relationship marketing; Contracts; Procurement; Program management

1. Introduction At first glance, there is a polarity in thinking about markets and relationships. Markets and perfect competition characterize agents who cannot influence price in equilibrium. Yet, relationships require firms to modify their behaviors in an interactive manner to affect exchange. Markets exhibit spot contracts with few dimensions, and there is a pressure to further reduce the number of variables relevant to the contract. Relationships have several dimensions contingent on unknown events, and the parties consciously seek to increase the dimensions along which exchange occurs in the quest for new ways to create value. Markets are based on spot contracts that are theoretically first best on efficiency considerations. Relationships are long term, often noncontractual, and efficiency considerations are remote. Ever since Adam Smith and formal thinking on wealth-generating processes (Smith, 1776), business theory has acknowledged the centrality of markets, but has sought to develop the theory in ways that modify the perfect competition model to accommodate relational interactions. The theory of market equilibrium took
* Corresponding author. Tel.: +65-6822-0751. E-mail address: (S. Seshadri). 0019-8501/$ see front matter D 2004 Elsevier Inc. All rights reserved. doi:10.1016/j.indmarman.2004.03.004

a long time in the making by the measure of academic careers, and its literature is more than a hundred years old. The literatures both on contract and relationship marketing theories have developed more recently. The first of these, the existing theory of contracts, is a departure from the perfect competition model. It explicitly acknowledges that agents interact through the price system, but also use a variety of formal and informal nonprice instruments and mechanisms to influence the decisions necessary for an efficient exchange between firms. Contracts are necessary to govern foreseeable and specific aspects of the exchange and are widely observed. They directly impact business performance. Considerations on financial returns, net of contracted expenses, drive practical transactions at the highest levels. While contracts may be explicit, there are also implicit and incomplete forms of contracting that lend themselves to longer term considerations. The second, the relationship marketing theory, is primarily concerned about this longer term. Relationships are necessary to transcend immediate and foreseeable economic concerns and are particularly important in situations of uncertainty and ambiguity. In such situations, future collaboration or termination is supported by implicit and explicit assumptions regarding the exchange (Dwyer, Schurr


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and Oh, 1987). These may evolve as they are mediated by key behaviors in the relationship to influence the dynamics of outcomes (Morgan and Hunt, 1994). In fact, contracts may take on different forms over the course of the duration of the relationship between partners to the exchange. Where does the transition between transactional and relational thinking occur? The two sides to the business exchange are not always on the same page, and mismatched expectations or approaches cause legal problems, often of major import. What terms of contracts are useful in relationships and what are purely transactional? More fundamentally, in the relationship marketing management approach, what should be left free of contracts; what should be contracted; and what would be the scope and choices among these contracts? We address these challenging questions here by arguing for the relevance of contract theory approaches to the relationship marketing theory. We will argue that contracts and relationships are complementary, and that contracts provide an evolving governance structure within which relationships themselves evolve. The paper develops the complementarities through a framework that links contract theory with relationship marketing for the mutual enrichment of theory. We begin with a literature review of the concepts from the relationship marketing literature relevant to contract theory. The following section develops the integrated framework, and subsequent sections illustrate three extensions of short-term complete contract approaches that complement the relationship marketing literature. These illustrations are drawn from the capacity contracting, outsourcing, and information technology (IT) services domains and serve to provide concrete examples of how key dimensions that define contract theory could extend to relationship marketing. The concluding section identifies promising directions for future contract relationship research.

2. Review and framework Four parts make up this section. We trace the recognition in the marketing literature that relationships are finite and may be terminated. The inherent incompleteness in relationships that this engenders is the source of information and verifiability problems, leading to a variety of costs that have historically been viewed as contractual problems. We next trace the developments in contract theory, especially those that ensue from progressively longer term considerations, leading to considerations that historically have been associated with relationships. Finally, we propose a framework that links markets, contracts, and relationships. 2.1. Relationship continuity and termination Marketing has been recognized as a process (Gro nroos, 1995); and relationship marketing is seen as a continuous process involving inputs, outcomes, and continual assess-

