Contractual Formalization and Governance of Long-Term Relationships

Abstract

In this paper I discuss the relationship between contractual formalization, contractual incompleteness and the governance of long-term relationships. I analyze data on contracts for the production and distribution of goods collected between 2004 and 2009 in two research projects, one carried out in four industrial districts in north-east Italy in different manufacturing industries, and the other conducted at European level on the wine sector with seven case studies. The data show that purely oral contracts are rare, while formalization is significant even if the amount of litigation before courts is almost nil. I first consider some factors affecting contract formalization. Then, I try to provide an explanation which relates to the governance of contractual relationships. I divide contractual relationships into market transactions, where parties rely mainly on detailed written contracts, and strategic relationships, which are partly regulated in writing – however vaguely – and partly not regulated at all. In this latter case, parties leave some issues unregulated because they may enter self-enforcing agreements or, if this is not the case, because they face radical uncertainty. In this situation, they prefer to resolve adaptation problems cooperatively instead of resorting to legal enforcement. I hold that for strategic relationships courts should adopt a mixed strategy: to adhere to written terms as much as possible and, for disputes arising on issues which are not regulated at all, to try to avoid filling the gaps and leave the determination to the parties.