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531 1415 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. 99-14 July 1999 massahusetts institute f tehnlgy 50 memrial drive Cambridge, mass. 02139

WORKING PAPER DEPARTMENT OF ECONOMICS Reputatin Effets and the Limits f Cntrating: A Study f the Indian Sftware Industry Abhijit Banerjee Esther Dufl N. 99-14 July 1999 MASSACHUSEHS INSTITUTE OF TECHNOLOGY 50 MEMORIAL DRIVE CAMBRIDGE, MASS. 02142

Reputatin Effets and the Limits f Cntrating: A Study f the Indian Sftware Industry Abhijit V. Banerjee* and Esther Dufl^ First Draft: Nvember, 1998 - 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. Email: banerje@mit.edu * Massahusetts Institute f Tehnlgy. Email: 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.

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).

1997-98) 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.

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.

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.

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.

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).

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.

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

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.

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

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

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

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

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

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

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

(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

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

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

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

4.2 The Sharing f Overrun The expeted share f the verrun paid by the average firm with reputatin 6p that wrks fr a hent f reputatin Oq, is: epo ^ + (1 - OfO) {s*is,ep,e)) Vfi + y hi the previus setin we shwed that the ptimal s is a dereasing funtin f Op. Therefre an inrease in 6p redues the share f the verrun paid fr by the firm bth thrugh its diret effet n s* and thrugh its effet n s. An inrease in 6p als shifts weight frm the send term in the abve expressin t the first term. The effet f this shift depends n the relative sizes f s* and =. Fr firms with a relatively lw reputatin, the ntrat is likely t be a flxed-prie ntrat and s* will be high. Therefre this third effet is likely t als be negative r even if it is psitive it shuld be small. Fr verj^ reputed firms, hwever, this effet might be negative and uld in priniple be negative enugh t unterat the tw ther effets: suh firms an inrease in their reputatin may atually inrease their share f the verrun. fr T summarize: Claim 3 If tw firms are mathed with lients wh have the same reputatin, the firm with the higher reputatin is likely t hear less f the verrun n average. The ne ase where this relatin may nt hld is fr very reputed firms. With randm mathing, the negative relatin between reputatin and the share f verrun als hlds withut ntrlling fr the reputatin f the lient. The mean verrun generated by a firm f reputatin 6p is given by the expressin: 6'FyF + (l -dp)yf- This is learly dereasing in 6p. Likewise, the verrun generated by a lient is dereasing in the lient's reputatin. With randm mathing, sine the reputatins f the tw parties are independent, it fllws that the ttal verrun is als dereasing as a funtin f the reputatin f the firm. Claim 4 The verrun generated by the firm (lient) dereases with the firm's (lient's) reputatin. With randm mathing, the ttal verrun generated in a relatinship is als dereasing in the firm 's reputatin. 21

4.3 Extensins f the Mdel 4.3.1 Nn-randm Mathing The assumptin that firms and lients math at randm is learly indefensible fr the ase where there is a repeat math. A repeat math learly signals high levels f mutual respet - in ther wrds mpared t the initial math between them, bth Oq and Of ught t be higher. The diretin in whih the new ntrat will differ frm the initial ntrat is therefre ptentially amljiguus. Hwever it may be reasnable t assume that sine there are many mre start-ups amng firms than amng the lients"^^, the firm's reputatin will imprve by mre than the lient's reputatin. In this ase, the new ntrat will be mre likely t be a time and material ntrat. The firm's share f the verrun shuld als g dwn. The assumptin f randm mathing is questinable even fr first time mathes. Firms with lw reputatins expet t get a fixed-prie ntrat. Therefre, they have the mst t lse frm being mathed with a lient wh has a lw reputatin. Frmally this is aptured by lking at the prperties f the funtin S = V- 0Fy-{^ - ^f)(1 - s*(s(%,0^)),0,m)(y + y?) -dvz - (1-0)s*{s{e.eF),e.eF){yF: + m- Nw if 6 is greater than 6'q \v*{e,ep) - w%9',9f) = (1 - ef){s*{s{9,ef)),9,9f) -s*is{9',9f)),9',9f)){y + yf) -{& - 0)yF + {e - e'>*{si9,9f),e,df){yf + y) +9'is*{s{9,9p),9,9F) - s*isi9',9p),9',9f)). Ignring terms that depend n the send derivative f the s*{-) funtin (the last term in the abve expressin), the effet f an inrease in 9f n W*{9, 9f) W*{9'q, 9f) is unambiguusly '57% f the firms were reated befre 1993, while mre than half f the lient are frtune 500 firms r equivalent. 22

