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5 fl-jq wrking paper department f enmis Reputatin Effets and the Limits f Cntrating: A Study f ttie Indian Sftware Industry Abhijit Banerjee Esther Dufl N July 1999 massahusetts institute f tehnlgy 50 memrial drive Cambridge, mass

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7 WORKING PAPER DEPARTMENT OF ECONOMICS Reputatin Effets and the Limits f Cntrating: A Study f the Indian Sftware Industry Abhijit Banerjee Esther Dufl N July 1999 MASSACHUSEHS INSTITUTE OF TECHNOLOGY 50 MEMORIAL DRIVE CAMBRIDGE, MASS

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9 Reputatin Effets and the Limits f Cntrating: A Study f the Indian Sftware Industry Abhijit V. Banerjee* and Esther Dufl^ First Draft: Nvember, This versin June 11, 1999* Abstrat This paper examines evidene f the rle that reputatin plaj's in determining ntratual utmes. We ndut an empirial analysis f the Indian ustmized sftware industry. We analyze a data set ntaining detailed infrmatin abut 230 prjets arried ut by 125 sftware firms that we had previusly lleted. The evidene supprts the view that reputatin matters. Ex ante ntrats as well as the utme after x-pst renegtiatin varj' with firms' harateristis plausibly assiated with reputatin. We argue that this pattern is nt nsistent with ptimal risk sharing and prpse a mdel f the industry where reputatin determines ntratual utmes, whse preditins are nsistent with several fats bserved in the data. We argue that there is n bvius alternative explanatin t the patterns present in the data. 'Massahusetts Institute f Tehnlgy. banerje@mit.edu * Massahusetts Institute f Tehnlgy. edufi@mit.iu *W thank Darn Aemglu, PhiHpp Aghin, Rland Benabu, Mathias Dewatripnt, David Gnsve, Jnathan Guryan, Oliver Hart, Dug Miller, Dilip Mkhrje, Ashk Rai, Emmanuel Saez, Andrei Shleifer, Jean Tirl, and Rihard Zkhausr fr helpful nversatins and Paul Jskw fr enuragement and supprt. We aknwledge finanial supprt frm the the Natinal Siene Fundatin, Alfred P. Slan Fundatin, the Shultz Fund and the Jhn D. and Catherine Ma Arthur Fundatin. We are espeially grateful t the sftware prfessinals in India, wh patiently answered ur many questins, and in partiular t Mr N. R. Narayana Murthy, frm Infsys Tehnlgies Limited, whse help and insights were ruial thrughut this prjet.

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11 1 Intrdutin The idea that there ar severe hinits t what an be ahieved thrugli ntrating has had an enrmus impat n the way enmists nw tliink abut firms, marl<ets and gvernments. Crrespndingly, there has been a grwing emphasis n tlie rle f reputatin as a way f unterating the prblems reated by the hmitatins f ntrating.^ Wliile less ften emphasized, a view f the wrld whih gives entral imprtane t issues f ntrating, reputatin and trust, als has imprtant nsequenes fr the press f grwth and develpment. Mst imprtantly, it suggests that the lak f a prper infrastruture fr ntrat enfrement (whih makes ntrating less effetive) and the diffiulty f building a seure reputatin^ are ptentially imprtant determinants f suess in getting ut f pverty, alng with the mre nventinal determinants suh as human apital and physial infrastruture. This paper attempts t quantitatively assess the imprtane f reputatin and, by impliatin, the seriusness f the limits n ntrating in the ntext f the Indian ustmized sftware industry. Custmized sftware is an bvius plae t study suh effets sine the desired end-prdut tends t be extremely mplex and diffiult t desribe ahead f time in a way that a third party (suh as a urt) wuld understand. In fat, typially the parties t the ntrat themselves d nt fully understand what they want until well int the prdutin press. Therefre, it seems naive t expet that they uld write a ntrat enfreable by the urts that wuld fully ver all ntingenies that uld arise in the prdutin press. Mrever, sftware prdutin ds nt require very muh fixed apital: indeed mst firms nwadays simply wn a number f PCs (whih are heap and getting heaper). The rest, inluding the premises, aess t a mainframe and links t a satellite, an all be rented."^ This limits the pssibility f the reputatin effets that interest us being nfunded with the effets f deferential aess t apital r the lak f real mpetitin. The Indian sftware industry is suitable fr suh a study fr a number f reasns: First, it is an industry whih is quite large (emplying 140,000 peple with a turnver f $1.75 biuin in 'Se fr example Grif (1994), Baker, Gibbns and Murphy (1997). Stemming frm prejudie, r a histry f bad perfrmane, as emphasized by Tirl (1996). hi Lidia, the gvernment has atually invested heavily, and by all aunts fruitfully, t make sure that firms have the ptin f renting expensive fixed inputs (suh as expensive mputers, building spae and equipment fr satellite telemmuniatin) in virtual "Sftware Tehnlgy Parks" (STPI, 1997).

