Supplier Relations and the Market Context: A Theory of Handshakes

Abstract This paper analyzes the degree of formality in industrial procurement. Contracts impose cost discipline on suppliers, but stifle cooperative innovation; noncontractual procurement provides cooperation but poor cost discipline. However, cost discipline comes naturally when there is not much vertical integration, because the promise of finding an alternative buyer to use as a bargaining threat enhances the supplier's incentive to make efficiency-enhancing investments. Thus, highly integrated industries use contracts, while less integrated industries do business on handshakes. In the latter, cooperative innovations flourish. This may help explain some international comparisons and changes in business practices observed over time.

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