negative. An '^^ unreputed firm (lient) benefits mre frm being mathed with a reputed hnt (firm) than a mre reputed firm (lient). While it is beynd the spe f this paper t expliitly mdel the mathing press that leads t this utme, the impliatin f this result is that firms with lw reputatins shuld be mre likely t be mathed with reputable lients and vie versa.**' It is easy t se that this kind f mathing will reinfre ur results in Claim 2 abut ntratual hie - the effets f a higher 6p and a lwer 6 always g in the same diretin. Turning next t the average share f the verrun brne by the firm, OpB =T 1" (1 ~ Gp^) {s*{s,6f,0)) j ^v se that the fat that higher ^^^'s are nw assiated with lwer 9's reinfres the result given abve in Claim 3, sine s* is inreasing in 9- The effet f an inrease in 6p n ttal verrun is hwever n lnger unambiguus in this ase. While a less reputed firm generates mre verrun, its partner, the mre reputed lient, generates less, s the net effet may nt Ij the ne given in Claim 4. We summarize these results in Claim 5 Less reputed firms will try t math with mre reputed lients and vie versa. This will reinfre ur previus results n the effet f firm reputatin n ntratual hie and the sharing f verrun. Clients wh wrk with less reputed firms will generate less verrun than lients wh wrk with mre reputed firms. As a result, ttal verrun is n lnger neessarily dereasing as funtin f the reputatin f the firm. 4.3.2 Chie f Prjets The fat that firms with lw reputatin pay fr mst f the verrun shuld learly influene their hie f prjets. This an be intrdued int ur mdel by making the plausible issumptin that the mst rewarding prjets (the nes with the highest V) will als have the highest pssibility f large verruns {y and Yf are ging t be large). It is easy t shw by intrduing this assumptin int the mdel f the previus setin, that keeping the reputatin f the lient fixed, less reputed firms will be mre willing t trade ff a lwer V fr a lwer y than mre "'This fllws frm the fat that s'{s{e,df)),o,of) - s'(s{e',df)),9',df) is psitive, while s' {s{0,0f),g,0f) ges dwn when Of ges up. Sine w d nt have data n lient reputatin we annt diretly test this preditin. We d bserve that lient generated verrun is smaller fr yunger firms, whih is nsistent with this preditin. 23

reputable firms. Frmally this is seen by diftrentiating the expressin fr ^V*{9-,6f) with respet t y- This yields -{i-e)s*{s{6,ef),e,bjr), whih is learly inreasing in 6^- less reputed firms benefit mre frm a lw y- Here we have assumed that it is pssiljle t redue y withut affeting jtf- This is nt espeially implausible: Y2K prjets are suffiiently simple and standardized that the spe fr lient side pprtunism is prbably very limited. On the ther hand the firm always has the ptin f simply ding the jb lakadaisially. It is interesting nnetheless t lk at what happens when a redutin in y is always ampanied by an equal redutin in yp. Differentiating the expressin fr W*{6,0p) with respet t y and yf yields the expressin -{1 - ep){i - s*{si0,er)),6,ep)) - {1 - e)s*{sie,bp),e.er). Differentiating this expressin with respet t 9p, yields (1 - s {s{e,0f)),8,0f)) + [Be -Of) :t7, whih, fr lw reputatin firms, shuld be psitive (sine 9 9f shuld be psitive). This tells us that even if y and yp mve tgether, the yungest firms will prbably be amng thse wh benefit mst frm hsing a lw y (and yp) prjet. '^'^ Claim 6 Lw reputatin firms will tend t be speialized in prjets whih have lw ptential fr lient-side pprtunism. In terms f what we bserve, this seems t suggest that lw reputatin firms will hse prjets whih ar simple and well-understd s that the lient des nt have t d very muh wrk t make lear what he wants. These prjets an be ither shrt prjets"*^, r prjets where the main gal is easily defined. Y2K prjets ar typial in this respet.^'' "Very reputable firms may als prefer prjets with lw y and yp - the benefit in that ase mes frm the fat that these prjets prtet the lients, wh in this ase will be the vulnerable party. The mplexity f a sftware prjet inreases sharply with its size, se Pressman (1997). '"Other prjets where the bjetives ar relatively easily defined inlude CAD prjets and migratin f an existing sftware frm ne platfrm t anther. 24

