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Contractual Provisions to Mitigate Holdup: Evidence from Information Technology Outsourcing

Foster School of Business, University of Washington, Seattle, Washington 98195
University of Illinois Urbana-Champaign, Champaign, Illinois 61820
University of Illinois Urbana-Champaign, Champaign, Illinois 61820
asusarla{at}u.washington.edu
rsubrama{at}uiuc.edu
karhade{at}uiuc.edu

The complexity and scope of outsourced information technology (IT) demands relationship-specific investments from vendors, which, when combined with contract incompleteness, may result in underinvestment and inefficient bargaining, referred to as the holdup problem. Using a unique data set of over 100 IT outsourcing contracts, we examine whether contract extensiveness, i.e., the extent to which firms and vendors can foresee contingencies when designing contracts for outsourced IT services, can alleviate holdup. While extensively detailed contracts are likely to include a greater breadth of activities outsourced to a vendor, task complexity makes it difficult to draft extensive contracts. Furthermore, extensive contracts may still be incomplete with respect to enforcement. We then examine the role of nonprice contractual provisions, contract duration, and extendibility terms, which give firms an option to extend the contract to limit the likelihood of holdup. We also validate the ex-post efficiency of contract design choices by examining renewals of contracting agreements.

Key Words: contract duration; extendibility clauses; holdup; underinvestment; information technology outsourcing; incomplete contracts
History: This paper was received on March 30, 2006.