February 25, 2007
Sticky Contracts
Posted by Gordon Smith

I have been reading lots of empirical work on contracts lately, and I am fascinated by the observation that some contracts are "sticky," meaning that the drafters do not change the contracts, even when they contain suboptimal provisions. My paper on the interpretation of venture capital contracts offers an example from the Benchmark case.

Pierre Azoulay and Scott Shane provide another example in their 2001 paper on exclusive territory provisions in franchising (Entrepreneurs, Contracts, and the Failure of Young Firms, 47 MGMT. SCI. 337 (2001)):

Despite the benefits of exclusive territories, some entrepreneurs fail to adopt this policy. The reason is not that they face higher costs of adoption. Rather, their limited knowledge of contracting leads them to overlook the importance of the franchisor encroachment problem when designing their contracts. Because franchise agreements are sticky, and bounded rationality prevents these entrepreneurs from identifying the payoffs associated with adoption, we often observe nonexclusive arrangements persisting until failure.

Why are contracts sticky? Azoulay and Shane attribute the stickiness of franchise agreements to bounded rationality and transaction costs:

Entrepreneurs will persist with initially selected routines until they fail…. First, entrepreneurs cannot change their routines unless they first recognize that those routines are flawed. This recognition requires an understanding of the cause-effect relationship between organizational design and firm performance, which many entrepreneurs lack. Second, even if an entrepreneur recognizes that a routine is flawed, he or she may be unable to change it. The changing of contract provisions involves incurring significant transaction costs that make the provisions sticky to adjustment.

This is very similar to the explanation that Brayden King and I offer in our soon-to-be-posted paper on the empirical study of contracts:

As an organization creates more and more routines, those routines become increasingly layered and interconnected, such that a change in one routine necessitates changes in other routines in the organization. Considering contracts as a particular type of routine helps us understand why changing contracts or adapting them to specific circumstances can be a very difficult and costly action. If the contract’s form is intertwined with dozens of other organizational processes, then it is conceivable that over time a particular contract form will become increasingly rigid and subject to inertia.

Contracts | Bookmark

TrackBacks (0)

TrackBack URL for this entry:

Links to weblogs that reference Sticky Contracts:

Recent Comments
Popular Threads
Search The Glom
The Glom on Twitter
Archives by Topic
Archives by Date
January 2019
Sun Mon Tue Wed Thu Fri Sat
    1 2 3 4 5
6 7 8 9 10 11 12
13 14 15 16 17 18 19
20 21 22 23 24 25 26
27 28 29 30 31    
Miscellaneous Links