12 ) and grwing fast (at an average annual grwth rate f 54% ver the past six years). Send, its main fus is n exprts (mre than 60% f its revenue mes frm exprts) and a large (ver 30%) and fast-grwing share f the exprts is ustmized sftware. Mrever, the industry's urrent fus is n expanding the exprt f ustmized sftware relative t its ther businesses n the grunds that this is likely t be its best bet fr the near future (NASSCOM, 1997).'' Cnsequently, the limits f ntrating are a majr issue in this industry and ne that everyne is learly nerned abut. Finally, the fat that the ntrats are typially arss lng distanes makes ntrating mre mpliated Ijth by making mnitring smewhat harder and, perhaps mre imprtantly, beause f the inherent diffiulties f internatinal litigatin (mbined with the defiienies f the Indian urt system). The data we use in this paper mes frm interviews f 125 sftware mpanies in three majr sftware develpment enters in India (Bangalre, Hyderabad and Pune)^. W lleted detailed data n the mpany and n the tw last prjets they have mpleted, inluding what kinds f ntrats were initially arranged between them and hw the ntrat gt renegtiated as the prjet evlved (w have a ttal f 236 ntrats in ur data set). Prima faie, the data supprts bth the view that ntrating is very limited and the view that reputatin is imprtant. All ntrats in ur sample are either fixed-prie ntrats r time and material ntrats. In fixed-prie ntrats the sftware firm - henefrth, the firm - gets a fixed prie and is suppsed t pay fr all realized sts. In time and material ntrats the sftware buyer - henefrth, the lient - is suppsed t pay fr all realized sts. A large fratin f the ntrats d hwever get renegtiated ex pst: the buyer ds nt pay the entire st in almst half the fixed ntrats and the lient pays less than the full amunt in abut a quarter f the time and material ntrats. There is als a simple pattern in bth the kind f ntrat that gets hsen and the sharing f the sts whih is a result f the renegtiatin. It is shwn in Figures 1 and 2. Figure 1 shws the fratin f fixed-prie prjets as a funtin 'in the past, exprt f sftware servies was almst exlusively n-site servies (r "bdy-shpping"), f. Heks (1996). ''In eah ity, w interviewed half f the firms wh belng t the sftware tehnlgy park (all exprters d). We seleted the firms randmly, but we versampled the firms that are nt fully-wned subsidiaries. N firm refused t meet with us and answer the questinnaire. Sme appintments uld nt be arranged due t the CEO's unavailability at the mment we were interviewing, and these firms were replaed.

13 f the fundatin date f the sftware firm, and Figure 2 shws tlie share f verrun'' paid fr by the firm as a funtin f the age f the sftware firnij Btli ar sharj^ly inreasing with the starting date f the firm. In partiular, firms reated in 1994 r after (half f the sample) Ijar a substantially larger share f the verrun than lder firms n average, and the share f verrun they bear is inreasing mre sharply with age ver this range. Measured bth in terms f the ex ante ntrat and in terms f ex pst utme, yung firms bear a larger share f the 'risk' f eah sftware prjet. This effet f age is perhaps the main empirial finding f the paper. We interpret this as an effet f reputatin n the grunds that the firms that started in the industry a lng time ag and have sur\'ivd ar mre likely t be the kinds f firms that lients an trust - the lder firms that annt be trusted ar likely t have already gne ut f business (sine eventually peple wuld have gt t knw abut them). T prvide further supprt fr ur interpretatin f the age effet as a reputatin effet, in Setin 5 we shw that a similar pattern exists when we use ther ptential measures f reputatin suh as whether there has been a previus transatin between the firm and the lient, whether it is an internal prjet (i.e., with a lient wh either wns the firm r has a lngterm arrangement with the firm)^, et. Further, we shw that different kinds f reputatin are t sme extent substitutes. Fr example, the differene between yung and ld firms disappears amng firms that wrk fr an internal lient. In setins 3 and 4 f the paper we develp a simple mdel based n ur bservatin f the industry ^^hih explains why reputatin wuld have the bserved effet n ntratual utmes. The basi idea f the mdel is that in mst ases by the end f the prjet the firm and the lient knw wh was respnsible fr st verruns. While this is nt ntratible, firms and lients uld nevertheless benefit frm it if they uld mmit t always fllw a ertain nrm. The nrm we emphasize here - learly there an be ther nrms that will als wrk - is that f being reliable: reliable firms always try very hard t ensure that they d nt exeed the st verrun that they had impliitly prmised, and pay fr any extra verrun when they fail t d s. The prblem is that this is typially nt nsistent with shrt-run prfit maximizatin by the firm r all '"The amunt f the prjet st that ges beynd the initial preditin. Beause the number f firms per year in the sample is small fr firms reated befre 1988, w have gruped these firms tgether. ''W will desribe this type f struture belw.

14 the lient, and an nty be sustained if the firms and hnts ar ither innately reliable r, mre nvntinall}', if the partiular equilibrium that they ar playing indues them t put sme value n tliir reputatin. We lk at equilibria where a ertain fratin f firms and lients are reliable and the rest are nt and investigate the impliatins f a hange in the fratin f thse wh ar reliable (interpreted as a hange in the average reputatin f the firms). The basi trade-ff that gverns what happens is that fixed-prie ntrats ar best fr prteting reliable buyers frm unreliable sellers while the reverse is true f time and material ntrats. Therefre there shuld be mre fixed-prie ntrats if the share f buyers wh are likely t be reliable is smaller, whih is nsistent with the evidene we desribe abve. We als argue that a number f ther preditins frm this mdel are nsistent with what we bserve. While we d prvide sme evidene supprting the brad premises f ur mdel, it is lear that we annt prvide sharp enugh evidene t rule ut alternative reputatin mdels: it is pssible, fr example, that the relevant reputatin is fr hnesty r fr a different frm f reliability. The bjetive f this paper is nt t distinguish amng different kinds f reputatin. Hwever ur reputatin-based stry des rule ut many alternative explanatins. In partiular it rules ut mdels where there are n ageny prblems as well as mdels f ageny prblems where there is n learning abut the firm's type. Of urse, this is all nditinal n establishing that we are in fat rretly interpreting the data when we impse the reputatin mdel n it. In ther wrds, it still remains pssible that what we ar piking up here is the effet f sme ther variable whih happens t be rrelated with these measures f reputatin. In Setin 6, we nsider sme f these explanatins. They fall bradly in tw lasses. First, there is a lass f alternative explanatins whih rule ut ageny prblems: the differenes in the ntrats is then explained ither by differenes in risk-sharing r by differenes in the prdutin tehnlgy available t the firm. Against this view, we first argue that it is very implausible that the ntratual variatins that we bserve are a result f ptimal risk-sharing. The basi pint is that in ur data set, firms are usually muh smaller than their lients and yung firms are espeially small. It is therefre very hard t understand why firms bear s muh f the risk (57% n average) and why espeially the smallest and yungest firms bear the mst.^ In respnse t the view that there ar differenes in the prdutin tehnlgy (essentially that ''There ar f urse ther determinants f the sharing f the risk. We disuss these issues in setin 6.