ment (Evans & Laskin, 1994). The advantages of relationship marketing can accrue to a firm if, and only if, the consumers are willing and able to engage in relationship patronage (Sheth & Parvatiyar, 1995). The underlying factors that emerge in the relationship research literature is that relationship continuity is an inherent and desired characteristic to achieve the benefits that a relational approach is expected to yield. That time is inherent to the process was identified early with the most important characteristic of relational exchange that it transpires over time (Dwyer, Schurr, & Oh, 1987) and possesses a long-term state in stages of relationship development, where deliveries of continuously purchased product have occurred, wherein companies will develop close relationships rather than play in the market, where they can obtain benefits in the form of cost reduction or increased revenues. These benefits are achieved by tailoring. . .durable investments (Ford, 1980, p. 340). Clearly, a characteristic feature of a relationship is its duration over the long term, where the parties to the relationship depart from spot-market-determined exchanges. But there is also recognition that relationships may be of finite duration, and that continuity is an ideal. Relationalism as expectations of continuity of a relationship leads to more relational exchanges, and as the transactions become more relational, they occur over longer periods of time, and have less definite termination dates. . . (Noordewier, John, & Nevin, 1990; p. 84). If a relationship yields rewards that fail to outweigh the costs, it would be dissolved (Dwyer et al., 1987); that is, as long as the relationship is productive, it would be continued. Low expectation of future exchange would be an outgrowth of current relational problems, whereas high expectations of future exchange would reflect a favorable perception of the current relationship (Crosby, Evans, & Cowles, 1990). Specific strategies will be necessary to assure relationship continuity. A set of relationship variables has been identified that impact continuation or termination of well-established and mature relationships, supporting the argument that relationship quality is the best predictor of the likelihood of future contact (Wilson, 1995). The likelihood of continuity in relationships is, therefore, not assured, and theories that link episode evaluation to the likelihood of relation continuity are recent areas of research (Mishra, 2001). This line of inquiry draws upon the behavioral concepts of contractual relations, which are at the foundation of exchange relationships (Macneil, 1974). Contractual exchange behavior arguably involves relations that project exchange between parties into the future (Macneil, 1980). In effect, the relationship marketing literature has specifically identified the issue of continuity, with contracting as the governing modes of exchange. The possibility of a finite duration to a relationship makes it resemble a sequence of episodes, not unlike several shorter implicit contracts that link together, forming a longer term contract that is incomplete with regard to its termination.

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2.2. Relationships and transaction costs The possibility of termination generates two key considerations that restrict relationships between firms. The one has to do with the sharing of information that the parties may acquire during the course of their exchange. The other has to do with the verifiability of the disagreements that may lead to termination. Both of these restrictions involve costs. Clearly, if relationships did not involve costs, understood as demands on resources, there would be no tradeoffs for relationships. Transaction cost economics (TCE) formally recognizes costs to relationships and has contrasted markets and hierarchies in business relations with this point of departure. The introduction of costs logically leads to questions on which party bears the costs for maintaining the relationship and what forms of allocations are used. The link with contractual arrangements arises naturally from the consideration of costs. TCE distinguishes between classical, neoclassical, and relational contracting in business exchanges, where internalization via vertical integration is unavailable or unattractive (Williamson, 1986). Classical contracts are complete and explicit and are enforceable by third parties in courts, and therefore treat information asymmetries and unverifiability problems as nonexistent. The neoclassical variety of contract (including agency theory contracts) is complete but implicit and includes royalties, fees, expenses, profit sharing, and the like. It recognizes information asymmetries. In contrast, relational contracts are incomplete and longer term. They recognize problems of unverifiable outcomes and actions. Joint ownership and alliances are akin to relational contracting. For instance, relational contracting is described as: The fiction of discreteness is fully displaced as the relation takes on the properties of a mini society with a vast array of norms beyond those centered on the exchange and its immediate processes. By contrast with the neoclassical system, where the reference-point

for effecting adaptations remains the original agreement, the reference-point under a truly relational approach is the entire relation as it has developed . . . (Williamson, 1986, p. 105). Transaction costs arise due to the dynamic nature of economies and forces us to look for allocation governance modes besides classical and neoclassical contracts. Incompleteness arises due to the costs associated with contracting in the presence of difficulties in (a) anticipation of contingencies and situations due to bounded rationality; (b) devising and agreeing to courses of action; (c) writing of explicit clauses and contingent agreements; and (d) monitoring and enforcement (Hart & Holmstrom, 1987). The inability to foresee contingencies in contracting itself would call for increased emphasis on relational contracting. Relations are necessary due to these increases in the costs in contracting; if costs did not exist for both contracts and relationships, then, parties to the exchange would use only one form or the other. This is especially true for growing markets, where increase in the scope and scale of transactions increases the costs in contracting. Despite these realizations, TCE posits the discrete transaction as the unit of analysis and, therefore, does not fully encompass the behavior of participants in long-term relationships. Exhibit 1 summarizes these aspects of the literature. The durable and evolutionary nature of relationships allows firms to depart from the static and termination-prone exchanges characteristic of markets. However, the restrictions on relationships introduced by termination, incomplete information, and verifiability difficulties necessitate the consideration of contracts, which we turn to next. 2.3. Contracts for relationships Contract theory, in its origins and development, has proceeded in the reverse way from market idealizations to information asymmetries, to unverifiable outcomes and actions, and to longer term considerations (Hart, 1995).

Durability Termination Continuity


duration uncertainty; absence of investments.

increasing scope; increasing number of variables in value creation; relational contracts; reputation; trust. reference point is entire relationship; episodes as internal and fully anticipated process; adjustments and considerations; neoclassical contracts.

Evolution Static discreteness; term of contract; classical, market and spot exchange.

Exhibit 1. Relationship dimensions and market pressures.


