Relational Contracts and Optimal Quantity Flexibility

Abstract

So far in this treatise, we have seen that relational contracts persist in practice. A reason for this is that unobservable or uncontractible performance is hard to capture in formal contracts. In this case, relational contracts may provide an effective remedy.More precisely, in long-term business relationships, these contracts help to overcome the problem of incentivizing performance by introducing informal agreements. We have also learned that formal court-enforceable contracts are the only enforceable contracts when the relation between the contracting parties is finite. But in the case of a repeated, open-ended relationship, the situation changes. Now, any formal court-enforceable contract may be extended with informal self-enforced agreements, and hence become a relational contract. That is exactly what we will do in this chapter: A supplier and a buyer contract on the basis of a formal quantity flexibility (QF) contract. With the goal of preserving and improving quality, they engage in a long-term business relationship, thereby making room for informal agreements on the actual utilization of quantity flexibility. We will see that an optimal relational contract exists. Moreover, a simple stationary contract design can be determined giving guidance to the supply chain partners to organize their business relationship in an optimal way.