Contractual Frictions Research Articles

When less is more: Information and the financing of innovation

This paper examines the impact of informational frictions when the entrepreneur anticipates having little or no bargaining power in negotiating with the financier and can select ex ante the innovation/venture he wants to develop. In this environment the entrepreneur faces a tradeoff between selecting an innovation that creates high value but one which only allows him to capture little or none of that value; or selecting a “pet-project” innovation that creates lower value but yields private benefits to him. In the baseline scenario, without contractual frictions, the financier is able to elicit first-best entrepreneurial effort, but cannot commit not to extract all innovation rents from the entrepreneur, leading the entrepreneur to select his favored but inefficient innovation. The key insight of the model is that the introduction of informational frictions like non-verifiability of effort or talent information asymmetry, while leading to reductions in effort (for a given innovation choice), may lead to more efficient (i.e. higher value) innovation choices ex ante, and indeed could generate a superior payoff to the financier and a greater total surplus from innovation. This yields several empirical implications, not least of which the potential motivation for financiers to commit to “opacity of information” when the resulting improvements in innovation selection dominate the impact of effort reduction.

Credit access and relational contracts: An experiment testing informational and contractual frictions for Pakistani farmers

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Intrafirm trade, input–output linkage, and contractual frictions: evidence from Japanese affiliate-level data

This paper revisits how vertical linkages between overseas affiliates and their parents are related to intrafirm trade by shedding light on variations in contractibility across sectors in the case of Japanese multinational enterprises based on affiliate-level data. We confirm that intrafirm trade is observed only in a limited fraction of affiliates. To include a large number of affiliates with zero intrafirm trade into our regressions, we estimate our model by Poisson Pseudo Maximum Likelihood. We find that Japanese multinational affiliates tend to export relatively more to their parents in vertically linked sectors especially if they trade goods with low contractibility. This relationship is evident for affiliates located in developing countries. This result indicates that input–output linkage is a significant determinant of intrafirm trade when the trade is affected by contractual frictions. We also confirm the robustness of the results regardless of the definition of contractibility indices by previous studies.

Trust, Efficient Contracting and Export Upgrading

Informal contracting institutions constitute an essential part of a country’s overall contracting institution, however, the nascent literature examining the effect of contracting institutions on the quality of products a country produces and exports, have paid a limited attention on the role of informal contracting institutions. We fill this gap in the literature by examining whether higher trust levels, as an informal contracting institution, leads to product-quality upgrading by reducing contractual frictions and opportunistic behaviors. Using industry-level data spanning 1995–2014, we examined this relationship using the generalized difference-in-difference method. We find that contract-intensive industries in trust-intensive societies experience a disproportionally higher increase in the production and export of higher-quality products compared to those industries in low-trusting societies. This result holds after controlling for conventional sources of comparative advantage and formal contracting institution. Hence, the result underscores the importance of informal contracting institutions for improved economic performance and stress the crucial fact that countries with strong and efficient informal institutions can still benefit in market-related activities even in the presence of weak formal institutions.

Modeling supply-chain networks with firm-to-firm wire transfers

We study a novel economic network (supply chain) comprised of wire transfers (electronic payment transactions) among the universe of firms in Brazil (6.2 million firms). We construct a directed and weighted network in which vertices represent cities and edges connote pairwise economic dependence between cities. Cities (vertices) represent the collection of all firms in that location, and links denote intercity wire transfers. We find a high degree of economic integration among cities in the trade network, consistent with the high degree of specialization across Brazilian cities. We identify cities with a dominant role as customers and suppliers to the entire supply chain using centrality network measures. The supply-chain network has a disassortative mixing pattern, which is explained by the heterogeneity in the size of Brazilian municipalities. We find that the supply-chain network becomes more disassortative during adverse times, such as the Brazilian recession in 2014 and the global financial crisis. We use entrepreneurship data and show that one potential driver of this change is the death of small firms, leading to a greater concentration of economic flows in larger centers. Our results suggest that adverse events significantly impact the supply-chain network with meaningful and heterogeneous economic consequences across municipalities. We run econometric exercises and find that courts’ efficiency plays a dual role. From the customer perspective, it may reduce contractual frictions and increase economic transactions between cities. From the supplier perspective, cities that are central suppliers to the supply chain may use courts’ inefficiency as a lawsuit barrier from their customers.

Contracting institutions and firm integration around the world

Firm integration is fundamentally shaped by contractual frictions. But do better contracting institutions, reducing these frictions, induce firms to be more or less deeply integrated? To address this question, this paper exploits unique micro data on ownership shares across more than 200,000 firm pairs worldwide, including domestic and cross-border ownership links. We uncover a new stylized fact: Firms choose higher ownership shares in subsidiaries located in countries with better contracting institutions. We develop a Property-Rights Theory of the multinational firm featuring partial ownership that rationalizes this pattern and guides our econometric analysis. The estimations demonstrate that better contracting institutions favor deeper integration, in particular in relationship-specific industries.

