Broken Contracts and Hidden Partnerships: Theory and Experiment

Abstract

Previous research indicates that unenforceable informal contracts (or commitments) promote trust and reciprocity. Nonetheless, while such contracts may benefit existing exchange, in dynamic environments they may also hinder one’s willingness to explore newly emerging Pareto efficient opportunities. This issue arises in both business and social contexts, and includes industry non-compete agreements as well as personal relationship commitment decisions. We report data from an experiment using a novel three-person trust game where, in different treatments, different players are able to communicate with each other. We find that when, between the point of commitment and the point of decision, no new information is received regarding the expected value of commitment, then people overwhelmingly decide in accord with their informal contracts and avoid exploring potentially Pareto improving opportunities. However, when new information arises that reduces the relative value of commitment, and when this occurs following the commitment but before the decision, then people are significantly more likely to deviate from their informal contract and pursue a Pareto improvement. Further, we observe a “contingency effect” where the likelihood with which people follow an informal commitment declines with the number of contingencies that must occur in order for the contract to be realized. Finally, none of the theories of lying aversion that we explore are able fully to explain our data.