Munich Personal RePEc Archive Trust and collaboration in the aftermath of conflict: the effects of contract structure Malhotra, Deepak and Lumineau, Fabrice 2011 Online at https://mpra.ub.uni-muenchen.de/38358/ MPRA Paper No. 38358, posted 25 Apr 2012 12:24 UTC 1 TRUST AND COLLABORATION IN THE AFTERMATH OF CONFLICT: THE EFFECTS OF CONTRACT STRUCTURE Deepak Malhotra Harvard Business School Baker Library, Room 471 Boston, MA 02163 Email: [email protected] Fabrice Lumineau University of Technology Sydney P.O. Box 123 Broadway NSW 2007 Australia Email: [email protected] Forthcoming Academy of Management Journal 2 TRUST AND COLLABORATION IN THE AFTERMATH OF CONFLICT: THE EFFECTS OF CONTRACT STRUCTURE Abstract. Leveraging a longitudinal dataset concerning 102 inter-firm disputes, we evaluate the effects of contract structure on trust and on the likelihood of continued collaboration. We theoretically refine and empirically extend prior research by (a) distinguishing between control and coordination functions of contracts, (b) separating goodwill-based and competence-based trust, and (c) evaluating the effects of contract structure on relational outcomes in the context of disputes. We find that control provisions increase competence-based trust, but reduce goodwill- based trust, resulting in a net decrease in the likelihood of continued collaboration. Coordination provisions increase competence-based trust, leading to an increased likelihood of continued collaboration. 3 TRUST AND COLLABORATION IN THE AFTERMATH OF CONFLICT: THE EFFECTS OF CONTRACT STRUCTURE Inter-firm relationships allow firms to create value and build competitive advantage (Agarwal, Croson, & Mahoney, 2010), but cooperation in such relationships is neither automatic nor easily fostered. Two key impediments to cooperation are the threat of exploitation by an opportunistic exchange partner (Williamson, 1985) and the possibility of coordination failures that can derail the efforts of even well-intentioned parties (Gulati, Lawrence, & Puranam, 2005; Knez & Camerer, 2000). In recognition of the mixed-motive nature of most exchange relationships (e.g., Kogut, 1988), and of the inherent difficulty in coordinating expectations and action (Camerer, 2003), firms rely on contracts to mitigate their risks, facilitate coordination, and promote cooperation (Lusch & Brown, 1996; Ring & Van de Ven, 1992). Despite the use of contracts to facilitate coordination and control, however, inter-firm disputes can emerge. This raises questions regarding the kind of relationship that will emerge, and the viability of continued collaboration, after parties have been unsuccessful in preventing conflict. In this paper, we examine these dynamics by evaluating how contract structure affects trust, and subsequently, the intent to continue collaboration, in the context of inter-firm disputes. We extend prior research on the effects of contracts on trust by (a) distinguishing the control vs. coordination function of contracts, (b) distinguishing the goodwill vs. competence dimensions of trust judgments, and (c) evaluating these relationships in the context of inter-firm conflict. We argue that a more nuanced approach that considers the different functions of contracts—coordination vs. control—and the different dimensions of trust judgments—goodwill vs. competence—may provide a more complete assessment of the effects of contracts on trust and collaboration. Prior research has often focused narrowly on a subset of these distinctions, 4 and in some cases overlooked these distinctions altogether (Puranam & Vanneste, 2009). Furthermore, our analysis of firms’ willingness to continue a relationship after having suffered a costly dispute allows us to evaluate the mechanisms underlying an important, but rarely studied aspect of inter-firm exchange: relationship repair (Zaheer, Lofstrom, & George, 2002). To test our hypotheses, we leverage a rich dataset comprising more than 150,000 pages of details regarding 102 business disputes arising in vertical exchange relationships in the years 1991-2005. The data include a wide range of contractual and exchange characteristics for each relationship, along with thousands of pages of communication between the disputants. The contracts enable us to codify the degree to which control and coordination provisions were incorporated into the agreement, and the communications allow us to code for statements that reveal goodwill-based and competence-based trust in the relationship. This is notable because, to our knowledge, the current dataset is the first to provide this level of detail on inter-firm conflict, and the first to allow such a fine-grained analysis of trust in inter-organizational relationships. THEORETICAL BACKGROUND AND HYPOTHESES Contracts as Instruments of Control and Coordination Seminal works in organization studies (Barnard, 1938; Burns & Stalker, 1961), as well as work by legal scholars (e.g., Baird, Gertner, & Picker, 1994; McAdams, 2009), decision theorists (e.g., Luce & Raiffa, 1957; Schelling, 1963), and economists (e.g., Camerer, 2003; Knez & Camerer, 2000), have previously contemplated the distinction between control problems (stemming from misaligned incentives) and coordination problems (stemming from misaligned