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This section develops the framework of the last section along these key dimensions. Three parts trace the development of contract theory from market equilibrium, complete but implicit contracting, and incomplete contracts. Special considerations that we identify from the incompleteness that link with relationship marketing are repeated contracting, reputation, and commitment. 2.3.1. Markets and equilibrium Formal economic models of firm behavior accumulated from as early as the mid-1800s with early equilibrium models (Friedman, 1999); new market-competition-oriented theories were introduced right through the 1900s, with conceptual frameworks from monopolistic competition, oligopoly theory, and other areas of industrial organization until the general equilibrium theory (Varian, 1984), which, in the mid-1900s, brought some closure to the macrolevel endeavor. The theory successfully showed, with formal models, that interfirm exchanges in an economy characterized by prices and quantities could be determined as a general equilibrium solution. Moreover, symmetric information and uncertainties could be included in the general market equilibrium framework. However, overlapping with the later part of this stream, there were two major theoretical developments that seemed outside the premises of the theory of market equilibrium. First, inquiries into the institutional governance of economic relationships, including the origins of property rights, now referred to as the New Institutional Economics or NIE, starting with Coase and developed by several writings of Williamson, and with recently proposed formal models (Gibbons, 1999; Hart, 1995; Hart & Holmstrom, 1987), demonstrate that the existence of firms was not adequately explained, as the interfirm exchanges could potentially be internal to a fully integrated economic entity. In other words, there were no natural limits to vertical and horizontal integration in the theory. Contracts, in this sense, could only be partially explained by the equilibrium approach. Second, fundamental contributions to game theoretic and utility theory methodologies and concepts (von Neumann & Morgenstern, 1947; with utility functions) allowed the formal modeling of risk and asymmetric information structures and were the basis of information economics (IE) approaches in exchanges (Harsanyi, 1967; with Bayesian equilibrium). The information asymmetries could not be included in the general equilibrium models, and market failure could result from some pathological situations (Akerlof, 1970). At best, contracts that depended on complete or symmetric information between firms were likely to be unrepresentative of the reality and result in a loss of efficiency. 2.3.2. Complete contracts Partial equilibrium models in the latter half of the 1900s explored a variety of causes of and solutions to market failure, based on NIE and IE considerations. Their legacy of identifying potential market failures or loss of efficiency

as a strategic consequence, rather than an outcome of irrationality or bounded rationality, has been inherited by strategic thinking in formal industrial marketing models. The considerations allowed the classification of contracts into (a) explicit contracts of the classical kind, of which spot market contracts with full information and institutions of governance, free of transaction costs, were typical; and (b) implicit contracts of the neoclassical kind, of which self-enforcing contracts with full commitment and mechanisms that balance the risk and incentive tradeoffs were typical. These approaches continue to provide valuable economic underpinnings for competitive marketing analyses at the end-user level (Chatterjee & Lilien, 1986); however, B2B transactions require theorizing at multiple tiers. The analyses of supply chain contracts are only recently finding moorings in the partial equilibrium models referred to above. Particularly used is the principal agent model (PAM) as a normative theory of supply chain contracting of the implicit kind (Bergen, Dutta, & Walker, 1992). The disclosure of private information is not enforceable, and often, the only remedy to the nondisclosure of material information is to rescind the contract. Uncertain costs complicate the contracting process. Even when the supplier is able to determine their cost with the smallest possible error, it may be of strategic interest to conceal costs when risksharing agreements are in place. Asymmetric information on uncertain costs allows suppliers the possibility of increasing their rents. The essence of the free enterprise society is that each party is entitled to make use of whatever information he has to obtain the best bargain he can get; neither party is under any obligation to assist the other party (Atiyah, 1995). This is the reason why risks of cost overruns would be impossible to contractually insure with a third party insurer. The insurer decides the materiality of information and may consider any history of cost overruns as evidence of moral hazard. In the special case of pure insurance contracts, however, there is a duty to disclose all material facts that would affect the risk assumed by the insurer. Even if the significance of the fact is not realized by the insured, it must be disclosed for such insurance contracts not to be rescinded in case of damage claims (Atiyah, 1995). The upshot is that the parties seek insurance within the exchange, adding costs and complexities to the contracts. Efficiency losses in exchange arise because firms trade off insurance based on their risk attitudes, with incentives based on contractual mechanisms under conditions of uncertainty and information asymmetry. Although complex, these contracts are still complete in the sense that they can identify and verify the outcomes of relevance to the exchange. This may not always be possible, especially as the exchange evolves. 2.3.3. Incomplete contracts Modern systems of production and consumption with intermediate goods exchanges between firms have evolved enormously. The rise in recent years of supply chain man-

