Formal Contracts Without Courts: Scoring Suppliers to Build Trust

Abstract: Why firms use contracts in a lawless world? Recent empirical findings point at the actual use of explicit (but imperfectly enforceable) formal contracts by businesses alongside substantial informal elements. In this paper we formally show the supporting role that formal contracts play for relational contracts. Even entirely disregarding contract enforcement through a Court or arbitrator, we formally show that contractual documents (even when known by the parties as not meant to be enforced) may have an important and positive influence on reputational or reciprocity-based sanctions upon their suppliers to sustain cooperation. We demonstrate that setting compliance with certain tasks in a formal contract reduces the cost of reputational punishments that firms may need to inflict in order to ensure the right incentives to provide effort. We also show that formal contracts impact the way in which reputational punishments will be structured: Formal contracts optimally induce a more eschewed pattern of sanctioning, compared to a benchmark case in which no formal contract has been agreed. Thus, when dealing with its counterparties a firm will be, when the relational contract comes together with a formal contract, less forgiving with those counterparties who have not performed the formal contract, and more forgiving with those other ones who have not infringed the provisions of the formal document.