expectations and behavior) in exchange relationships (Gulati et al., 2005). While these two issues have often been tackled separately in the literature (Kretschmer & Puranam, 2008), some recent studies have suggested that organizational structures—and, in particular, inter-firm 5 contracts—serve the functions of both control and coordination (e.g., Argyres, Bercovitz, & Mayer, 2007; Mellewigt, Madhok, & Weibel, 2007; Reuer & Ariño, 2007; Salbu, 1997). Organizational scholars have long considered the use of contracts as instruments of control (Macneil, 1978; Williamson, 1985; 1991). Inter-firm collaborations, have the potential of creating value, but parties to such relationships must contend with the risk of exploitation by their partners (Walker & Weber, 1984; Williamson, 1985). The legal underpinnings of contracts give firms the option of sanctioning an exchange partner who is unable or unwilling to abide by agreed upon terms (Joskow, 1987). The coordination function of contracts has received less attention (Argyres et al., 2007; Mayer & Argyres, 2004). A contract—and the contracting process—helps parties make explicit their assumptions and expectations regarding the transaction and each side’s role (Beatty & Samuelson, 2001; Smitka, 1994). Coordination- oriented provisions in a contract are aimed at mitigating the risk that misunderstandings will disrupt collaboration among (presumably) well-intentioned parties (Macaulay, 1963). In this paper, we build on the work of those who have called for a broader perspective on contractual complexity, and a more nuanced approach to studying the effects of contracts on relational attitudes and exchange outcomes (Mellewigt et al., 2007; Puranam & Vanneste, 2009). We evaluate contracts at the level of individual provisions, and distinguish between provisions aimed primarily at exerting control and those aimed primarily at facilitating coordination. Two Dimensions of Trust Judgments: Goodwill and Competence Following Rousseau, Sitkin, Burt, & Camerer (1998), and consistent with other influential conceptualizations of trust (Lewicki, McAllister, & Bies, 1998; Mayer, Davis, & Schoorman, 1995), we define trust as the willingness of a party to be vulnerable to the actions of another party based on positive expectations regarding the other party’s motivation and/or 6 behavior. Trust, so defined, can be distinguished from underlying dimensions of trust judgments, which entail attributions of the other party’s trustworthiness along relevant characteristics (e.g., integrity). Consistent with prior work on the attributional basis of trust (Ferrin & Dirks, 2003; Mayer et al., 1995; Weber, Malhotra, & Murnighan, 2005) we posit that attributions along relevant dimensions are what create in the trustor a willingness to accept vulnerability. We follow the lead of Nooteboom (1996) and Das & Teng (2001), who focus on two dimensions of trust judgments: “goodwill” and “competence.” Perceptions of goodwill entail attributions regarding the intention of the other party to behave in a trustworthy manner; perceptions of competence entail attributions regarding the other party’s ability to behave or perform as expected (Nooteboom, 1996).1 The Effect of Contracts on Trust Contracts and trust represent alternative means by which parties can manage risk in exchange relationships, but inter-firm relationships typically seek to use contracts while simultaneously attempting to build trust (Poppo & Zenger, 2002; Sitkin, 1995; Wicks, Berman, & Jones, 1999). The seemingly modal preference regarding inter-firm governance—to use contracts and build trust—has sparked a debate regarding the viability of this strategy. Some have argued that contracts and trust are often incompatible (Malhotra & Murnighan, 2002; Molm, Takahashi, & Peterson, 2000; Sitkin & Roth, 1993). Others suggest that contracts and trust are not only compatible, but mutually reinforcing (Gulati & Nickerson, 2008; Poppo & Zenger, 2002). This divergence makes it difficult to predict whether an emphasis on contracts will enhance or inhibit the prospects for continued collaboration after a dispute. Our goal is not 1 This distinction captures all three dimensions in Mayer et al.’s (1995) trust framework: ability, benevolence, and integrity. Competence captures attributions of ability; goodwill captures benevolence and integrity. Combining benevolence and integrity as “goodwill” is useful because many of the statements in our data are hard to categorize as either benevolence or integrity attributions; many are ambiguous, or are suggestive of a dual attribution. 