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Firms face many challenges in motivating their employees and coordinating their activities. As Gibbons (2000) points out, “if Coase is correct that firms will exist only where they perform better than markets could, then it is a short step to argue that inefficiency inside organizations will be typical, not exceptional”. In other words, being better than markets does not mean that firms are always efficient. Although firms do better than markets in certain situations (Coase, 1937), there are many problems and difficulties in firms as well.
As Gibbons and Roberts (2013) argue, in circumstances where contracting is not a problem, markets work well and perhaps are better than firms. But familiar sources of contracting difficulties, such as pre-contractual private information leading to adverse selection, post-contractual asymmetric information or hidden action leading to moral hazard, or contractual incompleteness for whatever reasons, mean that market solutions may fail. But the managed organizations, with a broad array of levers to affect motivations and behaviors, are less disadvantaged than markets when contracting is beset by great difficulties or high transaction costs.
The use of relational contract is one way that firms surpass the difficulties to write a complete and enforceable contract. According to the Encyclopedia of Law and Economics (Hviid, 2000), two features largely define what lawyers mean by a relational contract: incompleteness and longevity. Relational contracts govern continuing relations (Schwartz, 1992) and are in most cases long-term contracts (Goetz and Scott, 1980). The nature of the employment contract is often massively incomplete fraught with the complexities of time, uncertainty, and ambiguity. The employment relationship is a standard version of relational contract: First, it endures for some length of time; second, it is too costly or impossible to specify all contingencies in advance; third, the relationship and how it evolves facing new contingencies, is often characterized by its terms of governance, that is, which parties make which decisions.
Being an incomplete and relational contract gives employers much power in directing employees to do what employers want them to do. As Simon (1951) poses the question: Why is the employee willing to sign a blank check, by giving employer authority over his behavior? Also, the same questions are posed by Alchian and Demsetz (1972): “What ensures that the employee obey the employer’s instructions? What disciplinary power does a boss have that an independent contractor does not?” The employer, in many cases, acts to coordinate the activities of a number of employees and has the authority over what the employee does and the employee is directed by the employer about what to do. Under situations of incomplete contract, firms by using relational contracts and instructions can achieve better cooperation and prevent potential opportunistic behavior than market through using discrete contracts and prices.
Relational contracts are not the privilege of firms. Markets can also use relational contracts. But the relational contracts within firms are different from those between firms, as pointed out by Baker, Gibbons and Murphy (2001). Gibbons (2000) observes, “Firms are riddled with relational contracts – informal agreements that powerfully affect the behaviors of individuals within the firm. Virtually every collegial and hierarchical relationship in organizations involves important relational contracts, including informal quid pro quos between co-workers and unwritten understandings between bosses and subordinates about task assignment, promotion, and termination decisions”. Explicit contract is enforced by law, but relational contract is usually enforced by trust and by reputation (Seppänen, 2014).