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agement has brought wide recognition that firms engage in exchange at multiple levels. The coordination of investments for capacity building under conditions of evolving information structures that characterize supply chains lead, naturally, to incomplete contracts. The contracts are recognized to be incomplete in the sense that all the relevant contingent states that affect the contract cannot be characterized, or even known, at the time of contracting, although they may be observed at a later date. Moreover, at a subsequent time, these contingent variables may be observed but cannot be verified for use in enforcing the contract. For instance, the transaction-specific investment made by a supplier in a contracted procurement may be observed by the buyer but cannot be verified, except at a prohibitively enormous cost for contract enforcement by a court. A descriptive approach to incomplete contracts, albeit for short-run exchanges, is the earlier mentioned TCE, where the incomplete contracting scenarios of business with acknowledged costs of contracting are a central issue (Williamson, 1986). Recent reviews (Hart, 1995) link key TCE constructs, such as transaction- or party-specific investments and hold-up and lock-in costs, to the emergent formal, normative models of incomplete contracts. Moreover, the use of subjective, in addition to objective, measures in incomplete contracts aims at overcoming some problems of unverifiability of the important actions or outcomes. For instance, the trust construct is central in relationship marketing and may form one subjective measure (Baker, Gibbons, & Murphy, 1994). Another key construct, power, has been studied extensively in marketing; but some less well studied constructs are learning, reputation, and commitment. 2.3.4. Learning and repeated contracts Formal models in this context involve supergames and dynamic programming approaches to the agency problem. In infinitely repeated games, appropriately chosen punishment strategies will serve to ensure that first-best results (cooperative or fully integrated optimally efficient outcomes) would be sustained even in the presence of information asymmetries and implicit (but complete) contracts (Benoit & Krishna, 2000; Fudenberg & Tirole, 1989). The strong assumptions of no discounting and infinite repetition in formal models beg the question whether the optimal longterm contract over the entire duration of the relationship can be achieved by a sequence of short-run contracts. This is possible when agents have access to capital and rental markets (Salanie, 2002). Interestingly, the agent can exploit the long-term relationship by renting from the principal or by forming equity relationships with the principal, with benchmarks of market interest rates and market levels for return on investments. Learning from the outcomes of shorter contracts for the evaluation of progress within a longer term performance contract is useful for considerations such as progress payments. This is an example of the complementarities of markets and long-term relationships (Seshadri, 1994).

2.3.5. Reputation Reputation may be earned from performance outcomes over repeated contracts. The ability of markets to recognize reputation and reward or punish suppliers based on reputation effects is an influence on performance within the implicit contract itself (Fama, 1980). Outcomes and actions are observable to the parties in the incomplete contract but may not be verifiable by outsiders, and therefore, reputation in such circumstances is internal to the contract. When the market may be able to verify the actions that lead to poor performance, then, reputation is, in addition, external to the contract and provides better incentives for unverifiable effort in performance. This is another instance of marketrelationship complementarities. The ability to use reputation in incomplete contracts is a rationale for repeated contracts of short duration rather than a single long-term contract. In relationship marketing approaches, reputation is derivative from the network within which the dyadic relationship exists (Achrol, Reve, & Stern, 1983). 2.3.6. Commitment and Renegotiation The level of commitment is highly relevant in situations of long-term contractual incompleteness. Renegotiation of the contract is always a strategic possibility as unforeseen events unfold. Explicit long-term contracts are naturally useless in situations where renegotiation is possible and where dynamic considerations make commitment impossible. Therefore, implicit contracts are more likely in situations of incomplete information. A further question is whether and when a sequence of short-term contracts is preferable to a single long-term contract. Complex contracts contain elements that are renegotiated and others that allow commitment. Some specific aspects of transactions will be more easily anticipated, and these can be cast into shortterm, explicit, complete contract agreements, leaving other aspects to implicit contracts of the incomplete variety. The importance of so doing will rise if other aspects of the transaction are increasingly complex. As transactions become recurrent and less discrete, the importance of removing ambiguity, where possible, through contract agreements increases. Commitment to continuity and long-term relationships with the contracting parties is a central construct in relationship marketing. Commitment is derivative from interdependence and coordination, which are learned behaviors for both parties (Gundlach, Achrol, & Mentzer, 1995; Morgan & Hunt, 1994). Relationship commitment positively impacts relationship profitability, but evidence for the reverse effect was not found, as understanding between the parties might be more important in creating relationship commitment (Holm, Eriksson, & Johanson, 1996). Supplier-specific investments are credible commitments that the buyer makes and serve to increase coordination, buffer against technological uncertainty, and build closer relations in scarce skills markets (Bensaou & Anderson, 1999).


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Exhibit 2. Dynamics of markets, contracts, and relationships.

Exhibit 2 presents a schematic framework that summarizes the literature reviewed and positions the theory of contracts for relationship marketing theory. Exhibit 3 aims at contrasting contract and relationship theory along key dimensions identified in this section. 2.4. Contracts for relationships: Complementary systems? The shift in emphasis from the short-term, highly discounted future to a long-term, durable exchange is particular to relationship marketing management. So is the combination of the asymmetric information on actions and endowments and the unverifiable, although observable, outcomes. The treatments of change in both the normative PAM and the descriptive TCE theories are inadequate, as they focus on the short term. Both PAM and TCE provide valuable insights into how contractual approaches are important for relationship management, but they offer a predominantly

static picture, with discrete unitary transactions as the unit of analysis. Appropriate choices in the contractual domains of Exhibit 2 support the relationship domains. For instance, formal contracts relieve the burden of temptation to renege in informal contracts that will be necessary in long-term relationships when the future value of the relationship is difficult to estimate (Baker, Gibbons, & Murphy, 2001). In incomplete contracting situations, the optimal contract increases weights on both subjective (such as trust) and objective measures as the objective measures become more accurate (Baker et al., 1994). Overall, the value of the ongoing relationship is improved. Specific transactions can be formalized, while others that are better left informal would still yield desired behaviors due to the expectations of future business (Granovetter, 1985). Empirical work on short-term contracts in technology procurement shows that market contracts deliver a variety of benefits for suppliers as

Exhibit 3. A comparison of competitive markets and relationship contracts for dimensions of tradeoffs.

