Contract Structure for Joint Production: Risk and Ambiguity under Compensatory Damages

Forthcoming, Management Science

43 Pages Posted: 13 Sep 2016

See all articles by Michael D. Ryall

Michael D. Ryall

University of Toronto - Rotman School of Management

Rachelle C. Sampson

University of Maryland - Robert H. Smith School of Business; Georgetown University - Robert Emmett McDonough School of Business

Date Written: December 5, 2015

Abstract

We develop a model in which the parties to a joint production project have a choice of specifying contractual performance in terms of actions or deliverables. Penalties for noncompliance are not specified; rather, they are left to the courts under the legal doctrine of compensatory damages. We analyze three scenarios of increasing uncertainty: Full Knowledge – where implications of partner actions are known; Risk – where implications can be probabilistically quantified; and, Ambiguity – where implications cannot be so quantified. Under Full Knowledge, action requirements dominate: they always induce the maximum economic value. This dominance vanishes in the Risk scenario. Under Ambiguity, deliverables specifications can interact with compensatory damages to create a form of “ambiguity insurance,” where ambiguity aversion is assuaged in a way that increases the aggregate, perceived value of the project. This effect does not arise under contracts specifying action requirements. Thus, deliverables contracts may facilitate highly novel joint projects that would otherwise be foregone due to excessive uncertainty. Suggested empirical implications include the choice of contract clause type depending upon the level of uncertainty in a joint development project, one application being the level of partner experience with inter-firm collaborations.

Suggested Citation

Ryall, Michael D. and Sampson, Rachelle C., Contract Structure for Joint Production: Risk and Ambiguity under Compensatory Damages (December 5, 2015). Forthcoming, Management Science, Available at SSRN: https://ssrn.com/abstract=2837549

Michael D. Ryall

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Rachelle C. Sampson (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

Van Munching Hall
University of Maryland
College Park, MD 20742-1815
United States
(301) 405-7658 (Phone)

HOME PAGE: http://www.linkedin.com/in/rachelle-sampson-68a3b610/

Georgetown University - Robert Emmett McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States

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