15 yung firms ar mre inmpetent) w pint ut that the natural effet f suh inmpetene shuld be t lwer the prie the j'ung firms gets paid rather than t make them bear a lt f lisk that they an ill afl'rd. Mrever the evidene ds nt supprt tlie view that the differenes in mpetene between the firms is f a magnitude that an explain the differenes in the ntrats. Fr example, \v present in Figure 3 the average verrun as a funtin f firm's fundatin date. If the high shares f verrun paid by yung firms were a way t make them pay fr higher verrun, we shuld see average verrun falling with age. If anything, the ppsite seems t be true. The send lass f mpeting theries psits that there are ageny prblems but n learning abut the firm: we pint ut that this nflits with the evidene n the effets f sures f reputatin ther than age. These and related issues are disussed at sme length in Setin 6. As a final piee f evidene, we emphasize the fat that the neessity t build reputatin and trust is regnized and is emphasized repeatedly at the industry level as well as by individual firms. Fr example, the Natinal Assiatin f Sftware Servies Cmpanies (NASSCOM) diretry f the Indian Sftware industry has a large setin n "quality" (NASSCOM, 1997). The main element they stress is the number f Indian firms that have ISO 9000 ertifiatin r are in the press f aquiring it (ISO-ertified firms have prven that their sftware develpment presses fllw apprved rutines, whih is a way fr firms t establish a reputatin). The assiatin prvides tehnial nsulting t any member wh wants t get ISO ertifiatin. The Indian gvernment prvides finanial inentives fr firms wh aquire it. At the individual level, effrts t develp a reputatin ar als bvius.^" This paper is a part f a small but grwing number f papers that study the empiris f ntratual hie. ^^ Amng reent papers Crker and Reynlds (1993) is mst lsely related t this wrk. They examine the determinants f the hie between fixed-prie ntrats and mre flexible ntrats in U.S. Air Fre engine prurement. In their view, the key trade-ff is the fllwing: fixed-prie ntrats prtet the gvernment against ex pst pprtunism (in partiular it makes it useless fr the ntratrs t laim higher sts) but they require the '"20% f the firms in ur sample already have ISO ertifiatin. 13% ar in the press f getting it. "Mnteverde and Tee (19S2), Masten and Crker (1985), Jskw (1987) and Pittman (1991) ar imprtant early papers n this subjet. These papers differ frm urs in studying settings where there ar huge relatinshipspeifi investments and very lng term relatinships ar the nrm and where the key trade-ff is between tightness f ntrat (r ntrl) and flexibility.

16 The ability t draft an exhaustive list f requirements (a mplete ntrat), whih is pssible, but stly. Time and material ntrats d nt require a truly mplete agreement ex ante, but pen the rm fr pprtunisti Ijehavir by the ntratr.-'^ Cntrats will tend t be fixed-prie if the nature f the engine makes them easy t draft (if the engine is well knwn r the prdutin yle is shrt), and if the ntratr is mre likely t behave pprtunistially. Their empirial analysis f a panel f 44 ntrats between the gvernment and tw ntratrs nfirms these preditins. Their wrk shares therefre a entral intuitin with urs: the reputatin f the ntratr des matter fr the hie f ntrats. ^'^ The mre reputed a firm is, the less likely it is that the ntrat will be fixed-prie. entral differene is that flxd-pri ntrats are nt assiated with any ex pst st fr the ntratr, sine fixed-prie ntrats are "truly mplete agreements". In ntrast, we regnize the fat that in the sftware industry the ntrat is never mplete. Fixed-prie ntrats need nt be mre preisely drafted than time and material ntrats. Overrun happens in bth types f ntrats. The entral trade-ff is between ntaining pprtunism by the lient and pprtunism by the firm. Lafntaine and Shaw (1996) is anther paper that lks at the efi't f a firm's age n ntrats (in the ntext f franhising) and finds that the franhiser's age has n effet n the ntrat. Hwever as they pint ut, by hanging the franhise ntrat ver time a franhiser runs the risk f hurting its early franhisees (wh are lked int ne ntrat while their mpetitrs get a different ntrat that perhaps allws them t be mre aggressive). Beause f this rss-ntrat externality, ntrats may nt hange very muh ver time, even if the market ver time bemes mre knwledgeable abut the franhiser.-''* The rest f the paper is rganized as fllws: In Setin 2, we desribe the institutinal '^Bajari and Tadlis (1999) emphasize a related trade-ff in the private setr building industry (in a mdel where there ar n unbserved differene amng ntratrs). Time and material ntrats give the ntratr little inentive t ntrl the sts, but d nt require mplete drafts. Fixed prie ntrats give the ntratr strng inentives t ntrl st, but require mre preise design t avid stly bargainig if hanges ar needed during the mpletin f the prjet. The time sale and the mplexity f the prjet will determine whih ntrat is hsen. ''in their paper, they measure the reputatin by the number f litigatin nflits that the ntratrs had in the past. '""This paper is als related t papers suh as Barrn and limbek (1984), Shpard (1993) and Genesv (1993) whih test the impliatins f theries based n aymmetri infrmatin in industrial ntexts (but nt the impliatins fr the hie f the ntrat).

