Managing Complex Contracts: A Theoretical Approach

When a product is difficult to specify in a contract and requires specialized investments for a market exchange, the buyer and seller can find themselves locked into a mutually dependent relationship in which both win-win and lose-lose outcomes are possible. This paper presents a theory of such complex contracting in the public sector and identifies the conditions that increase the likelihood of win-win outcomes for the buyer and the seller. Rules that allow parties to incentivize cooperative behavior increase the chances of a winning outcome. Relationships can promote cooperation if structured to incorporate repeated play and external reputations. Finally, contract success is contingent on mutual understanding between the two parties. Both the buyer and the seller need to understand the rules and the relationship in the same way in order for the exchange to deliver a win-win.