Examining Bounded Rationality-

Based Transaction Costs Under

Leadership for a Digitally Driven World
Prevention and Promotion
Contracts
Jeesoo Kim
Paul Merage School of Business,
UC Irvine
Transaction Cost Economics
Two main behavioral assumptions (Williamson, 1985, 2000):
 Bounded rationality (BR)
 Intendedly rational but with cognitive limitation
 Prevents the inclusion of all relevant contingencies in contracts
 Opportunism
 Self interest-seeking with guile
 One party may take advantage of the other when unexpected disturbance arises in the presence of an
incomplete contract

TCE puts opportunism in the front seat while placing BR in the back
seat (Foss & Weber, 2016):
 BR only leads to incomplete contracts in the theory
 Opportunism drives the theory’s main predictions:
 Opportunistic behaviors increase transaction costs
 Objectives of this Paper
Explore 2 sources of BR-based transaction costs
Framing costs
Increased costs due to friction between the exchange parties arising
from the cognitive impact of contract frames
In the context of our study, results in less investment in the joint
venture (JV)

Envy costs
Increased costs due to friction between the exchange parties arising
from the cognitive impact of social comparison
In the context of our study, results in less investment in the JV
Contract Frames
Economically equivalent, but psychologically distinct
Prevention contracts frame Promotion contracts frame
contingencies as penalties contingencies as bonuses
“…specify obligations… “…promote understanding
prevent losses…penalty… …achieve rewards…bonus…
avoid underperformance” encourage success”
Invested Produced Penalt % Units Invested Produced Bonus % Units
y 2 10 +0% 35 3.5
2 10 -15% 35 3.5
4 20 +5% 40 8
4 20 -10% 40 8
6 30 +10% 45 13.5
6 30 -5% 45 13.5
8 40 +15% 50 20
8 40 -0% 50 20
 Investment in Initial Exchange
Prevention contract: Lower framing costs Promotion contract: Higher framing costs
• Frames exchange goals as obligations • Frames exchange goals as ideals (Weber
(Weber & Mayer, 2011) & Mayer, 2011)
• Unfulfilled obligations seen as failure • Unfulfilled ideals seen as success
• Less pressure to maximize
• Leads to greater pressure to maximize compliance with the contract &
compliance & increased vigilance to increased eager behavior to prevent
avoid sins of commission (Förster et sins of omission
al., 2003) • Thus, increases BR-based TCs in initial
• Thus, decreases BR-based TCs in initial exchange
exchange
H1. Prevention contracts will lead to greater investment in initial exchanges than
promotion contracts, as a result of lower framing costs.
Investment after Violation
When informal exchange expectations are violated, both safeguards and
enthusiasm to continue are needed
Prevention Contracts: Higher framing
costs
 Partner as potentially opportunistic (Weber &
Mayer, 2011)
 More likely to attribute violation to offending
party’s character
 Emotional experience ranges from slightly
positive to very negative (Roney et al., 1995),
limiting enthusiasm for continuing exchange
 Thus, higher BR-based TCs after violation
Promotion Contracts: Lower framing costs
 Partner as benevolent (Weber & Mayer, 2011;
Weber & Bauman, 2019)
 Less likely to attribute violation to offending
party’s character
 Emotional experience ranges from slightly
negative to very positive (Roney et al., 1995),
increasing enthusiasm for continuing exchange
 Thus, lower BR-based TCs after violation

H2. Investment will be greater following a violation of exchange expectations if the

parties implement a promotion rather than a prevention contract, as a result of less
framing costs.
Alliance Portfolio & Social Comparisons
• Firms participate in
multiple alliances
simultaneously
(Jiang et al., 2010; Potential
Andrevski et al., 2016) partner D
B
• Firms adjust each
relationship in
comparison to one
another
(Lavie, 2007)
E
C

Focal
manager
Contract Frames & Social Comparisons
• Prevention contracts set expectation that party is opportunistic (Weber & Mayer, 2011)
• Promotion contracts set expectation that party is cooperative and benevolent (Weber &
Mayer, 2011; Weber & Bauman, 2019)

Prevention contracts Promotion contracts

Low investment H3: Lowest investment

Upward • Negative expectation toward the potential • Positive is negatively violated
partner is met • Very negative emotional reaction
comparison • Negative emotional reaction • Highest BR-based TCs
• Higher BR-based TCs
H4: Highest investment High investment
Downward • Negative expectation toward the potential • Positive is met
partner is positively violated
comparison • Very positive emotional reaction • Positive emotional reaction
• Lowest BR-based TCs • Lower BR-based TCs
General Experimental Procedure SPLIT EVENLY
For example
Company A: 20 units
Construed as two companies potentially interested in a joint venture (JV) Company B: 20 units
Returns
some or
none
Company B SPLIT
Value of what chooses
Invest UNEVENLY
you invest how many For example
some or multiplies (5x) units to Company A: 9 units
all in JV
You choose send back Company B: 31 units
how much
Company
A will
NO SPLIT
invest For example
Invest
Value of what Company A: 0 units
some or all For example:
you invest Company B: 40 units
internally Company A: 8.8 units
multiplies (1.1x)

