The Value of Relational Contracts in Outsourcing: Evidence from the 2008 shock to the US Airline Industry* Ricard Gil Myongjin Kim Giorgio Zanarone Queen’s University University of Oklahoma CUNEF [email protected] [email protected] [email protected] December 2018 Abstract We study the importance of relationships, relative to formal contracts, as a tool to govern transactions across firm boundaries. Guided by a simple model, we show that the likelihood that a major airline continues to outsource a route to a regional partner after the 2008 crisis increases in the present discounted value of their relationship, and more so on routes characterized by strong contracting frictions. We also show that major and regional airlines involved in higher-value relationships are more likely to help each other under adverse weather by exchanging landing slots. Our evidence suggests that even in economies with strong institutions and in industries governed by sophisticated technology and standardized formal contracts, informal relationships play a central role in promoting cooperation and performance. Keywords: Relational contracting, adaptation, outsourcing, airlines JEL codes: L14, L22, L24, L93 * We thank Ricardo Alonso, Benito Arruñada, Dan Barron, Alessandro Bonatti, Giacomo Calzolari, Marco Casari, Decio Coviello, Matthias Dewatripont, Mikhail Drugov, John de Figueiredo, William Fuchs, Luis Garicano, Bob Gibbons, María Guadalupe, Hideshi Itoh, Mara Lederman, Alex Lin, Rocco Macchiavello, Bentley MacLeod, Mark Moran, Ameet Morjaria, Joanne Oxley, Mike Powell, Rachelle Sampson, Juan Santalo, Giancarlo Spagnolo, Jill Sparrow, Pablo Spiller, Catherine Thomas, Nick Vikander, Steve Tadelis, Patrick Warren, and audiences at Aarhus University, Pompeu Fabra University, Hitotsubashi University, EIEF, INSEAD, Queen’s University, Universidad del Pais Vasco, CEMFI, Universitat de Valencia, University of Maryland Smith School of Business, Bologna University, INSPER, HEC Montreal, ECARES, Rotman Toronto, IE Business School, the fifth CEPR Workshop on Incentives Management and Organization at LMU Munich, the second Workshop on Relational Contracts at CUNEF, the third Berkeley-Paris Organizational Economics Workshop, the tenth Organizational Economics Workshop at the University of Sydney, the NBER Organizational Economics Workshop, the 2017 Empirical Management Conference, and SIOE, the Winter Econometric Society Meetings and the European Economic Association Meetings, among others, for useful comments. This study received financial support from the Spanish Ministry of the Economy, Industry and Competitiveness through grant ECO2017-85763-R. The usual disclaimer applies. 1. Introduction A large share of production in modern economies occurs across organizational boundaries – that is, via transactions between firms and their independent suppliers, distributors, and strategic partners.1 It is well known that when formal contracts are incomplete, and therefore vulnerable to holdup and opportunism2, firms may rely on self- enforcing “relational” contracts to govern these transactions (e.g., Klein, 2000; Baker et al., 2002).3 Understanding how much relational ties increase cooperation, relative to purely formal contracts, is important for productivity, growth and policy in developed economies, where both governance mechanisms are potentially available. For instance, manufacturers should procure from few trusted suppliers, “Toyota-style”, only if the resulting increase in reliability offsets the cost savings of competitive arm’s-length procurement (Board, 2011). Analogously, in the policy realm, a government should consider liberalizing exclusive dealing to promote tight relationships between firms and distributors only if the resulting improvements in customer service justified the loss of competition. Unfortunately, because most empirical research on relational contracting analyzes settings in which the alternative of formal contracting is ruled out “by design”, there is remarkably little evidence that can be used to inform these choices. 4 For instance, McMillan and Woodruff (1999) show that relationships and reputations facilitate trade credit in Vietnam, where courts are dysfunctional. Similarly, Macchiavello and Morjaria (2015) show that contracts between Kenyan rose exporters and foreign buyers, 1 Lafontaine and Slade (2007) report that 50% of economic transactions in the United States occur in markets. More recently, Alfaro et al. (2016) estimate that in every WTO country the average manufacturing firm purchases at least 90% of its inputs (excluding capital and labor) from external suppliers. 2 On the transaction costs of interfirm contracting see, for instance, Coase (1937), Williamson (1971), and more recently, Hart and Moore (2008). 