17 settings in mre detail and present a number f basi fats abut the prdutin f ustmized sftware. The mdel is presented in Setin 3 and its preditins abut hw reputatin shapes the ntratual frms as well as the ex pst utme ar desribed in Setin 4. In Setin 5, we prvide evidene whih, in ur view, learly supprts the impliatins f this mdel. In Setin 6, we disuss alternative explanatins f the pattern bserved in the data. Setin 7 nludes. 2 Institutins and Basi Fats We begin Ijy desribing the sequene f events leading t the ff-shre prdutin f a piee f sftware.'^ The prjet begins when the lient sends a request fr prpsal t ne r mre firms. Eah interested firm studies the request (this sts the firm 1.25% f the ttal prjet st fr the median external prjet^*^), and submits a prpsal, whih inludes, amng ther things, a prpsed mde f payment and an estimate f hw muh the lient wuld have t pay. The lient hses a firm, and the firm and the lient agree n a ntrat. The ntrat speifis an estimate f effrt needed t mplete the prjet, a mde f payment, finanial details (prie, et.) and a prjeted shedule fr deliverables (whih ar speifi milestnes - rrespnding t phases f the sftware develpment press r t mdules f the sftware - that will be reahed in the urse f mpleting the prjet). The wrk then starts. The first phase is the writing f speifiatins. The firm, in llabratin with the user at the lient's end, writes the set f funtins that the sftware will exeute. Fr the median prjet, it takes 10% f the ttal prjet effrt t mplete this phase. ^^ At the end f this part f the prjet, what the lient wants and what it wuld st is usually learer t bth the lient and the firm and the shedule f deliverables is smetimes amended r larified. The send phase f the wrk is the lwer level design, ding and testing f the sftware. When a speified milestne is reahed, the firm sends the deliverable t the lient. Eah time this happens the lient an either aknwledge that it has been delivered (by signing ff) r request hanges. The firms als send regular status reprts t the lients (a little less than ne ''Tabi 1 shws the desriptive statistis mentined in this paragraph. "'Thse prjets where the lient des nt wn the firm r des nt effetively ntrl the part f the firm whih is wrking twards the mpletin f the prjet (see belw). 'Fr sme prjets, speifiatins writing and subsequent wrk ar deupled. One firm - r the lient itself - writes the speifiatins, and anther firm mpletes the prjet.

18 a week n average), keeping the lients up-t-date aljut the jh-gress f the prjet. In terms f prjet utmes ur main fus will be n verrun: verrun in industry parlane is the differene between the amunt f effrt atuallj' needed t mplete the prjet and the estimated effrt given in the ntrat. It is therefre imprtant t be lear abut what firms mean by an estimate. A standard textbk n sftware management (Pressman (1997), has an entire hapter n estimatin. He desribes the press as fllws: 'The prjet planner begins with a bunded statement f sftware spe and frm this statement attempts t dempse sftware int prblem funtins that an eah be estimated individually. Line f Cde r funtin pints (the estimatin variable) is then estimated fr eah funtin. Alternatively, the planner may hse anther mpnent fr sizing, suh as lasses r bjets, hanges r business presses impated. Baseline prdutivity metris (i.e., line f de per persn- mnth r funtin pint per persn mnths) are then applied t the apprpriate estimatin variable and st r effrt fr the funtin is derived. Funtin estimates are mbined t prdue an verall estimate fr the entire prjet.' (Pressman (1997)) Our interpretatin f this and ther material in this bk (whih is als nsistent with what we have learned frm industry sures) is that the estimate is the firm's best guess abut hw muh effrt will be needed t mplete the prjet, assuming that the firm's urrent understanding f the prjet is rret and that the firm adheres t its wn prdutivity nrms}^ The estimate is therefre learly nt meant t be an unbiased estimate f hw muh effrt the prjet will atually take. This is imprtant beause it tells us that verrun represents the extent f deviatin frm the firm's initial plan f atin. This als tells us that verruns ught t be quite mmn: first, beause the needs f the lient are typially nt very lear at the very beginning f a relatinship - even t the lient himself. Mrever the lient may nt put enugh effrt int understanding and explaining what he wants. Nt surprisingly then, the firm ften des nt understand what the lient really wants. When, in the urse f the prjet, the needs f the lient eventually beme lear, hanges have t be made and these are stly. Send, the amunt f time and effrt needed t design and "In ther wrds, the presumptin behind the estimate is that the firm has understd perfetly what the lient wants and that the firm implements the prjet at its nrmal level f prdutivity. 8

19 de a piee f sftware is diffiult t evaluate ex ante, even when the set f funtins is welldefined (bth fr the lient and fr the firm), and will depend n the type f tehnlgy Ijeing used, the ability and the experiene f the staff f the tw mpanies. Third, with the best f staff and the learest f gals there is als the risk that sme unexpeted prblem arises and delays r destrys the prjet. Finally, nt all firms try their hardest t ntrl sts and delays and ne wuld expet that sme prjets will end up sting muh mre than they ught t. Table 1 shws evidene frm ur interviews nfirming that verruns ar indeed mmn: it turns ut that 74% f the prjets are mpleted with a psitive verrun. The average verrun amunts t 24% f the initial estimate, and varies a lt (its standard deviatin is 34%, and the maximum verrun in the sample is 250%). Arding t the firms, verruns are due mstly t hanges required by the lient (these hanges ause 48% f the verrun n average). Anther 20% f the verrun is due t initial ambiguity in the speifiatins (i.e., t ases where the firm did nt understand what the lient really wanted), 8% is due t internal diffiulties in the firm (the mst frequent ne being the lss f the prjet manager in the middle f the way) and 13% t delays asined by the lient. Very few prjets (less than 5%) are mpleted with a negative verrun, and the mean verrun is learly nt zer. Bth firms and lients are, f urse, aware f the pssibility f verruns.^'-' Overruns, apart frm being wasteful in themselves (in s muh as they uld have been avided by bth parties being mre diligent), lead t delays whih are stly^" and are a ptential sure f nflit between the lient and the firm (nflits arise when eah side blames the ther fr the verrun). Vertial integratin and ntrats ar tw ways f limiting the waste due t verrun. Many freign mpanies have set up 100% wned subsidiaries in India.'^^ These subsidiaries are 100% exprt riented, and arry ut wrk fr their mther mpany and in sme ases, fr ther lients as well. A number f Indian sftware firms have als entered int arrangements under ' Fr example, the template f a firm's ntrat speifies that "the effrt estimates prvided fr the nversin and testing phases f this prjet have been prvided by the sftware firm n a best estimate basis. If the spe f the effrt hanges as a result f disussins during the detailed design phase, the sftware firm will analyze the impat f hanges n the prjet and may present revised shedules and sts. Changes in shedules and sts resulting frm suh hanges will be refleted by an amendment t this ntrat." '"Delays, while rarer than verrun, are far frm unmmn in ur sample: there are delays in 19% f the ases, and in 25% f the ases where there was an verrun. ' "Inluding AT.S;T, IBM, Mirsft, INTEL, ORACLE, Fujitsu and Mtrla.

