How Incomplete Contracts Foster Innovation in Inter‐Organizational Relationships

• Author: Regien Sumo,Arjan Weele,Wendy Valk,Geert Duysters
• Date: 01 September 2016
• DOI: http://doi.org/10.1111/emre.12075
• Published date: 01 September 2016

How Incomplete Contracts Foster Innovation

in Inter-Organizational Relationships

REGIEN SUMO,

1

WENDY VAN DER VALK,

2

ARJAN VAN WEELE

1

and GEERT DUYSTERS

2

1

Eindhoven University of Technology, Schoolof Industrial Engineering, Eindhoven, The Netherlands

2

Tilburg University, Tilburg School of Economics and Management, Tilburg, The Netherlands

Relative to relational governance, research into the use and effects of formal governance is scarce. Recent

contributions suggest that a specific type of contract that has intentionally been left incomplete, the performance-

based contract (PBC), fosters innovation. However, it is unknown how this effect occurs. To address this gap, we

draw on transactioncost economics and agency theoryto develop propositionson how PBCs affect innovation. PBCs

are characterized by low term specificity and rewards that are tied to performance. We propose that low term

specificity, that is, not stipulating how the focal firm’s partner should deliver the performance and which resources

to use, enhances the partner’s autonomy, which in turn fosters innovation. However, excessive low term specificity

inhibits innovation, since it may lead the partner to display opportunistic behavior. We furthermore propose that

performance-based pay incentivizes the partner to engage in innovation. This suggests that linking rewards to

performance attenuates the negative relationship between term specificity and innovation when the former is very

low. Finally, we propose that a morerisk-averse partner will engage in fewer innovative activities as such a partner

will be less sensitive to the pay-for-performance clause.

Keywords: Inter-organizational relationship; innovation; incomplete contract; transaction cost economics; agency

theory; term specificity; pay for performance; risk-averseness

Introduction

Firms often draw on both contractual and relational

governance to organize their inter-organizational

relationships (IORs) (Bradach, 1997; Mahapatra et al.,

2010), thereby taking advantage of their differential

impacts (Lindkvist, 1996). At the same time, the

performance implications of relational governance have

been studied much more extensively compared to the

impact of contractual governance (Sharma and Pillai,

2003; Vandaele et al., 2007). As contracts underlie

virtually any exchange relationship, it is important to

understand how the design of the contract may foster or

inhibit performance outcomes. Indeed, Schepker et al.,

(2014) emphasize the need to study the relationship

between contractsand relational outcomes.

This research specifically addresses how contracts affect

innovation, which is critical for firms to gain and sustain

competitive advantage (Brown and Eisenhardt, 1995;

Keupp et al., 2012; Hecker and Ganter; 2013; Hollen

et al., 2013). Since firms rely on externally developed as

well as internal knowledge to improve innovation and

create value (Chesbrough, 2003; Huston and Sakkab,

2006), external partners have become a critical source of

innovative solutions, ideas, and technologies (Van Echtelt

et al., 2008; Roy et al., 2004), not only for the focal firm’s

value proposition, but certainly also for their internal

processes/ daily operations. In our research, we focus on

innovation taking place within the context of a specific

IOR, more precisely in the contracted activities or

performance that a partner conducts for and in

collaboration with a specific focal firm. Within the context

of existing exchange relationships, partners may innovate

as part of their daily activities to incrementally improve or

more radically change the daily service delivery towards

the focal firm, with the aim to more efficiently achieve

performance targets such as quality and delivery time

(i.e., against lower costs). Thus, innovation as such is not

a contracted performance outcome, but a way to achieve

contracted performance/execute contracted activities more

efficiently and effectively. Both parties may benefit from

the partner’s innovations, for example, when innovation

results in a better service offering for the focal firm as well

as more efficient delivery of the transaction for the supplier.

IORs generally enhance (Faems et al., 2005; Goes and

Correspondence: Regien Sumo, Eindhoven University of Technology,

School of Industrial Engineering, PO box 513, CNT 0.16, 5600 MB

Eindhoven,The Netherlands, Tel: +3140 247 59 51. E-mail:

r.a.f.sumo@tue.nl

European Management Review, Vol. 13, 179–192, (2016)

DOI: 10.1111/emre.12075

© 2016 European Academy of Management