The pssibility f swithing t a lw y prjet shuld nt affet the firm's share f the verrun in ur mdel, sine y never enters the expressin fr the firm's share f the verrun.''^ It des hwever makes it mre likely that the results n the relatin between reputatin and mean verrun will be ambiguus. Beause firms with lw reputatin will hse prjets s as t limit verrun, lient generated verrun will be smaller when the firm has n reputatin and therefre, ttal verrun may g up with reputatin. Mrever, if these prjets have als less spe fr pprtunism n the part f the firm, the mean verrun generated by the firm may nt always fall with reputatin. 4.3.3 Cntrats fr Inentives Under the assumptins made s far, ntrats nly prtet the ntrating parties frm pprtunisti behavir n the ther side. They have n diret inentive effets. We an add inentive effets t the mdel by assuming that when s is hsen t be high enugh, the resulting s* will be lse enugh t 1 that even unreliable firms will prefer t at reliably. We als allw fr the symmetrial pssibility f induing an unreliable lient t at reliably by setting s lw enugh. We still rule ut the pssibility f getting the first-best utme by assuming that in rder t give any ne side the inentive t be reliable, the ther side has t be given very weak inentives. In this ease, ne s is high enugh t indue reliable behavir frm unreliable firms, there will be n reasn t raise it further. In ther wrds, the ptimal ntrat may nt be at the extremes. Hwever it will still be the ase that an inrease in Op and a fall in 6 will favr a ntrat with a lwer s. On the ther hand, sine the least reputable firms in this wrld will never behave unreliably, it turns ut that fr a ertain speifi range f values f 6p (thse exatly arund the value at whih the ntrat swithes frm a high s t a lw s) firms with lwer 6p will bth generate less verrun and bear a smaller share f it, mpared t firms with a higher Op-'^^ 'This is nt stritly true. A lwer y and yr may affet the hie f the ptimal ntrat and thereby affet the sharing f the verrun. Hwever, sine mst lw reputatin firms almst always have fixed st ntrats, this ftt may nt be very imprtant. It shuld be nted that this perverse nsequene f the inentive effet is mst likely in mdel like urs where the firm (and the lient) make disrete hies. With a smther set f hies, the inentive effet is never quite as dramati and hene it may never be the ase that mre reputable firms atually pay a higher share f the verrun. 25

5 Evidene In this setin, \v dument that the entral imphatins f the mdel ar nsistent with the data, by shwing that ntratual frms as well as the atual sharing f the verrun vary with harateristis likely t be rrelated with the reputatin f the firm. W then examine hw the ther i^reditins f the mdel math with the sftware data. Finally, w nsider sme bvius alternative explanatins f the patterns bserved in the data. 5.1 Measures f Reputatin W have already suggested three alternative measures f a firm's reputatin: its age, whether r nt it is in a repeat ntrat and ISO ertifiatin.''"^ We als make use f a furth metri - w mpare internal (prjets fr OSDC and mther mpanies) and external prjets. W wuld expet the differene between external prjets t be similar t the differene between first time and repeated relatinships, fr tw reasns. First, there is learly an element f reputatin: muh like in a repeat ntrat but even mre strngly, the firm and the lient must knw muh mre abut eah ther (and what they knw must be I)sitive) if they have deided t establish a lng term relatinship tgether."''' Send, the spe fr unreliable behavir in this type f relatinship is muh mre limited, sine bth parties share the ntrl rights. In ther wrds, this kind f relatinship is, in part, a substitute fr reputatin. Hwever, we need t be sensitive t the fat that mpanies wrking fr internal lients ar ptentially very different frm ther mpanies. In partiular, OSDCs will be established nly after the lient has spent a very lng time studying the firm. Fully-wned subsidiaries are ften run by peple wh had been previusly wrking in the US ffie f the firm. We therefre restrit the mparisns t firms that perfrm sme internal prjets (e.g. subsidiaries that wrks fr Nte that w think f the reputatin as being an attribute f the firm, mre than f the individuals wh mpse it. It uld be that an experiened prfessinal leaving his jb t reate a sftware firm takes his individual reputatin with him. It turns ut that individual reputatin seems diffiult t transprt (w asked what the past areer f the persn wh funded the sftware firm was, and examined whether this was related with sharing f the verrun, but did nt find that this was the ase). The main reasn is that the imprtant input the CEO f a sftware firm has t prvide is the management f the team, whih may r may nt be related t his ability as a sftware prfessinal. The internal/external mparisn is therefre lser t a repatd/first-time mparisn than t a yung/ld mparisn - sine the mathing in an internal prjet is like that in a repeat prjet. 26

