Jason Strachman
Information on this page was acquired from the Managerial Economics and Business Strategy text written by Michael R. Baye page 207 and pages 214-217.

A contract is a formal relationship between a buyer and a seller that obligates the buyer and seller to exchange at terms specified in a legal document. It sets specific terms under which the agreement is made -- defines what each party will be responsible for and defines a time requirement. The buyer and seller could be agreeing to something tangible or to a service related product.
Contracts are used to acquire inputs because it allows the purchasing firm to enjoy the benefits of specializing in what it does best because the other firm actually produces the inputs that the purchaser needs. Contracts work well when it is easy to write the agreement. However contracts are costly to write. It takes a lot of time to negotiate the terms which usually requires legal help on both sides of the negotiation. It is usually difficult to cover all the contigencies that can occur.
Determing how long a contract should be reflects the trade-off between marginal costs and marginal benefits of extending the length of a contract. Marginal costs increase as contracts become longer because as the time increases more time and money is spent writing contigencies into the agreement. Contract length will increase when the level of specialized investment required in an exchange increases. As an input becomes more common and the future becomes more certain, the marginal cost decreases which leads to a longer contract. However if the input becomes more complex and uncertain more detail must be written into the contract which increases the marginal cost and requires a shorter term. This requires firms to continually write new contracts after each short one ends which leads to high legal fees and time spent to negotiating new deals. Therefore firms may determine that contracts are not the best way to acquire the necessary resources.
Example 1:
Gary McGreggor owns a farm that grows corn. McGreggor wants to sell his corn to a local grocery store. McGreggor contacts the owner of the store and begins negotiation on establishing a contract. McGreggor states that he will provide 100 pounds of corn to the store per week for .50 cents per pound for the next 12 weeks. The store says those terms are unreasonable. The store requests 150 pounds of corn per week for .33 cents per pound for 10 weeks. After discussing the terms for a while, both parties agree to the terms of 125 pounds of corn per week for .45 cents per pound for 10 weeks. At 10 weeks, McGreggor and the store owner will discuss if they want to continue the relationship.
This example shows that creating a contract takes at least two parties and both parties must receive some gain in their mind or they will not agree to the terms. Contracts are legally binding so neither party can afford to agree to it if they do not like the terms.
As noted, contracts can set terms for services too.
Example 2:
XYZ Corporation needs to buy a new copy machine for the company. After settling on the Xerox R12 machine from Copiers R Us, Copiers R Us offers XYZ Corp a service agreement. The agreement says that Copiers R Us will service the machine for 12 months from the contract signing date. The service contract will cost XYZ Corp $1000. After the 12 months, XYZ can purchase another 12 month agreement if they want. XYZ Corporation agrees to the turns and pays $1000 for the 12 month service agreement.
A month later the machine stops working. XYZ Corporation calls Copiers R Us to come and fix the machine. Copiers R Us tells XYZ Corp that the reason why the machine stopped working was because it ran out of ink. Copier R Us charges XYZ Corp $50 for the service call and $30 for more ink. XYZ Corporation refuses to pay saying that it already paid for a service contract so why do they have to pay again? Copier R Us says the machine was not broken so being called to fix a machine that was not broken is not part of the service agreement.
This example shows that a contract can also cover a service and before a contract's terms are agreed on by either the seller or in this case the buyer both parties must clearly understand what the terms are. In this case, the buyer (XYZ Corporation) understand how much the contract cost and the time requirement, but it was unclear of what was actually covered under the service agreement. Maybe XYZ Corporation did read through the contract carefully before signing it and thought that service covered everything it thought could happen to the machine. It is possible that XYZ didn't think of the fact that the machine would run out of ink so that would be a contingency that was not thought of. Thinking of all the possible contigencies that could exist in the future is difficult which is a big disadvantage to contracts.
Some contracts have an out clause as a part of the specified terms that allows you to void the contract after a period of time for a certain amount of money. It is unclear if this agreement as such a clause. If it did, and XYZ Corp wanted to void the agreement it could follow the terms of the out clause.
Question 1:
The trade off between what two things works to determine the optimal length of a contract?
A. Marginal Cost and Marginal Benefit
B. Projected Revenue and Variable Costs
C. Projected Profit and Marginal Benefit
D. Sales and Fixed Costs
Answer is A
Question 2:
True of False -- The optimal contract length will increase when the level of specialized investment required to facilitate and exchange increases?
Answer is True
Question 3:
The more complex and uncertain the input becomes will the marginal cost of writting longer contracts.
A. Decrease
B. Maintain the same
C. Increase
D. None of the above
Answer is C