Academic journal article American University Law Review

A Bargaining Dynamic Transaction Cost Approach to Understanding Framework Contracts

Academic journal article American University Law Review

A Bargaining Dynamic Transaction Cost Approach to Understanding Framework Contracts

Article excerpt

Introduction: A Bargaining Lens That Explains the Rise of the LTA and the Persistence of Alternatives as a Cost Minimizing Strategy

Long-term agreements ("LTAs") in the supply chain, with their information sharing provisions, have been heralded as a new way of doing business.1 Recent scholars examining how these LTAs are structured explain their emergence as a byproduct of a new deverticalized production economy and the increased uncertainty in an innovation economy.2

Much of the literature examining LTAs in the manufacturing and innovation context have conceptualized these agreements as a blend of formal3 provisions that enable informal enforcement4 in a variety of ways. Recent scholars have studied LTAs in two primary contexts: the innovation economy and the standard form contract LTA in a manufacturing context between Original Equipment Manufacturers ("OEMs") and automobile suppliers.5 These scholars have treated these LTAs as a new phenomenon, and a new way of doing business that departs from the vertically integrated firm.6 Instead of making parts, companies now buy externally and enter contracts to govern their purchases.

Scholars of LTAs begin with the premise the premise that these LTAs are all necessarily incomplete. in the context of innovation of a new product that is yet undiscovered, the contract cannot specify performance obligations because of the uncertainty about the final product. in the manufacturing context, the uncertainty is different: it concerns whether the supplier will effectively collaborate with the buyer to produce high quality goods by participating in a process of learning by monitoring that will improve both the quality and timeliness of production.

One response to this uncertainty in each setting is to provide formal contract provisions that obligate the supplier or the innovator to share information.7 Innovation scholars posit that although these information sharing provisions are "formal," they facilitate informal enforcement that results in a "braiding" of formal contract provisions and informal norms for enforcement.8 Some argue that such settings call for "low-powered sanctions."9 Others, such as Professor Matthew Jennejohn, argue that braiding theory does not fully explain the diversity of arrangements that include unanimity requirements for decision making.10 He explains unanimity requirements as a specific response to threats the parties face, such as entropy and spillover.11

This Article takes a different approach, while still drawing on the literature of these scholars. The arrangements parties enter into in a variety of settings-to purchase or sell goods or to innovate on a product-can best be understood in terms of a bargaining dynamic that looks at how the private interests of the parties are turned into joint interests in the agreement reached.

it is a mistake to talk about the form of a contract without first understanding the bargaining needs and positions of the parties, and how those needs get reflected in the form of the agreement, given the options each party has. The form of the contract is not an end in itself. As a result, to analyze the form that contracting takes, one must understand the function that each party needs the contract to perform, as well as the kinds of transaction costs that each party must minimize if they want to go forward with their projects. These costs include opportunism, asymmetric information, uncertainty, and other frictions, such as entropy and spillover highlighted by Jennejohn.12 Each party approaches the bargaining with its own private goals and will reach a bargain only if the benefits of achieving those goals- through a particular contract type or form-outweigh the costs. This means firms are constantly looking for a contract form that will minimize their costs while maximizing contractual benefits.

This Article examines the choice of contractual form through this lens of bargaining theory. The choice of contractual form depends on how each of the parties defines its individual interests and its willingness to sacrifice some of its interests in order to get a deal that advances other interests-all in a cost minimizing way. …

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