20 whih the firm dediates a part f its emplyees, ffie spae, and mputers t a single freign lient. This is what is alled an "Off-shre Sftware Develpment Center" (OSDC). The lient sends a steady fratin f his sftware develpment needs t the firm, and is respnsible fr making use f the failities devted t him. This is in effet a type f vertial integratin: the OSDC bemes virtually a unit f the lient fr whm it wrks regularly. In suh ases the interests f the firm and the lient are learly better aligned and while there may be verrun, there is muh less reasn why the verrun shuld be wasteful. ^^ Sine we are interested in ntrats rather than vertial integratin ur fus in this paper is mainly n external ntrats (i.e., ntrats that are perfrmed neither within OSDC nr fr the mther mpanies f the firm). We bserve the fllwing types f external ntrats: Under fixed-prie ntrats, a fixed prie is agreed upn up-frnt, befre the speifiatin analysis. These ntrats are by far the mst frequent: 58% f external ntrats are fixed-prie ntrats. Under mixed ntrats the prie is fixed fr the speifiatin phase nly at the beginning f the press. The prie fr the mplete prjet is fixed nly when speifiatins are written and mre is knwn. Typially in suh ases the requirement analysis is paid fr n a time and material basis, thugh this is nt neessarily the ase. Under time and material ntrats, the entire prdut is paid fr n a time and material basis. These ntrats are the least frequent amng external ntrats (15%). A striking fat is that there appears t be n "intermediate" ntrats: all ntrats belng t ne f these three ategries. ^"^ Fr example, there ar n ntrats where the lient and the firm agree n sharing the sts. ^"^ While these ntrats predit extreme utmes in terms f st-sharing, we atually d nt always bserve this. It turns ut that a large fratin f ntrats get renegtiated ex pst. This is evident frm Table 2, whih shws the fratin f verrun paid fr by the firm and the prprtin f firms that pay all r nthing f the verrun fr the three types f ntrats. Even in fixed-prie ntrats, the atual verrun is ften shared between the lient and the firm (in 46% f the ases) while firms with time and material ntrats smetimes pay fr verrun (in ""Indeed there may be mre verrun in suh ases than in general preisely beause verrun entails less waste. Fr example, the lient may nt need t be very preise abut what he wants sine he knws that the firm will be happy t d whatever is asked f it. Or their variants: in sme ases prperty rights in the prdut substitutes fr ash payments. Suh ntrats ar bserved, albeit rarely, amng the prurement ntrats fr airplane engines studied by Crker and Reynlds (1993). 10

21 22% f the ases). Hwever it is als lear frm the figures in Table 2 that the initial ntrat has an lear influene n whih party bears the risk f the prjet: in fixed-prie ntrats, firms bear n average 63% f the verrun, while they bear n average 51.5% in mixed ntrats and 15.5% in time and material ntrats. Sine flxed-pri ntrats dminate ur sample, this evidene als implies that firms bear a lin's share f the verrun (57% n average fr external prjets, 76% fr the median external prjet). Sine firms ar typially muh smaller than their lients, this is at least smewhat surprising. There ar several ptential explanatins fr the pervasiveness f renegtiatin. First, even when a firm faes a fixed-prie ntrat it may have sme bargaining pwer beause it usually has the ptin f walking ff the jb. If it ds, it will nt get paid fr wrk that it has already dne, but it will als avid the verrun and, at least at early stages f the jb, the send ff"t may dminate. Send, the urt system in India is extremely ineffiient and ging t urt is very stly. Firms and lients will therefre prefer t make sme nessins in rder t avid ging t urt. In fat, there is n prjet in ur sample where the firm and the lient went t arbitrage urt (even thugh in sme asins the firm reprts a nflit with the lient). Mre generally, frm ur nversatins with industry peple we have the impressin that peple g t urt very rarely and therefre we ught t expet sme renegtiatin. Finally, firms and lients may vluntarily pay fr any verrun that is f their wn making, beause they are abut their reputatin fr being reliable. We had a number f nversatins where the CEO f the firm tld us 'it was ur fault and we paid fr it'. We als have sme mre indiret evidene that this is at least smetimes the ase: as mentined abve, we asked firms questins abut wh was respnsible fr the verrun. In what fllws, we assume that the firm is respnsible fr what it desribed as hanges due t ambiguities and verrun aused by internal diffiulties. Changes required by the lient and delays ming frm the lient's side are taken t be aused by the lient's respnsibility. Table 3 shws the share f verrun paid by the firm when the verrun is entirely due t the lient (lumn (1)), entirely due t the firm (lumn (3)), r due partly t bth (lumn (2)). In lumn (4), we present the effiient f an OLS regressin f the share f verrun paid by the firm n the share f verrun whih it aused. In all types f ntrats, firms always pay mre f the verruns entirely aused by their wn mistakes mpared t the verrun entirely due t the lient. Mrever, in all ases but ne, the share f verrun paid by the firm lies inbetween these tw numbers when the verrun is partly 11

22 aused by eah side. Furthermre, the OLS regressins indiate that, regardless f the initial ntrat, the larger the fratin f the verrun that a firm has aused, the larger tlie share it has t pay (if a firm auses ne additinal perent f the verrun, it bears apprximately 0.20 perent mre f it). In the next setin we present a mdel f the industry whih is based n the piture that emerges frm the abve disussin. The main elements we wish t apture in ur mdel ar the fllwing: ^t- the high levels f verrun, the fat that bth sides ar respnsible fr verrun, the use f simple ex ante ntrats, the fat that the ntrats get renegtiated ex pst, the fat that the ex ante ntrat ntinues t influene the renegtiated utme, the fat that firms and lients are aljut their reputatin fr being reliable and will ften vluntarily pay fr verrun that is f their wn making. 3 A Mdel f the Sftware Industry The mdel we prpse in this setin is an attempt t apture in as simple a way as pssible what, n the basis f ur experiene in the industry, we see as the fundamental strutures and nflits in the Indian ustmized sftware industry. The ntrating utmes that will be predited by the mdel will, as w shall se, math up reasnably well with what is bserved in the data. Hwever, ne uld me up with ther mdels, r at least mbinatins f ther mdels, whih als explain the data. W will disuss sme alternative explanatins in Setin 5. In the end, hwever, it remains plausible that elements f these ther mdels uld als be a part f any mprehensive stry f the sftware industry in mbinatin, perhaps, with the stry we tell. In this sense, the mdel is meant t be illustrative rather than definitive. The premise f the mdel is that sftware prjets ar prne t st verruns and that the main nflits ar ver the apprtining f these st verruns. Overruns an happen fr tw reasns. First, the hnt uld have been insuffiiently diligent in deuneating his requirements 12