Regional Trade Integration and Input Sourcing Patterns of Multinational Enterprise Plants: Evidence from the ECFA

This paper studies the impacts of regional trade integration on the input sourcing patterns of firms engaging in multinational production. We examine the responses of Taiwanese MNC affiliates in mainland China around the time of a single event --- the signing of the Economic Cooperation Framework Agreement (ECFA) between the Mainland and Taiwan in June 2010. Using data on firm-level ownership linkages in conjunction with transaction-level trade flows between 2006 and 2015, we find strong evidence that in response to input tariff reductions, firms increased imports not only from members but also from non-member trade partners. The scale effect through the demand response to lower input costs appears to dominate the direct substitution effect from the enhanced trade relation across the Strait, leading to a trade creation effect outside the integrated bloc. Moreover, to a large extent, the trade created outside the bloc appears to be contained within multinationals' organizational boundary. In particular, for contract-intensive products, firms mainly increased sourcing from related parties. The findings suggest that MNC production networks strengthen the trade creation effect of regional trade agreements by reducing contractual frictions and search frictions along input-output linkages.

Contractual frictions and margins of trade

A recent body of work has shown that quality of national institutions that enforce written contracts plays an important role in shaping a country’s comparative advantage. The current paper contributes to this literature by providing a comprehensive analysis of the mechanisms through which institutional frictions affect the pattern of aggregate trade flow by distinguishing its effect on the intensive and extensive margins. We find that better contracting institutions not only increase the probability of exporting (the extensive margin) but also enhance the export sales after entry (the intensive margin), particularly in industries where relationship-specific investments are most important. With around two-third to three-fourth share (depending on the definition used), the contribution of institutions along the intensive margin dominates that along the extensive margin. The benefits of improved institutions, particularly via the intensive margin, favor the less developed countries over the more developed ones. In addition, better contracting institutions increase the probability of survival of export products in more contract-intensive industries in particular. These findings are robust to measuring the intensive and extensive margins using a more granular export data based on firm-level aggregates, as well as the variety and destination based definitions.

When Less is More: Information and the Financing of Innovation

This paper examines the impact of informational frictions when the entrepreneur anticipates having little or no bargaining power in negotiating with the financier and can select ex ante the innovation/venture he wants to develop. In this environment the entrepreneur faces a tradeoff between selecting an innovation that creates high value but one which only allows him to capture little or none of that value; or selecting a pet-project innovation that creates lower value but yields private benefits to him. In the baseline scenario, without contractual frictions, the financier is able to elicit first-best entrepreneurial effort, but cannot commit not to extracts all innovation rents from the entrepreneur, leading him to select his favored but inefficient innovation the first place. The key insight of the model is that the introduction of informational frictions like non-verifiability of effort or talent asymmetry, while leading to reductions in effort (for a given innovation choice), do lead to more efficient (i.e. higher value) innovation choices ex ante, and indeed could generate superior payoffs for the entrepreneur and the financier, as well as a greater expected total surplus from innovation. This yields several empirical implications, not least of which the potential motivation for financiers to commit to opacity of information when the resulting improvements in innovation selection dominate the impact of effort reduction.

Two’s a Company, Three’s a Crowd: Contractual Compatibility Between Crowdfunding and Venture Capital

Crowd-based means of funding are emerging as a valid novel way of providing scarce seed-finance for entrepreneurial ventures. In recent years, securities-based variants such as equity crowdfunding or initial coin offerings (ICOs) are increasingly attracting higher funding amounts than reward-based models, in particular for commercially oriented ventures. However, securities-based crowdfundings also come along with the more complex contracts, since they introduce a large set of new shareholders in the firm, possibly with voting, information and cash-flow rights. This might have implications for the ownership structure and future governance of a company, and in turn influence the evaluations by prospective investors. This paper is concerned with exploring potential knock-out criteria in securities-based crowdfunding contracts and to what degree they serve as a deal breaker for the investment decision of subsequent professional venture investors. Using an explorative mixed methods approach, we find empirical evidence that, e.g., an inflated capitalization table owing to crowd investors holding direct securities in a company, redemption and voting rights by the crowd, as well as the non-existence of a drag-along clause, lead venture capitalists and business angels to refrain from an investment in an otherwise attractive but such-funded start-up firm. We conclude that contractual frictions play a decisive role in whether entrepreneurs can combine crowd-based means of funding with traditional forms of venture financing. Theoretical and managerial implications are discussed.

