Contracting for the unknown and the logic of innovation

• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/emre.12291
• Date: 01 June 2019

Contracting for the unknown and the logic

of innovation

ANNA GRANDORI

1

and MARCO FURLOTTI

2

1

Bocconi University, Milan, Italy

2

Nottingham BusinessSchool, Nottingham, UK

This paper discusses the components of contracts adequatefor governing innovation, and their microfoundations

in the logic of innovative decision processes. Drawing on models of discovery and design processes, distinctive

logical features of innovative decision making are specified and connected to features of contracts that can sustain

innovation processes and do not fail under radical uncertainty. It is argued that if newknowledge is to be generated

under uncertainty and risk, ‘relational contracts’, as usually intended, are not enough and a more robust type of

contractingis needed and it is actually often used:formal constitutional contractsthat associate resources, leave their

uses rationally unspecified, but exhaustively specify the assignment of residual decision rights and other property

rights, and the decision rules to be followed in governance. The argument is supported by an analysis of a large

international database on the governance of multi-party projects in discovery-intensive and design-intensive

industries.

Keywords: contracts; innovation; design; discovery

Introduction

A widespread tenet in organization, management and

economics is that strong uncertainty puts both rational

behavior and contractual governance under strain. The

roots of that thesislie in the bounded rationality argument

that, in the face of growing uncertainty, decision making

increasingly deviates from the classic complete

knowledge, utility maximizing approach. Actors proceed

with limited knowledge, rely on simplifying heuristics

and take decision-making shortcuts. In contract theory,

especially where bounded rationality is admitted, as in

the most important strands of transaction cost economics

and property right theory, it is generally contended that

as uncertainty grows, limitations in foresight render

contracts more and more incomplete, in the sense that an

increasing variety of matters are left unspecified

(Williamson, 1975; Hart, 1988). The mechanisms that

intervene to take care of those unspecified matters are

often thought to be mainly ‘extra-contractual’(Macaulay,

1963) and mainly informal: for example, self-enforcing

mechanismsbased on common interest –whateconomists

mean by ‘relational contracts’(Baker et al., 2002); and

social embeddedness in commonly accepted norms –a

view of relational contracts that is common in

management (Ring and Van de Ven, 1992; Poppo and

Zenger, 2002).

Both the above traditions in decision making and

contract theory face important a nomalies though,

especially when action projects aim at innovation –that,

in fact, is not prominently considered in those works. For

instance, how can the innovation rate be as high as it is,

if decision-making under uncertainty is shaped by local

search and ‘simple heuristics’(Grandori, 2010a)? How

does it come that different parties frequently enter into

collaborative agreements for innovative ventures, often

underpinned by rather ‘simple’contracts (Al-Najjar,

1995)? Is it simply because poorly observable cultural,

informal or socialrelations blend in to support governance

(Gilson et al., 2010)? How can this type of relational

agreements provide sufficient shelter for investing

significant human, technical and financial capital in risky

projects? Thesepuzzling questions invite some rethinking

of the cognitiveand contractual foundationsof innovation.

The rethinking pr oposed in this pap er contends that

when innovation is important, more ambitious responses

to uncertaintyare worthwhile, possibleand even common.

They can be identified by revisiting innovation studies in

various fields, looking for answers to disconfirming

questions such as: Is it really the case that the best that

Correspondence: Anna Grandori Department of Management and

Technology, ICRIOS, Via Roentgen 1, 20136 Milan, Italy, Tel.: +39 02

5836 2637. E-mailanna.grandori@unibocconi.it

European Management Review, Vol. 16, 413–426, (2019)

DOI: 10.1111/emre.12291

©2018 European Academy of Management