Caveat Venditor: The Conditional Effect of Relationship-Specific Investment on Contractual Behavior

Abstract

We offer a new perspective on the effect of relationship-specific investment on contract complexity, which has broad implications because complex contracts and vertical integration are substitutes. A simple model using transaction cost economics (TCE) predicts that buyer and seller relationship-specific investments have opposite effects on contract complexity. The model also predicts the signs of biases in OLS estimates of the effect of relationship-specific investments: unobserved heterogeneity causes downward bias in the estimated difference between the effects of buyer and seller specific investment, reducing the probability of finding opposite effects. We examine these predictions using data on agreements made by Romanian firms. When accounting for unobserved heterogeneity, seller relationship-specific investment has a positive effect on contract complexity while buyer investment has a negative effect. OLS estimates do not generate this result. The unique contribution of the paper is in simultaneously implementing TCE empirically, countering the problem of unobserved heterogeneity, generating estimates of the effects of specific investment that have opposite signs on opposite sides of the agreement, and explaining patterns of bias in the OLS estimates. Additionally, regional variation in court quality affects the complexity of contracts, suggesting that even moderate amounts of legal reform can have appreciable effects.