Rethinking Relationship-Specific Investments: Subcontracting in the Japanese Automobile Industry

According to modern contract theory, how firms structure their trading patterns and governance structures will depend both on the size of any relationship-specific investments they make, and on the feasibility of detailed contracts. Suppose contracts are hard to draft and enforce, but firm A must invest heavily in a capital asset whose value depends on A's continued trades with firm B. If A makes this investment on its own, B may try to restructure opportunistically the terms of the contract ex post. To mitigate the risk of such hold ups, predict contract theorists, A and B may negotiate a variety of governance mechanisms they would not otherwise choose. In the extreme, they may even decide to merge. The puzzle to this theory is less in its logic. It is more in its empirics. Over the past two decades, scholars have looked hard for evidence of governance arrangements driven by large relationship-specific investments. Although they find some evidence of such arrangements in idiosyncratic industries like public utilities, aerospace, and defense, they find less evidence in more "ordinary" industries. Within this context, the Japanese automobile industry has played an important symbolic role: an "ordinary" industry thought to be structured by extra-contractual governance arrangements driven by substantial relationship-specific investments. In this article, we re-evaluate that ordinary industry. Despite examining a variety of data on ties among suppliers and assemblers, we find less evidence of large relationship-specific investments than most accounts imply, and less evidence of extra-contractual governance arrangements driven by such investments. Perhaps, we suggest, the time has come to reconsider whether relationship-specific investment theory explains quite as much as we have thought.