Performance Verifiability and Output Sharing in Collaborative Ventures
Management Science · 1996 · Volume 42 · Issue 1
Abstract
This paper studies the problem of contracting between two firms when they try to exploit their complementary resources in a collaborative venture (CV), but their performance in the CV cannot be precisely verified by the other party or by a third-party arbiter. Using a mathematical model that treats performance verifiability as a continuous variable, the paper first establishes that a party whose performance cannot be perfectly verified has an incentive to shirk if it is paid only a flat fee and that this shirking problem is more severe as its performance is less verifiable. Then, the paper shows in a general setting that a contract under which each party shares a fraction of the output is superior to a contract under which one of them is paid only a flat fee when performance verifiability is sufficiently low. In addition, with some specific assumptions about the forms of the revenue and cost functions, the paper also shows that a party’s share of the venture’s residual output in the equilibrium is an increasing function of its productivity and a decreasing function of its opportunity cost. Finally, the numerical examples constructed in the paper suggest that a contract which combines the self-enforcing mechanism of output sharing with the third-party enforcement mechanism of arbitration generally performs better than a contract that utilizes only one of these mechanisms.
Keywords
joint ventures, transaction costs, double moral hazard, contracting, residual claimancy
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