3 Reviews of the theoretical literature on relational contracting in economics are offered by MacLeod (2007), Malcomson (2013), and Gil and Zanarone (2017). Outside economics, the interplay between formal contracts and relational ties has been also emphasized in the legal literature (e.g., Macauley, 1963; MacNeil, 1978) and in the sociology and management studies literatures (e.g., Uzzi, 1997; Dyer and Singh, 1998; Poppo and Zenger, 2002; Ryall and Sampson, 2009). 4 See Cao and Lumineau (2015) for a recent review of qualitative empirical studies in the sociology and management literatures. 2 unenforceable in court due to their international nature and to flowers’ perishability, are constrained by relationships and reputations. While strong and convincing, the results from these studies cannot be used to predict how much relationships affect cooperation when they coexist with sophisticated formal contracts, as in supply chains, distribution networks and strategic alliances in developed economies. Our paper importantly contributes to fill this gap. We study a large and strategically crucial industry – air transportation in the United States – in which outsourcing relationships between major and regional airlines are pervasive and regulated by highly detailed and standardized formal contracts. Using a simple relational contracting model, we develop a strategy to measure the present discounted value of these outsourcing relationships. We show robust evidence that partnerships that have high relationship value (and hence can enforce relational contracts) perform significantly better than those that have low relationship value (and must therefore rely more on the letter of the formal contract). In particular, we show that relationships with higher value: (1) are more likely to survive the 2008 industry-wide shock induced by the financial crisis, and (2) cooperate in more slot exchanges under adverse weather. Three features of the U.S. airline industry are especially beneficial for our purposes of this study. First, despite the existence of reliable courts, transaction complexity limits the effectiveness of formal contracts as adverse weather requires rapid adaptation of flight schedules that is hard to specify ex ante or negotiate ex post (Forbes and Lederman, 2007). This creates a potential demand for relational contracts. Second, the value added of relational ties is potentially high as insufficient adaptation – and the ensuing flight delays and cancellations – severely affect airlines’ profits and consumer welfare. A study commissioned by the Federal Aviation Administration (FAA hereafter) and produced by NEXTOR (2010) finds that delays cost $8.3 billion a year to the airline industry (due to increased spending on crews, fuel and maintenance), and nearly $16.7 billion to passengers. The same study also estimates that delays generate an additional $7.9 billion in indirect costs (foregone travel plus GDP reductions due to increased cost of doing 3 business).5 Third and finally, the vertical structure of the airline industry – long-term relationships between major and regional airlines characterized by contractual incompleteness, repeated interactions and the importance of adaptation and flexibility – resembles other industries (e.g., Lerner and Merges, 1998, on biotechnology alliances; Arruñada et al., 2001, and Zanarone, 2013, on car distribution networks; Corts and Singh, 2004, and Kellogg, 2011, on oil drilling outsourcing). Therefore, our results are also relevant and informative on the role and importance of relational contracting for cooperation in those contexts. 1.1. Overview of the empirical strategy and results We begin our study by documenting that adaptation occurs within major-regional partnerships rather than in arm’s-length transactions. We explore detailed data on landing slot exchanges following a slot rationing jointly called by the FAA and the NYC airport authorities. We show that major airlines almost exclusively adapt to the rationing by exchanging slots with regional airlines in their network, despite the availability of slots from airlines outside the network. In particular, the majors identify all slots that need to be moved to guarantee optimal adaptation of flight schedules following the slot rationing, and rapidly get their regional partners to exchange slots both with the major and with each other as needed. Motivated by this evidence, in the second part of our study we systematically investigate how differences in the strength of relational ties affect the stability and performance of otherwise similar outsourcing networks. Guided by a simple theoretical model, we show that when a major airline outsources a given route to a regional partner before the 2008 shock, it is more likely to continue