Empirical research shows contracts form the basis for trust in business relationships

Todd Zenger’s current research examines issues regarding trust, envy, and committed relationships. But that’s not to say he’s a social scientist looking only at the soft side of human relations. Instead, he’s a hard-nosed empiricist and business professor gathering and analyzing data that can help organizations and developing nations prosper.

In fact, his recent study, “Do Formal Contracts and Relational Governance Function as Substitutes or Complements?” co-authored with Laura Poppo of Virginia Tech and published in Strategic Management Journal, questions social science assumptions about contractual relationships and comes up with some competing and compelling data.

Todd R. Zenger

“A debate continues in social science regarding the role and value of formal contracts,” says Zenger, senior associate dean and professor of organization and strategy at the Olin School of Business. “Many sociologists, social psychologists, and organizational theorists argue that contracts or other formal incentives that support exchange undermine trust and contaminate the business relationship that would otherwise be supported by the social norm of reciprocity.

“Even some empirical business research questions the value of contracts,” Zenger continues. “Businesspeople say, ‘No, I don’t look at the written contract. It’s the deep-seated social contract that matters.'”

But Zenger’s empirical research—an in-depth survey of senior corporate managers regarding their sourcing of information services—also confirms the importance of trust in supporting business transactions but argues that contracts play a critical role in generating that trust.

“We found that contracts and relational governance act as complements,” says Zenger. “If I make explicit in a contract that which can be made explicit, I minimize the amount of required trust and thereby encourage its formation. In other words, the more I put into a contract, the more confident and assured I am and the more I will trust you on those dimensions that are difficult to contractually specify and thus require trust.”

His research also undermines the validity of managers’ frequent claims that written contracts aren’t as important as relationships. “Managers don’t talk about the importance of contracts because they aren’t important now, once the relationship is established,” says Zenger. “Contracts, however, may be vitally important at the beginning of that relationship.”

Moving Out of Committed Relationships

But contracts—and the legal system that supports them—do much more than simply solidify new exchange relations. They provide the foundation on which a flexible and responsive economy is built.

In his study “Moving Out of Committed Relationships,” co-authored by Sergio G. Lazzarini, Ph.D. ’02, of São Paulo’s Ibmec School of Business and Gary J. Miller of the Washington University Department of Political Science, and based in part on game-playing laboratory experiments, Zenger posits that in a highly dynamic business environment (such as that in which America and most of the world now find themselves) businesses need the ability to form new relationships when new opportunities arise.

“While a history of exchange develops trust and real value in a contract, there’s also real value in being able to sever the relationship at the right time,” says Zenger. “What you really want is an economic system that supports difficult but valuable exchanges, but allows flexibility to move out of these relationships and into new relationships when sufficiently compelling opportunities emerge.”

For example, says Zenger, in many Third World countries without an established and trusted legal system, business exchange is often based solely on personal relationships, which can make for solid commitments. “But the downside of trust as the sole basis for supporting relationships is that it doesn’t allow you to easily move out of these relationships to initiate others,” says Zenger. “On the other hand, a contract provides a less painful exit. And, if there are contractual safeguards, I’m more willing to take a jump and enter into a new relationship.”

But that’s not to say Zenger champions a purely legalistic business environment. Rather, he sees the formal relationship of the contract as a framework upon which the critical, informal trust relationships can be woven. While both formal and informal are critical, the formal is more easily and directly shaped.

“I’m interested in the interplay between formal and informal relationships, both of which are necessary in most business exchanges,” he says.

“Often, you want a relationship that’s not so close it can’t be severed when necessary, but not so distant as to fail to adequately support an exchange,” says Zenger.

Still, the debate over formal and informal relationships simmers.

“Some say that adopting contracts sends a very negative signal to an exchange partner, revealing your pessimistic assumptions about human nature that discourages trust,” Zenger says. “Others say the contract gives them confidence to support trust and work together, as it limits opportunities to take advantage of each other. The likelihood of cheating in the short term is less, so prospects for long-term exchange are better.”