Relational contracts and the decline of General Motors

In many cases, it is difficult, if not impossible, to write complete state-contingent contracts. In such circumstances, people will often rely on ‘informal agreements sustained by the value of future relationships’, that is, relational contracts. The underlying idea in the relational contract theory of the firm is that there are differences in the way relational contracts function between firms (outscoring) and within firms (an employment agreement).

Baker et al. (BGM, 2002) make this point that relational contracts occur both within and between firms and argue that the difference between them lies in what happens if the relational contract breaks down. An independent contractor can leave the relationship and take the assets belonging to it with him. This an employee cannot do. In BGM, an independent contractor can, if he wants, sell the finished product elsewhere while an employee does not own the finished product and thus cannot leave the relationship with the asset or the product. The strength of the threat to discontinue the relationship determines the implementability of relational contracts. As an example consider the situation where the market for the good is highly volatile. In this case, a relational contract may be unworkable since the supplier has an incentive to violate the relational contract when the market price is high. If the supplier is part of the firm, such an option does not exist and the relational contract that holds the internal transfer ‘price’ constant may be self-enforcing. The relational contracting theory can be seen as being related to Williamson’s idea that the resolution of disputes is more easily achieved within firms them between firms in the sense that mechanisms for dispute resolution can be seen as a feature of a system of self-enforcing relational contracting within the firm.

That's me discussing the application of relational contracts to the theory of the firm. Over at the Organizations and Markets blog Nicolai Foss highlights an application of relational contracts to the decline of General Motors over the last 30 years. Foss comments on a recent NBER paper by Susan Helper and Rebecca M. Henderson on Relational Contracts and the Decline of General Motors. Foss writes,

In a new NBER paper, “Management Practices, Relational Contracts, and the Decline of General Motors“, Susan Helper and Rebecca Henderson argue, however, that GM and Toyota are directly comparable in terms of the relational contracts existing inside their corporate hieararchies and across the boundaries of these two companies, and that their differential performance is explainable in terms of the differences between the contracts. Relying on recent contract theory research on relational contracts (rather than the older, but neglected work of Harvey Leibenstein), Helper and Henderson reject a number of conventional explanations (e.g., that GM’s investment policy was oriented towards the short term), and convincingly argue that GM had difficulties understanding the nature and important role of relational contracts behind Toyota’s success and therefores truggled to implement similar relational contracts. They point to a number of reasons why relational contracts may be difficult to build, centering on problems of creating credible commitments and communicating clearly and suggest that these problems were rampant in GM. In all, a very nice read that can be used in a number of different classes (org theory, economics of the firm, strategic management). Highly recommended!

The abstract of the paper reads,

General Motors was once regarded as one of the best managed and most successful firms in the world, but between 1980 and 2009 its share of the US market fell from 62.6 to 19.8 percent, and in 2009 the firm went bankrupt. In this paper we argue that the conventional explanation for this decline – namely high legacy labor and health care costs – is seriously incomplete, and that GM’s share collapsed for many of the same reasons that many of the other highly successful American firms of the 50s, 60s and 70s were forced from the market, including a failure to understand the nature of the competition they faced and an inability to respond effectively once they did. We focus particularly on the problems GM encountered in developing the relational contracts essential to modern design and manufacturing. We discuss a number of possible causes for these difficulties: including GM’s historical practice of treating both its suppliers and its blue collar workforce as homogeneous, interchangeable entities, and its view that expertise could be partitioned so that there was minimal overlap of knowledge amongst functions or levels in the organizational hierarchy and decisions could be made using well-defined financial criteria. We suggest that this dynamic may have important implications for our understanding of the role of management in the modern, knowledge based firm, and for the potential revival of manufacturing in the United States.