Delegation in Vertical Relationships: The Role of Reciprocity

Abstract

Abstract We analyze the decision of a firm to produce an input internally or to delegate the production to a better-informed supplier. The supplier can produce inputs of different qualities. As quality is not verifiable, a selfish supplier always produces the quality that minimizes his costs. A supplier that is motivated by reciprocity may instead produce the quality that maximizes the revenues of the buyer. Accordingly, reciprocity could increase the use of the market. To trigger reciprocal behavior the buyer must propose a contract that the seller perceives to be kind. We find that for reciprocal behavior to show up, it is enough that the supplier is moderately reciprocal. Lastly, we provide some intuitions about how our results change if the supplier is liquidity-constrained and must be granted non-negative profits in all circumstances.