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In addition, although the loose, evolving governance structure of an alliance can help the parties adapt to unforeseen events, it may also compromise coordination between the firms. Unlike an “inside-the-firm” transaction, in an alliance there are often no formal mechanisms for making decisions or resolving disputes expeditiously. The “footprints” of this are delay and lack of focus, problems that plagued the highly publicized alliances between IBM and Apple in the early 1990s. These alliances were supposed to develop a new operating system, a multimedia software language, and the PowerPC. Instead, by 1994 IBM’s senior management had become so frustrated in its protracted negotiations with Apple over the operating system for the PowerPC that it concluded it would have been better off acquiring Apple rather than dealing with it through an alliance.
Finally, just as agency costs can arise within departments of firms that are not subject to market discipline, alliances can also suffer from agency and influence costs. Agency costs in alliances can arise because the fruits of the alliance’s efforts are split between two or more firms. This can give rise to a free-rider problem. Each firm in the alliance is insufficiently vigilant in monitoring the alliance’s activities because neither firm captures the full benefit of such vigilance. Firms that repeatedly engage in alliances may be less prone to free ride, lest they establish a reputation that precludes them from finding future partners. Influence costs can arise because the absence of a formal hierarchy and administrative system within an alliance can encourage employees to engage in influence activity, such as lobbying, to augment their resources and enhance their status.
Implicit Contracts and Long-Term Relationships
Strategists pay a lot of attention to organizational structure; corporate executives often agonize over whether to make, buy, or ally. But the pressure to make the right decision is considerably lessened in the presence of implicit contracts. An implicit contract is an unstated understanding between independent parties in a business relationship. When implicit contracts are honored, they can substitute for complete contracts, rendering the make-or-buy decision moot. Implicit contracts are generally not enforceable in court, however. Nor is there a central office that can resolve disputes through governance. Parties to an implicit contract must rely on alternative mechanisms to make the understanding viable. A powerful mechanism that makes implicit contracts viable is the threat of losing future business if one party breaks the implicit contract for its own gain.11
To see why the threat to withdraw future business can be so powerful, imagine two firms in the vertical chain that routinely transact business with each other. Their longstanding relationship has enabled them to coordinate their activities through formal planning and monitoring of product quality, and as a result, both firms have profited significantly. In particular, suppose that the upstream firm sells inputs to the downstream firm for a $1 million profit every year, and the downstream firm processes the inputs and sells a finished product to consumers for a $1 million profit of its own. Each firm has an alternative trading partner, but each would only reap profits of $900,000 per year if forced to switch.
Although each firm apparently has no reason to switch, the relationship has a potential complication. Each firm could increase its profit at the expense of the other by performing less of the planning and monitoring that make the relationship successful. Specifically, suppose that the upstream firm estimates that by breaking its implied commitments to the downstream firm, it could boost its annual profits to $1.2 million. If it does this, however, the downstream firm will
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learn that it has broken its commitments, and the relationship will end. Each firm would then be forced to do business with another trading partner.
How much does the upstream firm benefit by honoring its implicit contract indefinitely? In one year, it earns $100,000 more by transacting with the downstream firm than with its alternative trading partner. If the firm’s discount rate is 5 percent, the net present value of honoring the implicit contract indefinitely would be $2 million.12 This far exceeds the short-term (i.e., one-year) increase in profit of $200,000 from breaking the contract. Indeed, to make breaking the implicit contract worthwhile, the discount rate would have to be 50 percent! This high hurdle for switching helps sustain the implicit contract.
Thomas Palay’s study of rail freight contracting illustrates the power of long-term relationships in sustaining cooperative behavior.13 He discusses a railroad that purchased specially designed auto-rack railcars to move a particular make of automobile for a major auto manufacturer. Soon after the railroad made the investment, however, the manufacturer changed the design of the car, making the auto racks obsolete. Even though it was not contractually obligated to do so, the manufacturer compensated the railroad for more than $1 million to cover the unamortized portion of the investment. The director of shipping at the automobile manufacturer alluded to the importance of maintaining a long-term relationship as the basis for this action. “We’ve got to keep them healthy, viable, and happy to guarantee that we’ll get the equipment we need, when we need it.”
There are many implicit contracts within firms. Workers often expect raises and promotions later in their job tenure if they work hard early on, even if such rewards are not specified in any contract. Andre Shleifer and Lawrence Summers suggest that hostile corporate takeovers are often motivated by shareholders’ desire to renege on implicit contracts with employees who have made relationship-specific investments in the firms they work for.14 A serious consequence of this—and why, according to Shleifer and Summers, hostile takeovers could hurt the economy—is that in a climate of hostile takeovers, employees will refrain from investing in relationship-specific skills in their firms. This will reduce productivity and raise production costs.
