Competition, Governance, and Relationship-specific Investments: Theory and Implications for Strategy

Abstract: This paper builds formal models to examine an endogenous decision of investing in relationship-specific assets, and to address the question of how competition affects a supplier’s choice of producing a general-purpose product or a relationship-specific product for its buyer, and when the availability of a governance arrangement designed to share investment cost increases the relationship-specific investment. We offer a balanced perspective that both emphasizes the superior transaction value of the relationship-specific product in addition to its high transaction cost and considers the competing effect of alternative investment plans. Using bi-form games to formalize value creation and value appropriation, we show that, depending on multiple factors including the return and the cost of the relationship-specific product and the outside market price of its general-purpose substitute, competition among suppliers may make a supplier switch from producing the general-purpose product to producing the relationship-specific product, or switch in the opposite direction; in addition, the parameters also determine when the buyer and the supplier would agree to the governance arrangement and to what extent the governance agreement leads to greater relationship-specific investments. The model and its extensions generate new insights on investment decisions in relationship-specific assets.