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well, such as diversification (better marketing, R&D and product development, and other customers), short-term (capacity utilization, contract control, and quality), and long-term benefits (follow-up contracts, technical skill, and employee motivation; Nordberg, Campbell, & Verbeke, 1996). The degree of contractual completeness or incompleteness may be chosen in a way that minimizes the total cost associated with the exchange (Crocker & Reynolds, 1993). Markets versus contracts reflects the tensions of the old general equilibrium competitive paradigm versus the later partial equilibrium supply chain paradigm. The tension is partially eased with the advent of theoretical work on the market for contracts, where spot markets are benchmarks for contract design. What is new in our framework to understanding the behavior of firms in the supply chain is explicit models of the interface between contractual transactions and relationship marketing, or contracts for relationships, where contracts are the benchmarks for relationships. One aspect will help understand the other. Linking markets, contracts, and relationships approaches is the perspective offered by our framework. An approach that focuses on the interface of markets for contracts for relationships may be fruitful. An explicit focus on the interfaces between contracts and relationships has the following advantages: It requires a dual understanding of how (i) a competitive market and contractbased approach may apply in some situations and makes explicit the assumptions for these situations; and (ii) a relationship marketing approach may apply in some situations and makes explicit these assumptions. Moreover, it requires (iii) an interactive understanding that reveals how the parties will strategically use the contractual and relationship marketing options to influence their chosen approach in each situation. Our framework developed above and summarized in Exhibit 2 poses a theoretical challenge on how contractual transactions may support relational transactions. It is logical to ask how the complete or incomplete contracts that we encounter in supply chains derived from short-run considerations support the relational strategies in B2B markets necessary for the long run. For immediate anecdotal evidence of this need, observe the new economy or the Internet age, which is proliferating situations of contractual incompleteness. The absence of comprehensive laws governing international e-commerce, the poor arbitration of web sales disputes across borders, and a variety of information asymmetries characterize this business environment today. Relationship marketing must coevolve with contractual agreements. In the remaining sections of this paper, we turn to three illustrations of the complementarities between welldesigned contracts and relationships. We choose these illustrations, as they represent extensions predominantly along three key dimensions of our framework. The first, the capacity reservation contract, is along the dimension of

unverifiability; the second, procurement, is along the dimension of information; and the third, software services, is along the dimension of long-term durability. We next examine the domain of outsourced capacity in the manufacturing industry, which is increasingly complicated with uncertainty and shortening product lifecycles.

3. Capacity reservation contracts Suppliers in manufacturing industries have an option to sell capacity in (i) the open (spot) market and (ii) through prenegotiated contracts with buyers (Grey, Olavson, & Shi, 2002). In the former, competitive market pressures will determine pricing; in the latter relationship, contracting will come into play especially when capacity expansion comes into consideration where unverifiability is endemic. While different approaches are called for in these two instances, there is a degree of interplay between transactional and relational contracts, which is the focus of our interest. We believe that aspects, such as search and selling costs associated with booking and selling capacity in the open market, would (and should) influence the suppliers pricing strategies and capacity allocation (Hazra, Mahadevan, & Seshadri, 2002). 3.1. Contingency contracts There are several studies related to contractual agreements on capacity reservation between the supply chain members (Tayur, Ganeshan, & Magazine, 1999). To show how uncertainty and longer term considerations involving contingencies may be introduced to contracting, alternative contract mechanisms have been proposed in the last few years. In high-technology manufacturing, a proposed contract is a reservation fee paid by the supplier that would be deducted at the time that the customer places an order. This mechanism enables the supplier to plan capacity expansion (Jin & Wu, 2001). In a pay-to-delay capacity reservation (Brown & Lee, 1997), the buyer undertakes an obligation to buy at least y < z units of capacity at a lower cost. The reserved capacity is typically take-or-pay, that is, even if the buyer does not fully utilize the reserved capacity that it pays. Furthermore, the buyer can procure additional capacity up to a maximum of z y units later at a higher cost. These agreements are likely to succeed in repeated buying situations, where contract compliance is necessary to support trust on other noncontractible dimensions of the relationship. Automobile manufacturers contract capacity in advance with trucking firms for a lower-than-market cost and display elements of a relationship approach (Henig, Gerchak, & Pyke, 1997). A similar contract mechanism is where a supplier offers a portion of its capacity in advance at a cost lower than of the market. For additional capacity, the buyer pays at the market price (Serel, Dada, & Moskowitz, 2001). The ability of suppliers to tailor their contacts


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to buyer inventory control policies is typical of relational contracting. Other work models information asymmetry issues in contracts and assesses the value of information to the suppliers in setting the price for the contract (Corbett & Tang, 1998). The importance of these contingency-contracting mechanisms is that they benchmark long-term adjustments against markets. While the contract itself is the governance mode, contract elements may be subject to bid. For instance, among other terms, the discount from the spot market price, the percent of capacity reserved, or the settlement for buying less than the booked amount may all be bid. Varieties of the contracts include quantity flexibility, deductible reservation, back-up agreements, buy-back, pay-to-delay, and take-orpay. For instance, buy-back agreements are useful for procuring goods with finite shelf life, whereas quantity flexibility is useful during periods of high demand uncertainty. Deductible reservation and take-or-pay contracts are often employed in high-technology manufacturing, enabling suppliers to invest in specific capacity. What these variants tell us is that the buyer can shop around for the right mix of elements in the longer term contract. Key inputs to overcome the verifiability problems are facilitated by introducing markets into the relational approach. In sum, there exists not only a market for suppliers within the supply chain, but also a market for contract types. Our next example is procurement under asymmetric information in supply chains.

