The Effect of Relationships on Contract Choice: Evidence from Offshore Drilling

We build a simple model to show that relationships and high-powered formal contracts can be either substitutes or complements, depending on the relative impact of relationships on incentive problems and contracting costs. Empirically, in the offshore drilling industry we find that oil and gas companies are less likely to choose high-powered fixed-price contracts as the intensity of their relationships with drillers increases. This supports the conclusion that relationships and formal contracts are substitutes in this setting, indicating that relationships reduce incentive problems more than contracting costs. We further test the effect of relationships on different types of wells that differ in the severity of their contracting costs and incentive problems, and find results consistent with our theory. ∗Harvard Business School, Boston, MA 02163; [email protected] and [email protected]. We thank George Baker, Dale Jorgenson, Paul Oyer, Steve Tadelis, and seminar participants at Harvard, MIT, Carnegie Mellon, and London Business School for helpful comments.