23 r he uld have made a mistake. As a result, when the firm mes up with a prdut he might realize that this is nt what he wants and demands hanges. The firm is, f urse, happy t make the hanges - sine they ar Part imprving - but nly if it is adequately mpensated. The issue is whether the lient will be willing t mpensate it enugh. Send, verruns uld als happen beause the firm was either lazy r unluky in the way it arried ut the prjet. Sine the verrun uld me frm ither side, when there is an verrun, there is a real pssibility that eah side will blame the ther fr it. This need nt be a prblem if utsiders, and speifially the urts, an bserve wh was really respnsible. Our assumptin will Ije that this is nt pssible in mst ases. This is learly smething f a ariature f reality: firms and lients learly d try t set up systems t ensure that it is lear, ex pst, wh was t blame fr any verrun. The predure f defining deliverables and having the lient sign ff n eah deliverable is ne suh system. One a lient signs ff n a deliverable, he is t a large extent mmitted t admit that at least up t that pint the firm had dne what it was suppsed t d. This learly limits the spe fr future disagreements. Nevertheless, there seem t be lts f disagreements and this is presumably asribable t the fat that even after many milestnes have been reahed, there remains substantial ambiguity abut what exatly needs t be dne. 3.1 Disagreements, Overrun and Cntrats We apture the pssibility f this kind f disagreement as fllws. The lient (C) wants the firm (F) t build a piee f sftware that will be wrth V t the lient (we will assume risk-neutrality n bth sides thrughut, s this is best thught f as a mney payff and the sts as mney sts). In a wrld where the lient an desribe the prdut it wants perfetly and the firm als understands this desriptin perfetly, the prjet shuld st y (i.e., the estimate is y). We adpt the nrmalizatin that y = 0. Hwever we assume that in every prjet the atual st will be psitive, i.e., there will be verrun: the lient's desriptin f the prjet will always be inmplete and the firm will never understand it perfetly. Ttal verrun will thus be the sum f verrun aused by the firm (y^ and verrun aused by the lient (y)- Assume that all verrun is initially paid fr the by the firm. 13

24 The amunts f the verrun, yp and y, ar determined, respetively, by the ftrt put in by the firm and the hnt in desribing and understanding the prjet. S])ifially w assume that firms fae a hie between a high level f yp, yp^ and a lw level, y _. Likewise, the lient faes a hie between y and y_- Ceteris paribus, bth firms and lients prefer high levels f verrun - this may be beause ntrlling verrun takes effrt r beause the firm (r the lient) gets t keep a part f the verrun it has generated (say the firm is lying abut its sts). The extra private benefits t the lient and the firm f a high level f verrun ar, respetively, Bq and Bp. Assume that y y> Be and yp yf> Bp s that it is always effiient t minimize verrun. Hwever, we will assume that bth y and yp ar knwn nly t the firm and its lient: third parties suh as the urts nly bserve ttal verrun {y + yp)?''^ Mrever, we restrit all ntrats t being linear and in additin require that they d nt invlve thrwing away any mney. In ther wrds, we nly nsider ntrats where the lient pays the firm an amunt P+ (1 s){yp +y) - where P is a pr-spifid fixed payment and s is the share f the verrun brne by the firm (s G [0,1]) - and neither party makes any payments t anybdy else. Of partiular interest t us will be tw extreme ntrats: the ntrat with s = 1 (rrespnding t a fixed-pri ntrat) and the ntrat with s = (whih rrespnds rughly t a time and material ntrat).'^'' It will be key t ur analysis that neither f these ntrats bviusly dminates the ther. The fundamental trade-ff mes frm the fat that s is ne number that is being used t give inentives t bth parties: a high s will give gd inentives t the firm but nt t the lient, while a lw s ntrat des the reverse. As a result, it will typially nt be pssible t implement the first bst.^'^ T mplete the desriptin f the ntrating press we need t say wh prpses the ntrat. Our reading f the industry pratie is that the ntrat is usually prpsed by the ^'In ther wrds, the fat that, say, tw peple were assigned t the prjet fr 14 weeks is verifiable but nt what they were atually ding - they uld have been really wrking n a different prjet fr mst f that time. "''The rrespndene is nt exat beause a time and material ntrat typially pays a markup n the realized sts rather than a fixed payff. Similar results hld fr that ase but the expsitin is smewhat mre umbersme. -'"'This basi tensin is very general. Our restritin t linear ntrats, while vital in the disrete ase we have hsen here, an be relaxed if we ar prepared t g t the mdel where verrun varies ntinuusly: the impssibility f implementing the first best in that ase is a nsequene f the results in Hlmstrm (1982). 14