Two’s a company, three’s a crowd: Deal breaker terms in equity crowdfunding for prospective venture capital

Crowd-based means of funding are emerging as a valid novel way of providing scarce seed-finance for entrepreneurial ventures. In recent years, securities-based variants such as equity crowdfunding or initial coin offerings (ICOs) are increasingly attracting higher funding amounts than reward-based models, in particular for commercially oriented ventures. However, securities-based crowdfundings also come along with the more complex contracts, since they introduce a large set of new shareholders in the firm, possibly with voting, information, and cash-flow rights. This might have implications for the ownership structure and future governance of a company, and in turn influence the evaluations by prospective investors. This paper is concerned with exploring potential knockout criteria in securities-based crowdfunding contracts and to what degree they serve as a deal breaker for the investment decision of subsequent professional venture investors. Using an explorative mixed methods approach, we find empirical evidence that, e.g., an inflated capitalization table owing to crowd investors holding direct securities in a company, redemption and voting rights by the crowd, as well as the non-existence of a drag-along clause, lead venture capitalists and business angels to refrain from an investment in an otherwise attractive but such-funded start-up firm. We conclude that contractual frictions play a decisive role in whether entrepreneurs can combine crowd-based means of funding with traditional forms of venture financing. Theoretical and managerial implications are discussed.

Contractual frictions and the patterns of trade: The role of generalized trust

Extant studies on the relationship between ‘domestic institutions, comparative advantage, and international specialization’ have primarily focused on formal institutions. This paper contributes to this literature by focusing on domestic informal contracting institutions vis-á-vis generalized trust as a source of comparative advantage. Employing a bilateral industry trade data, the paper finds robust evidence that countries with high generalized trust level export relatively more in industries that are prone to contractual frictions. Results on export margins further suggest that countries with a high generalized trust level enter more markets, ship more products to each destination, and have higher export per product and export intensities in those industries. On the one hand, the results reemphasize the importance of trust for improved economic performance. On the other hand, the results explain why a country endowed with weak formal domestic contracting institutions may still have a comparative cost advantage in contract intensive industries due to having strong domestic informal institutions such as generalized trust.

Inequality Affects Long-Run Growth: Cross-Industry, Cross-Country Evidence

The theoretical literature has predicted that inequality affects long-run growth by reducing human and physical capital, particularly in the presence of imperfect credit markets and other contractual frictions. We test these four mechanisms using measures of inequality at the country-level, dating as far back as the 1700s, and the 1800s, and data for 27 manufacturing industries across 88 countries during 1981–2015. Our findings show industries that are more dependent on financial markets experience lower long-run growth in real output, number of firms and real salaries in more unequal countries compared to more egalitarian. Similarly, industries intensive in physical capital experience lower growth in salaries in highly unequal countries. However, there is no evidence that industries intensive in human capital experience any differential growth in output, the number of firms, average number of employees or salaries in unequal countries compared to more egalitarian, suggesting that the progress made in public schooling provision could have lessened the effect of inequality. Moreover, industries with complex contractual arrangements experience lower growth in the number of firms and paradoxically higher growth in the number of employees hired in more unequal countries, in line with the predictions of the theoretical literature. These findings are robust to using contemporaneous indicators of inequality and instrumental variable specifications.

Collective exclusion

This paper studies collusion among vertically integrated incumbents who may either delegate output production to a more efficient downstream entrant (“accommodating regime”) or refuse to supply the entrant and produce the final good themselves (“exclusionary regime”). Accommodating agreements yield higher collusive profits, but suffer from contractual frictions: An incumbent may first offer the entrant a high wholesale price for the input, and then undercut the entrant on the final good market, so that the entrant cannot recover its high input costs downstream. When the efficiency gap between the incumbents and the entrant is small, this hold-up effect dominates over the efficiency effect. Depending on modeling choices, exclusionary collusion is then either more profitable than accommodation, or is the only sustainable collusive regime.

Two’s a Company, Three’s a Crowd: Contractual Deal Breakers in Securities-based Crowdfunding for Later-stage Venture Capital

Crowd-based means of funding are emerging as a valid novel way of providing scarce seed-finance for entre-preneurial ventures. In recent years, securities-based variants such as equity crowdfunding or initial coin offer-ings (ICOs) are increasingly attracting higher funding amounts than reward-based models, in particular for commercially oriented ventures. However, securities-based crowdfundings also come along with the more com-plex contracts, since they introduce a large set of new shareholders in the firm, possibly with voting, information and cash-flow rights. This might have implications for the ownership structure and future governance of a com-pany, and in turn influence the evaluations by prospective investors. This paper is concerned with exploring potential knock-out criteria in securities-based crowdfunding contracts and to what degree they serve as a deal breaker for the investment decision of subsequent professional venture investors. Using an explorative mixed methods approach, we find empirical evidence that, e.g., an inflated capitalization table owing to crowd inves-tors holding direct securities in a company, redemption and voting rights by the crowd, as well as the non-existence of a drag-along clause, lead venture capitalists and business angels to refrain from an investment in an otherwise attractive but such-funded start-up firm. We conclude that contractual frictions play a decisive role in whether entrepreneurs can combine crowd-based means of funding with traditional forms of venture financing. Theoretical and managerial implications are discussed.