Contract can be used to reduce

uncertainty of payout from Company
Experiment 1: Procedure & Participants
Do prevention or promotion contracts lead to greater initial exchange
investment as a result of differential framing costs?
236 MBA students enrolled in full-time or part-time MBA program

Round
Condition
1
Promotion Promotion
Prevention Prevention
No contract No contract
Experiment 1 Results & Conclusions
7.2 Initial exchange
investment:
7
 Reliably higher under
6.8
prevention (M=6.97) than
Framing costs= promotion contracts (M=6.15)
6.6 0.82 units or  Higher transaction costs under
10.25% of promotion contracts than
6.4 total possible prevention contracts (TC=0.82,
investment p<.05)
6.2
Conclusion:
6  As a result of less framing
costs, prevention contracts
5.8 were more effective at
facilitating exchange
5.6
Exchange Participation
investment with a novel
Promotion Prevention
exchange partner
Experiment 2
Do prevention or promotion contract lead to greater investment
after violation of informal exchange expectations?
150 Mturk Workers in the US

Contract condition R1 R2
No contract
No Contract No Contract
Violation
No contract
Prevention Prevention
Violation
No contract
Promotion Promotion
Violation
 Experiment 2 Results & Conclusions
8 Framing costs=  Longitudinal analysis:
Promotion Contract 1.01 units or  Promotion contract: Participants invested more of
7 Prevention Contract 12.63% of their resources in JV in Round 2 (M = 7.66) than
total possible Round 1 (M = 4.51)
No Contract  Prevention contract: Participants invested
6 investment significantly more in the JV in Round 2 (M =
6.65) than Round 1 (M = 4.52)
5  Test of differences: Increase in JV investment
JV investment

across rounds was significantly larger in

promotion than prevention condition
4
 Cross-sectional analysis:
 Exchange participation in Round 2 was
3 significantly higher in the promotion contract (M
= 7.66) than the prevention contract condition (M
2 = 6.65)
 Transaction costs were higher under prevention
contracts than promotion contracts (TC= 1.01, p
1 < .05)
 Conclusion:
0
Round 1 Round 2  Promotion contracts reduced BR-based TCs, so
are more effective at restoring investment
following a violation of informal exchange
expectations
Experiment 3
Do prevention or promotion contracts increase investment
after social comparison?
201 Prolific Workers in the US
2 (prevention contract vs. promotion contract) X 3 (upward
comparison vs. downward comparison vs. no comparison)
between-subjects design
Same procedure as Study 2 except before deciding whether to
accept the proposed contract, participants reviewed a
contract that Company B ostensibly offered a similar
company (Company X) for a similar JV
Results Framing costs=
 Investment & bounded rationality-based
transaction costs:
0.98 units or  Under downward comparison,
12.25% of
participants showed a higher level of
total possible
investment
investment under prevention contracts
(M=7.53) than promotion contracts
(M=6.55)
 Transaction costs were higher under
promotion contracts than prevention
contracts (TC=0.98, p=.063)

 Under upward comparison, no such

effects were obtained

 Conclusion:
 Lower BR-based TCs (framing costs +
envy costs) under prevention contract X
downward comparison
Overall Summary
Hypothesis Results
H1: Greater initial exchange investment under prevention
than promotion contract Supported

H2: Greater investment after violation under promotion

than prevention contract Supported

H3: Under upward comparison, less investment under

promotion than prevention contract Unsupported

H4: Under downward comparison, greater investment

under prevention than promotion contract Supported
Overall Contribution & Implication
Demonstrate that bounded rationality can drive transaction costs even in
the absence of opportunism
 When the possibility of opportunistic behavior is controlled, participants have differential TCs
depending on the contract frames and presence or absence of social comparison
Show economically equivalent contracts can lead to different BR-based
TCs
 Prevention contracts result in lower BR-based TCs: (1) in the initial exchange (framing costs)
and (2) when other parties receive worse terms (framing + envy costs)
 Promotion contracts result in lower BR-based TCs after exchange expectations are violated
(framing costs)
Show social comparison between contract partners can create envy costs,
which vary across contract frames
 When other exchange partners receive worse terms, prevention contracts result in lower BR-
based TCs than promotion contracts (framing + envy costs)
 Questions?

Thank you so much for listening!

jeesoo.k@uci.edu