25 firm. W^ will make this ur maintained assumptin, nting hwever that similar results wuld hld if we allwed the lient t prpse the ntrat. 3.2 Nrms When the first best annt be ahieved by ntratual means, it is pssible t imprve n the utme if the behavir f the firms and the lients is at least partly nrm-gverned. Speifially assume that there are tw types f firms and tw types f lients. Of these, ne type f firm and ne type f lient bserves a nrm f being reliable, by whih we mean that they always pay fr any verrun that they themselves have generated, as lng as the ther side des the same. In partiular, they will pay fr the verrun that they have generated, even if the ntrat stipulates that the ther side pays fr it - in ther wrds they d nt neessarily maximize urrent prfits. Hwever, if the ther side ds nt at reliably they d nt at reliably either - they simply tr}' t maximize urrent prfits. Assume by ntrast, unreliable firms and lients always at t maximize their urrent prfits. When a firm and a lient are mathed, they d nt diretly bserve eah ther's types. Rather they assign prbabilities t the ther party being reliable, n the basis f what they knw abut them. The prbability that the firm puts n the lient's being reliable, 6, and the prbability that the lient puts n the firm's being likewise. Op, therefre summarize their respetive reputatins. We will return t the questin f hw these reputatins are sustained and their evlutin later in this setin. 3.3 Cntrats fr Prtetin In this setting, sine the reliable firms and lients ar ging t be slf-rgulated, the funtin f the ntrat is t prtet reliable lients against pprtunism by unreliable firms and vie versa. The ntrat prtets beause it prvides a fall-bak ptin when the ther party is being unreliable. If a firm, fr example, generates a large amunt f verrun and refuses t pay fr it, it an be taken t urt and fred t pay at least the share f the verrun it has ntrated t bear. Hwever as we have already argued in Setin 2, we expet these ntrats t be renegtiated. We assume that the renegtiated utme is a sharing f the verrun whih is ptentially different 15

26 frm what is in the ntrat and is represented by the share f the verrun paid fr by the firm when tliere is a dispute, s*{s,9,9p). It is natural t assume that s* is inreasing in s. We wuld als xjjet that mre reputed parties will have mre bargaining pwer and therefre pay less (beause, fr example, the urt will pay mre attentin t their plaints but als beause ther determinants f bargaining pwer suh as reditwrthiness tend t be rrelated with reputatin), i.e., ^f- > and ^- < 0. Assume als that s* is bunded belw by «!_> and abve by s* < 1.^^ 3.4 Firm Behavir Reliable firms and lients always pay fr any verrun that they generate. It fllws that they always hse a lw level f verrun - yp fr the firm and y fr the lient. At the end f the ntrating perid they bserve the verrun generated by the ther party and als whether r nt they agree t pay fr it. If the ther party refuses t pay fr the verrun it has generated there is a dispute: then the firm and the lient end up splitting the verrun in the rati s*/(l s*). Unreliable firms want t maximize their shrt run earnings. They have fur ptins: t mimi the reliable firms and hse yp and t pay fr all f it as lng as the lient behaves reliably and t g t the dispute utme therwise; t hse yp but t at reliably in all ther respets (i.e., t pay fr all f it as lng as the hent behaves reliably and t g t the dispute utme therwise); and t hse ither yp r yp and t g diretly t the dispute utme. Unreliable lients als want t maximize shrt run earnings and fae a similar trade-ff. The atual hie made by unreliable firms and lients will depend n the s that is written int the ntrat, as well as n what they expet the ther side t d. The fllwing prpsitin gives nditins under whih unreliable firms and hents indeed are unreliable i.e., hse a high level f verrun and then get int a dispute: Claim 1 The unique equilibriutn behavir f unreliable firms and lients is t hse yp = yp and y = y ""^ g the dispute utme subsequently, as lng as the tw fllwing nditins hld: Given that \v have assumed risk nutrahty, the natural interpretatin fr s* is that it is the expeted share f the verrun brne by the firm in the event f a dispute. The atual share will presumably vary arding t exat irumstanes f the negtiatin press, and, n assin, may turn ut t be 1 r 0. 16

27 (i)s*{ijf-yf) < Bf and ( 1 -s^) (y -y) < Be (a) yp and y are bth suffiiently dse t 0. These nditins ar nt neessary fr there t be an equihbrium with unrehable behavir but they have the advantage f being easy t interpret. The first nditin essentially says that even if it were pssible t give inentives separately n yp- and y, neither party uld be indued t make their first best hie purely n the basis f thse inentives - simply beause in ur setting renegtiatin rules ut the mst extreme ntrats (s* = r s* = 1). The send nditin illustrates an additinal sure f inentives that arises Ijause f the speifi struture we assume - by hsing t dispute, the disputant neessarily takes n respnsibility fr sme part f the verrun generated by the ther party. If the ther party was reliable, he uld have avided this part f the verrun by behaving reliably himself. This might give him a reasn t behave reliably. The send nditin in effet rules ut this partiular sure f inentives, sine it says that if the ther party is reliable his ntributin t verrun is very small. Fr mst f this setin w will assume that bth these nditins hld and, nsequently, unreliable firms and lients hse high levels f verrun and then g t the dispute utme. We realize that the first f these nditins is atually quite stringent. Hwever we will suggest later that ur results n ntratual hie d nt really turn n this prperty: it is simply nvenient, sine it limits the number f pssible ases. 3.5 Mathing Fr mst f this setin we assume that firms and lients are mathed randmly with eah ther. This f urse ds nt apply t the lients wh ar ging bak t a firm that they have already wrked with - there the questin is whether the riginal math was mre r less randm. Even in the mre mmn ase f first time mathes, hwever, ne may expet sme seletin, espeially sine - as will be pinted ut later - there are benefits frm mathing apprpriately. The pssibility f seletive mathing is, hwever, limited by the fat that lients ften have quite speifi needs and the number f firms with the apaity t meet thse needs at any pint f time, may be quite small. Mrever, lients ften rely n hearsay in seleting whih firms t apprah with a request fr prpsal and this may imply mre r less randm seletin frm 17

