This paper contributes to recent scholarship regarding Long Term Agreements (LTAs) by providing empirical evidence that suppliers are more likely to undertake the costs of an LTA if the transaction requires significant capital expenditures or the potential for large sunk costs. Through a survey of a random group of 63 Ohio supplier/manufacturers, the paper explores why supplier/manufacturers with a full range of contractual and non-contractual solutions might choose one set of arrangements over others. It then seeks to link its findings to a broader theory of how parties bargain to solve durable problems under conditions of uncertainty, sunk costs and opportunism, while minimizing costs. Although only a small portion (17%) of our sample size indicated that they used LTAs in the majority of their transactions, this group indicated they were more likely to produce customizable goods and have significant capital expenditures. Such a finding is consistent with a model of bargaining in which parties in a transaction seek to achieve their overall goals of wealth maximization while minimizing costs under conditions that include bounded rationality, sunk costs and opportunism. If a product is customized for a particular buyer, and the supplier invests sunk costs toward customization, that investment makes it difficult and costly to exit the relationship or resale to others. Where such vulnerabilities exist, the need for protection may justify the costs of LTAs. The non-adoption of an LTA by some suppliers demonstrates that the new organizational form of networked firms governed by an LTA and straddling markets and hierarchies has not captured all of manufacturing, reflecting a diversity of arrangements. The non-adoption of the LTA may be one way suppliers respond to the stresses and frictions of the new architecture of supplier relations. Those stresses show that the new organizational paradigm is not static and it suffers from the same hazards as any exchange relation. The willingness of suppliers to adopt an LTA when facing large sunk costs shows the continuing importance of sunk costs in institutional decision making and offers an additional reason beyond the need to collaborate under conditions of uncertainty to explain why parties adopt LTAs. The other type of risks of opportunism and vulnerability from investing large resources may be best handled by entering an LTA because it offers security, including implicit protections needed for the supplier to invest. The switching costs that lock parties into to a mutual dependency and protect parties who have invested comes gradually but without the LTA, the supplier would be reluctant to undertake the initial investment.
supply chain, sunk costs, empirical, opportunism, transaction cost minimization, contractual choice
(forthcoming 2020)(with Jessica Ice)
Kostritsky, Juliet P. and Ice, Jessica, "Why Choose LTAs? An Empirical Study of Ohio Manufacturer’s Contractual Choices Through a Bargaining Lens" (2020). Faculty Publications. 2057.