Relational Contracts

Framework Summarized by Sam Mishra, MBA (MIT Sloan)

Relational contracts are a pervalent form of doing business. These are tacit understandings or formal written agreements that partners in business use to co-operate in the facilitation of business transactions. As long as the relationship is good, the firm tends to reward its partner. However, if the relationship turns sour, for whatever reason, the firm will punish its partner.

Diagramatically, the contract moves along the blue line shown below:

The biggest appeal of a relational contract is long-term mutual gain between two parties. However, if one party reneges on the contract because of bigger short term gains, the other party has no option but to punish the first party by not getting into a similar relational contract again.

I consulted with an OEM (original equipment manufacturer) whose core competency is to manufacture off-shore for brand-name firms, who are its customers. Once, the OEM failed to make a key delivery on time. The brand-name firm punished it by not giving any more manufacturing contracts to the OEM. The OEM tried to gain this brand-name customer back unsuccessfully in every CES (Consumer Electronics Show) show in Las Vegas for the next ten years, but the brand-name firm did not oblige. One of the key executives with the OEM said this: "We should never screw a customer, because the customer never comes back." This is a real-life example of lost business because the OEM reneged on the relational contract that every delivery was to be on time, and got punished...

Also see Pareto Frontier and Game Theory.