practices for all participants in the supply chain. Recent studies characterize the evolution of electronic markets from transaction to relationship contracts in three phases. An aggregation phase is followed by a value-added services phase, followed by an integration phase with customer processes (Ganesh, Madanmohan, Jose, & Seshadri, 2004). Despite integration efforts, a strategic procurement approach recognizes that a supply chain can almost never be designed by a central planner. There is no one firm or entity that is actually making decisions for the entire chain, and information asymmetries and uncertainties will continue to affect individual firms in the chain differently. Therefore, procurement strategies must seek to match the risks and returns to the individual firms in the supply chain to obtain best results. Clearly, this awareness complicates the job for strategic procurement theory by explicitly including conflicts in interests. 4.1. Procurement games Collaboration between suppliers and buyers is growing, in response to the need for innovation, investment, and incentives, on the one hand, and rising demand and supply side risks on the other. While collaboration is necessary in modern procurement, there is inherent competition between alternate partners in a multisourcing world. In addition, the complexity of sourcing arrangements often requires multiple contracts between the same two partners, for separate agreements. For instance, development and manufacture contracts with the same suppliers may require two-stage contracting (Laffont & Tirole, 1990; Seshadri, 1995; Seshadri, Chatterjee, & Lilien, 1991). Procurement agreements are transactional when they are governed by short-lived, arms-length contracts of the classical kind, with provision for third-party intervention, such as court judgments. Some procurement agreements are transactional in nature because the items procured are commodities or all contingencies in the agreement can be anticipated easily and written into contracts. Other agreements are incentive contracts that apportion the financial burden of risk and must be self-enforcing and based on verifiable outcomes. These outcomes must substitute other, perhaps, more relevant ones, as the parties would find it prohibitively expensive to verify such outcomes, unobservable actions, and asymmetric information on capabilities. Paradoxically, the greater ability of buyers and sellers to contract in a transactional mode for the routine portions of procurement allows them to develop more complex relational contracting agreements, based on trust, with the same partners. Collateral contracting is an example of such thinking (Macneil, 1974). A rationale for this is that the violation of trust can now be punished through the contract on a separate procurement, giving each partner a greater degree of confidence that trust will not be violated. The argument is similar with the gametheoretic reasoning on punishment strategies in repeated

4. Procurement in supply chains Prime uncertainties in global supply chains are due to currency risk, resource availability, and asymmetric information about potential synergies. There is an interaction between risk, resource, and information in procurement, which provides the impetus to move from markets to relationships. Three aspects isolate this impetus. (i) Firms require capital to fund procurement. However, borrowing rates and exchange rate fluctuations affect every multinational corporation. Global supply chains experience a similar exchange rate exposure, particularly in transaction, economic, and translation exposures. (ii) Individual members of the chain may be forced to borrow at higher interest rates for individual loans. Resource sharing within procurement dyads may be viable and should be supported with relationship contracts (Seshadri, 1994). (iii) Access to information throughout the chain is critical for potential resource-sharing synergies, but sharing financial information outside the firm is too radical for many organizations. In fact, functional silos and data ownership are a struggle even within organizations. The new B2B procurement functionalities and strategies, often using electronic exchanges and the Internet, serve to expand market reach, lower prices, cut the cost of the buyers procurement processes, and identify industry best

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games that players may use to threaten an inferior equilibrium for deviations from the Pareto superior outcome (Benoit & Krishna, 2000). This allows a superior relationship to be sustained in equilibrium. When buyers are unable to commit to long-term contracts, and production learning is possible, dual sourcing contracts reduce the two-period, repeated contract costs (Klotz & Chatterjee, 1995). Relationship contracts impose new burdens among agents in multiple sourcing arrangements. We next turn to a framework for program management incorporating both market and relational elements.

5. Software services industry Our third example is along the dimension of continuity and long-term stable exchange. The IT services industry includes a complex and volatile set of contracting and relationship structures. Supply-chain aspects of the industry relate to the outsourcing of software development and the integration of outsourced applications and hardware. Transactions in the current software services industry are typified by four dominant structures applied at each tier of the supply chain: (a) time- and material-based contracts employing persons with a specific skill for specific tasks; (b) fixed-price contracts with incentive fees for specific project engagements, with clearly defined incentives for service level agreements (SLAs) and final deliverables; (c) relational engagements with ongoing deliverables1; and (d) technological product alliances as platforms for productspecific customizations. Longer term exchanges link episodes at the relationship level and link the contracts themselves at the supracontract level. The incomplete contracts approach is a possible foundation to interpret outsourcing or insourcing decisions for information products (Brynjolfsson, 1994). Large overruns are frequent, and these generally incomplete contracts are often renegotiated. The initial contract has a bearing on whether the service providers share of the overrun is high (for a fixed price contract) or low (for a time and materials contract; Banerjee & Duflo, 2000). In the rest of this paper, we examine one framework, the project within a program management approach, which makes the link explicit. The literature applying the contracts and relationship approach to software markets is limited; what are available are experiential cases, white papers, and methodological approach notes with limited or no research support. Available evidence indicates that generic technical skills (e.g., Java, C+, SQL, etc.) are traded discretely as commodities, while specialized solutions, such as enterprise application integration, networking solutions, and business performance