Book Reviews

James Rauch of University of California, San Diego reviews “Global Production: Firms, Contracts, and Trade Structure,” by Pol Antràs. The Econlit abstract of this book begins: “[vii] Based on previously published articles and the CREI Lectures in Macroeconomics delivered in Barcelona in June 2012 and aimed at graduate students and researchers interested in recent developments in international trade, [front flap] provides an overview of the issues facing multinational companies and their global sourcing strategies. [27] Addresses the various ways in which the contracting environment shapes the location and internalization decisions of firms in the global economy. [TOC] Discusses [3 et seq.] goods that are made in the world — the effects of the information and communication technology revolution, the reduction of manmade trade barriers, and global participation in the process of globalization; [28] workhorse models — an intellectual history and overview of firm-level analysis; [59] contracts and export behavior — simple imperfect-contracting variants of the Melitz model; contracts and global sourcing — contractual frictions in the two-country model of global sourcing; contracts and sourcing — evidence and the multicountry version of global sourcing; the transaction-cost approach; the property-rights approach; and internalization — empirical evidence. [back flap] Antràs is Robert G. Ory Family Professor of Economics at Harvard University.”

Long-Term Relationships: Static Gains and Dynamic Inefficiencies

Do contractual frictions matter when firms are engaged in repeated interactions? This paper argues that long-term relationships, which allow firms to (partly) overcome the static costs associated with low contractibility, will under certain circumstances create dynamic inefficiencies. We consider the repeated interaction between final good producers and intermediate input suppliers, where the provision of the intermediate input is noncontractible. A producer/supplier pair can be a good match or a bad match, with bad matches featuring lower productivity. This allows us to build a cooperative equilibrium where producers can switch suppliers and start cooperation immediately with new suppliers. Every period, one supplier has the opportunity to innovate, and in the baseline model, innovations are imitated after one period. We show that (i) innovations need to be larger to break up existing relationships in the cooperative equilibrium than in either a set-up where the input is contractible or when we preclude cooperation in long-term relationships, (ii) the rate of innovation in the cooperative equilibrium is lower than in the contractible case, and may even be lower than in the non-cooperative equilibrium and (iii) cooperation may reduce welfare. Next, we assume that the frontier technology diffuses slowly to suppliers (instead of after one period). In that case, for sufficiently slow diffusion, the innovation rate in the cooperative equilibrium may be higher than even in the contractible case. Finally, we show that cooperation may also increase relationship specific innovations.

Foreign Market Entry Under Incomplete Contracts

AbstractThis paper shows that incomplete contracts serve as a determinant of the mode of foreign market entry – that is exports versus foreign direct investment (FDI). When contracts between two agents within a firm are too costly to be written, the share of multinational firms may be higher or lower compared with a world without contractual frictions. The direction of change depends on the technologically required relative contribution of headquarter services in the joint production process. For example, in industries that use more inputs from the management unit as compared to inputs from a component supplier, the share of firms engaging in foreign direct investment is higher than under complete contracts. This effect may be so strong that the share of multinational firms increases in trade freeness.

Ownership and R&D Intensity in Foreign Affiliates Under Incomplete Capital Market

Whereas international joint venture is a dominated strategy in the property rights theory of the firm, this article shows that it can be optimal in the presence of contractual and financial frictions. We use the data of Chinese foreign affiliates to test and support our key theoretical result that joint ventures are in general more R&D intensive than wholly foreign-owned enterprises and this result is reinforced in financially more vulnerable industries. Furthermore, when wealth constraints loosen, the share of joint venture in foreign affiliates is also likely to decrease and decrease more in financially more vulnerable industries.

Analysis of challenges and opportunities in Islamic banking

Islamic banking has achieved exceptional growth in the last two decades and has been able to sustain it even during the recession and afterwards. In this paper, we highlight that lack of flexible financing options, incomplete product mix, scale diseconomies, contractual frictions and constraints in liquidity management are potential future challenges for this industry. The study also highlights growth opportunities by noting that Islamic banks in many jurisdictions are yet to enter into infrastructure financing for development spending, energy financing, investment banking and sovereign financing.