28 the pint f view f everything that is pubuly bservable. In suh ases, randm mathing may nt be a bad apprximatin t the truth. 3.6 Reputatin Reputatin in ur mdel is reputatin fr being reliable. There are at least tw pssible interpretatins f what makes a firm reliable. In ne interpretatin it is an intrinsi prperty f the firm (i.e., the wner f the firm genuinely prefers t be reliable rather than rih) and sme firms have it and thers d nt. In a send interpretatin, all firms ar greedy, but sme ar patient and therefre able t restrain their greed in favr f better lng term utme and the rest are impatient (r have mre pressing immediate needs). In ther wrds, reliable firms and lients play a strategy that rrespnds t a gd equilibrium f a repeated game while the unreliable play strategis that maximize shrt run prfits. Clearly this wuld nly wrk if there is sme mehanism by whih the histry f past behavirs bemes pubh. We therefre psit that if a firm r a lient has been unreliable in the past, with sme prbability it bemes publi infrmatin at sme pint in the future. ^'"^ The gd equilibrium is sustained by the threat (say) that n firm will ntrat with a lient wh is knwn t have been unreliable in the past and vie vrsa.'^'^ Under ither interpretatin, there are several mehanisms by whih reputatin an evlve. First, in thse ases where the firm and the lient have ntrated at least ne befre, the presumptin is that bth had behaved reliably s that they bth nw have a better reputatin vis a vis the ther. '^^ Frty-ne perent f the ntrats in ur sample invlved a lient with whm the firm had wrked already. This prprtin is rughly the same amng yung and ld firms. Send, the age f the firm shuld be a sure f reputatin. We have already assumed that if a firm r a lient has been unreliable, with sme prbability this bemes publi infrmatin at sme time in the future. One that happens n ne will want t ntrat with it any mre sine it is knwn t be unreliable and it will prbably end up exiting frm the industry.^^ This ^"This might happen beause a disgruntled emplyee reprts what really happened r an inriminating dument gets t the wrng hands. '"This frmulatin lsely fllws Tirle (1996). Se als Kandri (1992). "Fr an expliit mdel f hw reputatin evlves within a speifi relatinship, see Rauh and Watsn (1999)..Ti Under ur send interpretatin abve, the equilibrium strategies atually ditate that n ne ntrats with 18

29 seletin press ensures that lder firms (and lients) will typially Ij mre reliable. This is reinfred by the fat that infrmatin is revealed ver time and therefre a firm that has Ijen in the industry a lng time and des nt have any blak marks against it, is mre likely t be reliable. Fifty-seven perent f the firms in ur sample were reated in 1993 r after. Finally, firms may be able t establish a reputatin by demnstrating that they fllw presses whih, in priniple, shuld redue verrun. Press ertifiatin by utside agenies, suh as ISO 9000 ertifiatin, are therefre anther ptential sure f reputatin. "^^ As we nted in the intrdutin, firms in the industry ar urrently very keen t aquire ISO ertifiatin, preisely beause they think that it will imprve their reputatin. Nineteen perent f the external ntrats in the sample were dne bj' ISO-ertified firms. ISO-ertified firms tends t be lder firms (nly 9% f the yung firms have ISO ertifiatin). 4 Theretial Results 4.1 The Optimal Cntrat Sine we have assumed that it is the firm wh prpses the ntrat, and the firm knws its wn type, the prpsed ntrat an be used as a signalling devie - a firm that plans t be unreliable will prefer a ntrat where it pays very little f the verrun and therefre, by hsing t absrb mst f the verrun a firm may be able t signal that it is reliable. Given that w are in a signalling envirnment, we will expet that there will be many equilibria. Hwever all suh equilibria will invlve pling sine in a separating equilibrium all the unreliable firms and lients wuld be wrse ff than they wuld be pretending t be reliable. Amng the set f pling equilibria we fus n ntratual utmes where the ttal jint a firm r a lient that is knwn t have behaved unreliably. Under the first interpretatin firms and lients that ar knwn t be unreliable shuld still make less mney and therefre shuld be mre likely t exit. ^'ISO ertifiatin is awarded by internatinal r Indian agenies, themselves aredited, whih examine that the presses f sftware prdutin in the firm fllw sme apprved rutines. In partiular, the firm must fllw speified predures t reprt n the prgress f the sftware and t perfrm the tests. Cnsequently, the sftware develpment press shuld be easier t mnitr fr ISO ertified firms. Mrever, ISO ertified firms ar mnitred every ne in a while, and lse the ertifiatin if they annt prve that they fllwed the apprved methds. This shuld give strng inentive t the ISO ertified firms t stik t standard predures and reprt prblems reliably. 19

30 surplus f a firm and a lient wh ar bth reliable is maximized. This is always a Baysian- Nash equilibrium (sustained by the belief that nly pprtunists deviate). The fat that it is als Paret ])timal frm the pint f view f the reliable types makes it an bvius fal utme. This expressin fr jint surplus is: W{s,B,9r) = V - epy- {I - er){l - s%s,9,ef)){y+w) -dvf - (1-0)s*{s, O, 9[r){yp + y^). The third term in this expressin gives the ttal surplus that is lst beause in a pling equilibrium a reliable lient must allw fr the pssibility that the firm is unreliable, while the fifth term is the surplus that is lst beause the firm must allw fr the pssibihty that the lient is unreliable. T find the ptimal ntrat we need t maximize the abve expressin fr W. Differentiating W with respet t s gives us the expressin: ds* [(1 - OF){y + yf) - (1 - d){yf + y)]-gj This expressin is psitive if and nly if [(1 9p){y + Vf) (1 9){yF +y)] > 0. The fat that this last expressin is independent f s, dereases in 0/? and inreases in 9 gives us: Claim 2 The ptimal ntrat is always either a fixed prie r a time and material ntrat (s is either r 1). It is a fixed-prie ntrat when mst lients are reliable while firms are mre likely t be pprtunists, and a time and material ntrat in the reverse situatin. This ards well with the fat, reprted abve, that these ar the nly tw types f ntrats.'^'* It als nfirms the intuitin, given abve, that fixed-prie ntrats are instituted t prtet lients against pprtunism, while time and material ntrats prtet firms. Firms that have a high reputatin will get time and material ntrats while the rest f the firms will nt. 'The reader may feel that the result that the ntrats ar always at ne r ther extreme is driven by the assumptin f risk-neutrality. This is partly true, in the sense that if the tw parties are suffiiently risk-averse a less extreme ntrat will be hsen. Hwever nte als that s* is always stritly between zer and ne - the effetive ntrat is never very extreme. Therefre it may well be the ase that the initial hie f an extreme ntrat is nsistent with ptimal risk-sharing. 20