1 Gartner group views SLAs as not simple contracts on service up-time reliability, such as 99.9%, but as relational contracts tailored to specific customers.

solutions, and so forth, follow a long-term relational approach (Lee, Trauth, & Farwell, 1995). Engagements themselves require multiple skill sets. Generic but diverse skills are bundled together for a unique skill assortment by a special engagement. IT firms that focus on outsourcing business develop long-term relationships with clients. As an outcome of the program management effort, buyers and sellers can specify the longer term relational contract. This includes a broad specification of the terms of reference for specific classes of activities. The program management approach requires open-ended discussions with buyers on partnering possibilities, scenario planning, and project development. Individual projects are determined within these terms of reference. Market contracts would be entirely transactional in nature and have rigid price performance tradeoffs. There is a transactional character that develops here. In the course of delivery, there will be a need for third parties to come on board and write market contracts. For instance, in most large business process outsourcing (BPO) exercises, the systems integration component is heavily dependent on third parties and bid contracts. Project management, which would spell out the degree of off-shoring, the degree of on-site testing, handover protocols, and so forth, will require expertise in delivery, and the interface between the buyer and the seller must bring closure to many of the specific activities that will be invoiced and paid. Exhibit 4 provides an illustration of the contracts map in IT services. In many firms, the outsourcing process in IT is given insufficient attention. The process includes the identification of objectives, evaluation and selection of suppliers, and, ultimately, transition to and measurement and evolution of the outsourced service. The basic structure of the outsourcing model covers the extremities of B2B market structures contract or relationships. There are varied risks in outsourcing, and the significant expenditure involved in multiyear, multimillion-dollar IT and BPO. Management recognizes the need for an appropriate structure to fulfill known and likely requirements. The structure would distinguish between strategic and operational considerations in outsourcing and lead to a design on the transactional relational continuum, as in Exhibit 4. A program is made up of a specific set of projects identified by an organization that together will deliver on some defined objective, or set of objectives, for the organization. The objectives, or goals, of the program are typically at a strategic level, such that the organization can achieve benefits and improvements in its business operation. At the most fundamental level, program management could be seen as an evolved form of project management. While project management is about optimizing the key ingredients of time, cost, and quality, program management is optimizing the time, cost, and quality aspects of multiple projects happening simultaneously and competing for the overall resources with


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Exhibit 4. The IT services contract map.

independent ROIs and separate time horizons, but bound by a common larger interest. Program management addresses the need to analyze and prioritize projects in terms of their contribution to a firms objectives and goals. Organizations, from engineering to information technology, public utilities to banks, and government departments to industry, find themselves trying to complete many projects with few resources. Also known as multiproject management, program management is evolving beyond managing simultaneous projects into a tool

that is capable of handling the complexities that arise due to the overlapping demands on limited resources placed by simultaneous projects. Project management is based on relatively simple linear relationships within activities and tasks, using a large number of substitutable resources. Program management is focused on handling multiple programs with limited and nonsubstitutable resources (e.g., software development and biomedical research in a bioinformatics program). Exhibit 5 summarizes the key differences between project and program management.

Exhibit 5. A comparison between project and program management.

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Internal or project-integrated agents hired by BPO suppliers must follow contractual or agency mechanisms that overcome adverse selection and moral hazard problems efficiently. The interface of such efficient management of third party dealings with the longer term relationship is the responsibility of both sides. A typical cycle in the IT services is: Phase 1. An IT service provider uses a one off project to qualify for a buyer firms IT vendors/suppliers list. The contract follows stages of the outsourcing life cycle in this phase. Phase 2. Having gained an entry into the firms list, the IT service provider initiates the process of consolidating ` -vis other IT vendors/suppliers list using its position vis-a the program management approach. Phase 3. As the IT service provider gains more projects, it moves towards relational contracts and participates in strategic IT investment decision making. Phase 4. As a preferred supplier and, possibly, an advisor to the firm on its IT investments, the IT service provider initiates fresh IT projects and uses its current position to wield some control on the allocation of future IT projects. This completes the cycle as it again competes with competing IT service providers to gain the project contract. This completes the cycle. An incumbent firm would again compete with rival IT service providers for the next project

contract. The success of the relational marketing approach in this framework is intimately related to the efficiency of the internal market for project delivery, as captured in Exhibit 6. The relationship contract continuum is wrapped around itself in this cycle of program and project management. The mix of incentives provided by formal and informal contracts we refer to earlier (Baker et al., 2001) is again discernable here. The next section concludes the paper.

