Flexibility in Long-Term Relationships: An Experimental Study

Problem definition : We compare two types of contracts that can govern business partnerships: indefinitely binding agreements (IBAs), wherein partners are bound together in a relationship of indefinite duration, and temporarily binding agreements (TBAs), wherein they are able to dissolve the relationship at any moment. Academic/practical relevance : Managers need to determine what type of contract they want to engage in with their business partners. Although Toyota famously argues for building strong, long-lasting relationships with its suppliers, such a commitment makes it difficult to escape from profit-losing relationships. Methodology : We conduct laboratory experiments in which subjects are matched in groups of two and play a two-person newsvendor game. In the IBA treatment, subjects are bound together; in the TBA treatment, they have the ability to dissolve their relationship and be subsequently rematched. We also consider a treatment where the subjects can choose between IBA and TBA, as well as treatments where dissolutions are made more difficult or lead to a fixed outside option rather than rematching. Results : We find that average earnings are higher in the IBA treatment. However, subjects in the TBA treatment with long-lasting partnerships tend to perform better than the average pair in IBA. We argue that TBA facilitates sorting between subjects, whereas IBA provides a greater incentive for forward-looking teaching behavior among subjects. When given the choice, most subjects choose TBA and do better than when the type of contract is imposed on them, irrespective of their choice. We also see evidence of better performance when dissolutions are no longer automatic upon request or lead to the subjects exiting the rematching pool. Managerial implications : Having the flexibility to dissolve a relationship can be beneficial—but this option must be used wisely. When entering into partnerships with suppliers and customers, managers should balance out the teaching benefits of long-term contracts, with the potential drawbacks of unpunished disingenuous behavior. Short-term contracts may be preferable if the parties can refrain from breaking up the partnership in dark times, which are beyond the control of the business partners.