7 to reconcile the vast amount of prior research on this topic, nor do we align ourselves completely with either side. Rather, we borrow from both literatures in order to expound a more comprehensive (and nuanced) perspective on the effect of contracts on trust and collaboration in the aftermath of conflict. Our review of prior research suggests that both positive and negative effects of contracts can be better understood when we separately consider the effects of control vs. coordination provisions on goodwill- vs. competence-based trust. The Effect of Control Provisions on Trust Those who have posited a negative relationship between contracts and trust have largely focused on the control function of contracts and on the goodwill dimension of trust (Bernheim & Whinston, 1998; Malhotra & Murnighan, 2002; Sitkin & Roth, 1993; Tenbrunsel & Messick, 1999). Macaulay (1963) and Ghoshal & Moran (1996) suggest that the mere suggestion or introduction of contracts may signal distrust of the other party’s intentions, thereby disrupting the process of trust development (Pillutla, Malhotra, & Murnighan, 2003). Tenbrunsel & Messick (1999) argue that an over-reliance on control mechanisms changes the decision frame of exchange partners; including too many control provisions may, ironically, promote opportunistic behavior by inducing a “business” rather than “ethical” framing of the interaction. Finally, Malhotra & Murnighan (2002) argue that overly controlling contracts, which leave little room for discretion, crowd out trust development because they lead to situational rather than personal attributions for the cooperativeness of partners. This may be especially likely during conflict, because parties are less likely to make generous attributions of each other’s behavior when the relationship has turned antagonistic (Ross & Stillinger, 1991). These mechanisms suggest: Hypothesis 1. The higher the number of control provisions in a contract, the lower the subsequent level of goodwill-based trust. 8 Prior research has not directly examined the effect of control provisions on competence- based trust. However, there are two reasons to expect that control provisions will enhance perceptions of competence in the context of disputes. First, by eliminating incentives for cheating and reneging, control provisions may force parties to focus more time and effort on their roles and responsibilities. This “substitution effect” away from nefarious conduct may promote exactly the types of behavior (e.g., attention to detail, timeliness, etc.) that enhance competence attributions. Another possibility is that the time spent on drafting contractual language, even for control provisions, leads to a clarification of expectations and assumptions, which in turn facilitates competence attributions (Argyres et al., 2007; Mayer & Argyres, 2004). We therefore hypothesize the following: Hypothesis 2. The higher the number of control provisions in a contract, the higher the subsequent level of competence-based trust. The Effect of Coordination Provisions on Trust In addition to serving a control function, contracts provide a means by which parties can coordinate their expectations and efforts (Gulati et al., 2005; Mayer & Argyres, 2004; Reuer & Ariño, 2007). As a result, common knowledge structures such as shared language and routinized interactions emerge that make it easier for parties to communicate their ability to meet each other’s needs (Morgan & Hunt, 1994; Puranam, Singh, & Zollo, 2006). The process of coordination can thus facilitate competence-based trust development. In their analysis of 11 contracts signed between two firms, Mayer & Argyres (2004: 400) provide a relevant example: “HW Inc. had expressed frustration in the first two projects over the length of time it took Softstar to complete what HW Inc. perceived to be minor changes…Softstar added a system architecture section to the third [contract]. This section allowed both firms to better understand 9 how the entire product fit together and the impact to Softsar if HW Inc. made a late hardware change.” In this incident, the revised contract was aimed at aligning expectation regarding the link between change requests and delays, lest HW Inc. attribute delays to Softstar’s incompetence. Coordination structures may be especially important for competence perceptions after a conflict has arisen, because disputing parties are unlikely to otherwise engage in the kinds of spontaneous communication that mitigate conflict and promote positive attributions (Hinds & Mortensen, 2005). This suggests: Hypothesis 3. The higher the number of coordination provisions in a contract, the higher the subsequent level of competence-based trust. Coordination provisions are also expected to increase goodwill-based trust in the context of disputes. By creating channels through which differences in perspective will be resolved, coordination provisions help mitigate misunderstandings of the kind that raise questions about the intent of the other party; this promotes—or at least minimizes damage to—attributions of goodwill during a conflict (Vlaar, Van den Bosch, & Volberda, 2007). Moreover, parties that establish norms and procedures that allow them to coordinate on when and how to expend effort in the relationship will be less likely to face situations where one party feels over-worked or exploited, or is concerned that the other side is not meeting its reciprocal obligations (Malhotra, 2004). Evidence from the laboratory supports this. Ahn, Ostrom, Schmidt, Shupp, & Walker (2001) find that prior experience in a pure coordination game (with no incentives for non- cooperation) helps parties to coordinate towards a mutually cooperative outcome even in subsequent interactions that provide incentives for non-cooperation. This suggests: Hypothesis 4. The higher the number of coordination provisions in a contract, the higher the subsequent level of goodwill-based trust.