6. Conclusion The paper was motivated with the observation that contractual markets and relationships display convergent tendencies in modern economic systems and that an integrative review of the literature is likely to be valuable for the development of theory. The theoretical underpinnings of the market paradigm, historically, have led to the notions of transactional contracts. The more recent developments of incomplete contracts have refocused attention to relational contracts. This new frontier is closely related to the domain of relationship marketing theory. Our paper argues that relationships for markets is a viable approach to understanding how firms actually approach their business, as relationships and contracts are extremes in a continuum. We illustrate the ideas by examining capacity reservation contracts, procurement in supply chains, and a framework for program management in the IT services industry.

Exhibit 6. Market for relationships cycle.


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We end the paper with an outlook for research employing the framework for the dynamics of markets, contracts, and relationships. We briefly identify aspects of exchange that hold promise for research based on our framework. (a) Capacity building in the supply base. The suppliers decision to build capacity that is dedicated or difficult to convert to other uses is an irrevocable decision. Its import changes with the stages of contracting and, rarely, is it possible to directly contract for such investment. (b) Perceptions of sunk costs. Although sunk costs are irrelevant to decisions concerning future relationships, the contract relationship experience behind sunk costs could have significant carry over effects. (c) Monitoring and administrative costs. Buyers and sellers incur these costs in managing the relationship. The origins and impact of these costs depend on structures and relationships in the buying and selling centers and on the flexibility of cross-center purchasing processes and configurations. (d) Subcontracting and hierarchical supply tiers. The decision to mix subcontracting with direct reporting by suppliers changes the cast of partners. The information requirements to manage the one-to-many tier supply base are very different, depending on the mix. (e) Supply efficiencies and positive externalities. Supply strategies have effects on other stakeholders in the business. The presence or absence of after-markets and arbitrage are concerns, with effects on the welfare of the entire supply base and consumers at large. (f) Insurance and risk aversion. The risk attitudes of firms in longer relations may differ. As uncertainties differ, the insurance that they require may vary over the course of the relationship. However, the insurance required is rarely directly contracted. (g) Incentives and effort aversion. The nature of effort and the value added to the relationship will change over the longer term. The role and type of performance incentive are likely to change as well. Clearly, it is close to impossible to directly contract for the effort or enforce the performance. (h) Asset ownership and capital equipment. The firms property rights entering into a relationship are preconditions for its existence. However, these may change during the course of the exchange. The contractual agreements clearly influence such evolutionary relationships. (i) Outsourcing and rents. The specific competitive advantage outsourcing affords arises with differential access to technology. The outcomes that suppliers achieve with their actions are often superior to those that the buyer achieves, and therefore, outsourcing more than compensates for the rents that must also be outsourced.

(j) Information rents and selection processes. The process of partnering, discovering hidden abilities of partners, and learning how to discriminate will involve costs. Varieties of communication and revelation mechanisms have different institutional arrangements, leading to costs that could be borne by different parties. (k) Financial structure, debt and interest, ownership, and equity. The chosen mix of financial arrangements is often sustained beyond the duration of the exchange. This may lead to a mismatch with the changing information content of the exchange. (l) Estimate aversion in uncertain environments. Changes in specifications, technology, and abilities often dissuade parties from arriving at critical estimates prior to engaging in the exchange. The estimation approach is influenced by the stage at which it is conducted. (m) Upstream and downstream influences. The suppliers supplier and the buyers buyer are influences in the exchange between any given supplier buyer dyad. A concern is the compatibility of the risk reward tradeoffs within the dyad, with the external tradeoffs on both sides. (n) Unreliability and reputation. Market pressures on the parties will change as a result of their reputation for performance or unreliability. Repeated exchanges and the learning from the observation of specific outcome variables lead to these reputations. (o) Certification and role of third parties. Firms aspire to win competitive and noncompetitive certification awards. The value of such third-party certification is both as an advertisement and as an incentive to improve performance. (p) Vertical integration, outsourcing, and engagement maturity. Outsourcing challenges the conventional market-contracting as well as vertical integration approaches. The development and maturity of outsourcing engagements define the chances of success and overall benefits. These components of exchange cover the spectrum of contract relationship phenomena. As areas for research, they will yield further insights when both forms of exchange are understood to evolve simultaneously. The complex nature of some contracts that we have reviewed is a reflection of the simultaneous relationship-building burden that they must anticipate and due to the need to deal fairly with unforeseen contingencies. Longitudinal case studies would be particularly useful, as will empirical methods that relate similar frameworks to business performance. Empirical tests of the propositions arising from such insights will add to the growing stream of descriptive models of interfirm exchange, for the formalizations of relational aspects. We expect that research will be fruitful in examining alternate structures in the relation contract continuum for global supplier base development and its impact on business performance.

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Acknowledgements The authors thank participants at the 7th International Research Conference on Customer Relationship Marketing Management at Freie Universitat Berlin for valuable discussions. We are grateful for the detailed comments of an anonymous reviewer on previous versions of the paper and to Michael Ehret for his suggestions. References
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Sudhi Seshadri obtained his PhD in Business Administration from The Pennsylvania State University and has served on marketing faculties of Indian Institute of Management Bangalore, The University of Maryland at College Park, and, most recently, as Visiting Professor at Singapore Management University. Randhir Mishra graduated from the Fellow Program in Management at the Indian Institute of Management Bangalore, holds a Masters degree in Business Economics from Buckingham University, and is currently on the business development team for Satyam Computers.