Managers’ Perceptions and Microfoundations of Contract Design

Abstract

In interfirm exchanges such as contracts, transaction cost economics theory (TCE) argues asset specificity, critical for value creation, poses hazards requiring contractual safeguards. TCE assumes actors have foresight to mitigate these hazards even though specificity is typically hard to observe, suggesting managers’ impressions may be biased. Taking a microfoundational approach, we explore how individual negotiators form perceptions of optimal asset specificity and aggregate them to a firm-level assessment that may be influenced through negotiation. We then explore how managers may actively manipulate their counterpart’s perceptions to maximize their firm’s value capture. We theorize about when this may occur and the implications for contractual governance, value creation/capture, and repeated exchanges – each of which may vary from extant predictions. By applying both an expanded bounded rationality assumption (including cognitive distortions) and net value capture motivation symmetrically, we augment contract design research allowing it to predict when and how managers’ strategic behavior may impact exchange outcomes. As a result, this analysis provides a more nuanced understanding of when contract design may intentionally deviate from efficient governance predictions.