To support their argument, Shleifer and Summers quote from William Owen’s book, Autopsy of a Merger, about the merger between Trans Union and the Pritzker family’s Marmon Group. Most of the employees at Trans Union’s corporate headquarters lost their jobs after the merger, in violation of what many of them felt was Trans Union management’s implicit promise of guaranteed employment. Owen asked former employees what they had learned from the experience. One said that in the future he would be much less willing to invest in his relationship with his employer: “I learned that I should cover my butt the next time around . . . and have my foot out the door immediately the next time it happens. . . . All of a sudden, you find the rug pulled out from under you—and there is nothing you can do about it. . . . You’ve worked hard for many, many years, tried to do the best job you could for the compa- ny—I loved that company—but what do you have to show for it? How can you go to another company and give 100% of your effort?”15
In response to stories like this, many countries as well as many U.S. states have enacted business combination laws that create barriers to hostile takeovers. For example, in some places the board of a target firm can move to delay an acquisition by as much as five years, even if shareholders have approved the deal. Marianne Bertrand and Sendhil Mullainathan have shown that when manufacturing facilities are protected by business combination laws, they tend to be less productive and are less likely to close.16 This suggests that, on balance, it is more important to protect the market for corporate control (discussed in Chapter 2) than to preserve implicit contracts within the firm.
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EXAMPLE 4.6 INTERFIRM BUSINESS NETWORKS IN THE UNITED STATES: THE WOMEN’S DRESS INDUSTRY IN NEW YORK CITY17
Business networks based on social ties and governed by norms of trust and reciprocity exist outside Japan. As Brian Uzzi has shown, they even exist in New York City. Uzzi recently studied business networks in the “better dress” segment of the women’s apparel industry in New York City. This is a highly fragmented industry, with low barriers to entry and intense competition, both domestic and international. One might expect that in such a context, arm’s-length contracting would be the norm and social ties would not count for much. Uzzi’s research demonstrates that this is not the case. He shows that many business relationships in this industry are characterized by what he calls embedded ties: relationships characterized by trust and a willingness to exchange closely held information and work together to solve problems.
The design and marketing of women’s dresses is carried out by firms called jobbers. Working with in-house or freelance designers, these firms design dresses and market these designs to retail buyers, who then place orders. Most jobbers do not manufacture the dresses themselves. Instead, they manage a network of subcontractors, including grading contractors, who size the dress patterns; cutting contractors, who cut the fabric; and sewing contractors, who sew the dresses. The jobbers also manage the flow of raw materials in the production process. For example, they purchase fabric from converters and send it to the cutting contractors, who cut the fabric to make the pieces of the dress.
Uzzi observed two main ways of organizing exchange in this industry: arm’s-length ties, or what the participants called market relationships, and embedded ties, which they called close or special relationships. Market relationships were characterized by a lack of reciprocity between the parties in the exchange. “It’s the opposite of a close tie,” one participant reported to Uzzi. “One hand doesn’t wash the other.” They also lacked social content. “They’re relationships that are like far away,” according to one manager. “They don’t consider the feeling for the human being.” Many exchanges in this
industry were governed by arm’s-length relationships. However, for major transactions that participants considered for the company’s overall success, the exchange was often governed by embedded ties.
The “close” or “special” relationships that Uzzi observed were characterized by a high degree of trust. Such trust often developed when one party voluntarily did a favor for another, which was then reciprocated later. For example, a subcontractor might work overtime so that a jobber could fill a rush order. Later, the jobber might place an order to help the subcontractor keep its shop running when demand was slow. According to Uzzi, trust gave the parties access to resources and information that improve efficiency, but would have been difficult to acquire through arm’s-length contracts. It also promoted collaborative problem solving. One manufacturer told Uzzi, “When you deal with a guy you don’t have a close relationship with, it can be a big problem. Things go wrong, and there’s no telling what will happen. With my guys [his key contractors], if something goes wrong, I know we’ll be able to work it out. I know his business and he knows mine.”
Relationships in this industry based on trust could be extremely powerful. In one instance, according to Uzzi, a jobber was moving its production to Asia and would thus be ending its relationship with its New York City subcontractors. This jobber had strong incentives not to inform its subcontractors that it was going to leave. By doing so, it risked provoking opportunistic behavior by its subcontractors (e.g., shirking on quality) to take advantage of what they would now regard as a temporary relationship. Yet, the CEO of this firm personally informed the subcontractors with whom he had a special relationship, and he promised to help them adapt to the loss of his business. In turn, those subcontractors continued to provide high-quality services. This firm did not inform the subcontractors with whom it had market relationships that it was planning to close its New York operation.