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A New Look at Power and Efficiency Theories in Contracting

A New Look at Power and Efficiency Theories in Contracting

Stephen J. Carson and Mrinal Ghosh

Are marketing channels designed to benefit all parties (i.e., to be “efficient”) or are they built to suit the purposes of powerful firms? A new study in the Journal of Marketing seeks to reconcile two conflicting viewpoints that together drive most research on interorganizational relationships in marketing, strategy, and economics. On one hand, governance theories like Oliver Williamson’s Nobel Prize-winning Transaction Cost Economics rely on an “efficiency” rationale to argue that channels are designed to maximize the joint value accruing to all firms in the channel, regardless of the power differential between them when they enter the relationship. On the other hand, traditional power theories based on social exchange theory, resource dependence theory, and, most prominently, monopoly theory suggest that powerful firms dictate channel designs to maximize their own payoffs from the relationship, usually at the expense of their weaker partners.  
We provide a more nuanced and integrative argument. Specifically, we argue that powerful firms will have an effect on channel design, but only when uncertainty does not allow the firm to “price-out” its power—i.e., to extract the full value it offers its partner in the relationship—through a fixed, upfront price. In other words, only when the level of uncertainty surrounding the exchange is high will power pull channel governance away from efficiency.  
We test our theory in two contexts—high-technology R&D relationships between clients and independent contract research organizations and buyer-vendor procurement relationships for customized industrial systems. The contexts were carefully chosen to provide an unambiguous governance prediction based on Transaction Cost Economics. Specifically, in both our contexts, investments are predominantly made by one party (the client/buying firm) in the technology of the vendor. As such, efficiency theories predict that to safeguard their investments, buyers will seek say, fixed price contracts (efficient governance) over pricing contracts that enable ex-post negotiations (inefficient governance). Our integrative framework argues that when uncertainty is low, the powerful firm lets the fixed price (efficient governance) contract stand and secures its value through high upfront prices. However, when uncertainty is high, the powerful party cannot commit to refrain from invoking its power throughout the ongoing relationship; as such, it abandons the efficient fixed price contract in favor of the inefficient contract where prices are negotiated ex-post. This moves channel governance away from the predictions of Transaction Cost Economics. Our theory receives strong support in both contexts across multiple governance variables. In both settings, power affects channel design, but only under incomplete contracting conditions brought about by high uncertainty. 
Our theory and results have key implications for power and efficiency theories as well as research into formal contracting, informal relationship governance, and anti-trust regulation. 
Most immediately, the theory allows us to predict when powerful firms will use their positions to influence channel design versus when they will not. Rather than attributing this choice to differences in preferences across powerful firms, we show that it is a result of an optimization process in which the best option for the powerful firm is to support efficiency—i.e., maximize joint value. However, it can only do so when uncertainty is low and it can credibly commit to tying its own hands as a means of guaranteeing favorable treatment of the weaker firm ex-post. In the absence of this ability to commit (under high uncertainty), the powerful firm chooses a governance form to benefit itself. 
Our theory also fills key gaps in Transaction Cost Economics by examining the process through which firms agree on channel governance. In general, the transaction cost framework relies on natural selection arguments to support its claim that parties will, somehow, arrive at an efficient governance arrangement because, otherwise, Darwinian selection would lead them to extinction. We argue that natural selection is not well-suited to relationships involving powerful firms since they could choose an inefficient governance structure, extract value from their partner, and let the partner suffer the consequences. One implication of our theory is that the Transaction Cost Economics framework is correct to ignore the role of power under certain conditions (low uncertainty), but has to account for the role of power in more incomplete contracting (high uncertainty) settings.  
Our study also offers novel insights into the functioning of formal and informal contracts. When analyzing formal contracts, the results illustrate how looking at aspects of channel design such as relationship safeguards without considering the initial price can lead to incorrect inferences about the balance of power and the motives of the parties. Indeed, any “unfairness” in formal contracts due to an imbalance in power will primarily be reflected in the price, not other terms. 
In addition, while the literature on informal governance tends to associate it with the presence of relational norms, our analysis suggests that it can also be imposed by powerful firms if they cannot provide the credible commitments necessary to price-out their power. Crucially, it is imposed in order to expropriate value from the weaker firm during ex-post renegotiations. In this case, informal governance is neither efficient nor indicative of a cooperative, mutually-oriented relationship. It is simply a second-best, but feasible, choice for the powerful firm. 
Finally, the results help inform the long-running debate in anti-trust regulation between monopoly and efficiency perspectives. Transaction cost arguments have tended to support non-standard modes of organization as serving efficiency purposes—again, without regard for the process through which they are adopted by the firms. However, we caution that this will not be true if the terms of trade are biased in favor of the powerful firm, as they are likely to be under incomplete contracting conditions brought about by high uncertainty. 

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From: Stephen J. Carson and Mrinal Ghosh, “An Integrated Power and Efficiency Model of Contractual Channel Governance: Theory and Empirical Evidence,” Journal of Marketing, 83 (July).

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Stephen J. Carson is David Eccles Scholar Professor of Marketing, David Eccles School of Business, University of Utah.

Mrinal Ghosh is Gary M. Munsinger Endowed Chair in Entrepreneurship and Innovation, University of Arizona, USA.