Week7_Susarla et al. (2010)_Ada

Key Concept:

Hold-up problem: In economics, the hold-up problem is central to the theory of incomplete contracts, and shows the difficulty in writing complete contracts. A hold-up problem arises when two factors are present:

1. Parties to a future transaction must make non-contractible relationship-specific investments before the transaction takes place.
2. The specific form of the optimal transaction (e.g. quality-level specifications, time of delivery, what quantity of units) cannot be determined with certainty beforehand.[1]

The hold-up problem is a situation where two parties may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits. The hold-up problem leads to severe economic cost and might also lead to underinvestment.

Motivation:

To improve service quality and to lower information technology cost, firms are fueled to increase their use of IT outsourcing. However, practitioners and academics realized that IT sourcing is fraught with difficulties and high rates of failure. One of the underlying risks comes from the hold-up problem. This paper uses a unique dataset to empirically examine this question.

Main findings:

1. Task scope is positively and significantly associated with extensive contracts;
2. Task complexity is negatively associated with contract extensive ness;
3. Task complexity is negatively associated with long term contracts, which suggests that firms might be wary of the greater threat of inefficient bargaining posed by the vendor in a longer term contract;
4. Task scope is positively associated with the presence of extendibility clauses;
5. Task complexity is positively associated with extendibility terms in contracts;
6. Contract extensiveness is positively associated with duration;
7. Contract extensiveness is positively associated with extendibility.

Contributions:

This paper highlights that contracts are fundamentally incomplete and that nonprice provisions play a strategic role in contracts structuring. Drawing on literature that describes contractual solutions to the holdup problem, they argue that parties are motivated by payoffs from repeated interaction to undertake specific investment and to reduce the likelihood of inefficient bargaining.