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Caveat venditor: The conditional effect of relationship-specific investment on contractual behavior

Author

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  • Peter Murrell

    (Department of Economics, University of Maryland)

  • Radu Paun

    () (Competition Council, Romania)

Abstract

We offer a new perspective on the effect of relationship-specific investment on contract complexity, which has broad implications because complex contracts and vertical integration are substitutes. A simple model using transaction cost economics (TCE) predicts that buyer and seller relationship-specific investments have opposite effects on contract complexity. The model also predicts the signs of biases in OLS estimates of the effect of relationship-specific investments: unobserved heterogeneity causes downward bias in the estimated difference between the effects of buyer and seller specific investment, reducing the probability of finding opposite effects. We examine these predictions using data on agreements made by Romanian firms. When accounting for unobserved heterogeneity, seller relationship-specific investment has a positive effect on contract complexity while buyer investment has a negative effect. OLS estimates do not generate this result. The unique contribution of the paper is in simultaneously implementing TCE empirically, countering the problem of unobserved heterogeneity, generating estimates of the effects of specific investment that have opposite signs on opposite sides of the agreement, and explaining patterns of bias in the OLS estimates. Additionally, regional variation in court quality affects the complexity of contracts, suggesting that even moderate amounts of legal reform can have appreciable effects.

Suggested Citation

  • Peter Murrell & Radu Paun, 2008. "Caveat venditor: The conditional effect of relationship-specific investment on contractual behavior," Electronic Working Papers 08-001, University of Maryland, Department of Economics.
  • Handle: RePEc:umd:umdeco:08-001
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    Keywords

    transaction cost economics; TCE; contract; contract complexity; property-rights theory; relationship-specific investment; legal system; transition; Romania;

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
    • P3 - Economic Systems - - Socialist Institutions and Their Transitions

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