their mther mpany and als fr external lient). This insures that the seletin f firms fr internal prjets des nt invalidate the mparisn (sine all firms in this sub-sample have been seleted fr sme internal wrk). 5.2 Chie f Cntrat and Sharing f the Overrun 5.2.1 Struture f the Cntrats An impliatin f the mdel is that ntratual frms will be restrited t ntrats where the ex ante rule is that firms will bear ither all r nthing f the st verruns. As pinted ut, this impliatin rests n the partiular assumptins we have made, Ijut it mathes well with the bserved pattern. As we desribe in Setin 2, there are three majr types f ntrats: fixed-prie, time and material and "mixed" ntrats. Fixed prie ntrats ar linear ntrats with s = 1. As we disuss abve, time and material ntrats ar similar t suh ntrats, with s = 0. In mixed ntrats, the initial agreement speifies a payment fr the speifiatins nly. At the end f the speifiatin phase, anther agreement is speified fr the develpment and testing phases. This kind f ntrat eff"etively splits the prjets int tw sub-prjets. Fr eah f them, a separate sharing rule is hsen, whih is either 1 r (ften, time and material fr the speifiatin phase and fixed-prie fr the subsequent wrk). In ther wrds, mixed ntrats ar a juxtapsitin f fixed-prie and time and material ntrats. It is easy t understand why, when the prjet is brken int these tw phases, speifiatins tend t be written n time and material and the rest f the wrk tends t be dne using a flxd-prie ntrat. In the speifiatin phase, the ptential fr the lient t generate an verrun is extremely large. In partiular, when the firm first sends the speifiatins, he an pretend that the speifiatins written d nt rrespnd t what he wanted. The whle effrt f the firm until that pint bemes in effet useless. Therefre, it is imprtant t give the lient higher pwered inentive. On the ther hand, at the time the send sub-ntrat is written, a large part f the unertainty abut what the lient really wants is reslved, sine he has agreed (in writing) t the speifiatins. Therefre a fixed-prie ntrat, whih give better inentives t the firm, an beme ptimal frm that pint n. In pratie, the hie f the ntrat fr the send phase f the prjet is ften endgenus: if the firm feels that a substantial amunt 27

f unertainty remains, it an in general insist n getting a send time and material ntrat. Mixed ntrats ar therefre ex ante mre nstraining fr the lient than fr the firm. 5.2.2 Reputatin and the Chie f Cntrat The reputatin f the firm determines bth whih ntrat it will get (hie f s) and what share f the verrun it will end up paying (atual s*). Firms withut a reputatin will be mre likely t be have fixed-prie ntrats than time and material r mixed ntrats. Firms in fixed-prie ntrats shuld bear mre f the verrun than firms with ther types f ntrats. Finally, nditinal n having any partiular type f ntrat, firms withut a reputatin will bear mre f the verrun than firms with a reputatin. The mbined effet f these is, f urse, that firms withut a reputatin will bear a larger share f the verrun. '''^ This sub-setin presents data related t these impliatins. We presented evidene that age des matter in the intrdutin, as a mtivatin fr this prjet. The relatinship is illustrated in Figures 1 and 2. The prprtin f fixed-prie ntrats and the share f the verrun l^rne by the firm are inreasing with the fundatin date f the firm. Table 5 shws the means f the firm's share f the verrun fr eah type f firm, and the differene between lw and high reputatin firms. In lumn (1), w reprt the mean fr the sample f external firms. In lumns (2) t (4), we shw the ntrast between yung firms (reated in 1994 r after) and ld firms (reated in 1993 r befre). Yung firms ar signifiantly mre likely t have fixed-prie ntrats (the prbability is 26% higher). They als bear substantially mre f the verrun bth n average (19%), and within the prjets with fixed-prie ntrats (the differene is 13%). The pattern is less lear fr ISO ertifiatin: ISO-ertified firms ar nt less Hkly t get fixed-prie ntrats and they d nt pay fr a lwer fratin f the verrun in general. Hwever, nditinal n ding fixed-prie ntrats, they bear less f the verrun (20.4%). A relatinship with a lient has the same effet as a general reputatin. Firms engaged in a ''It shuld be emphasized that the full efft f reputatin ptentially inludes things that ar nt neessarily the ftet f reputatin per se. As pinted ut abve, the effet f reputatin n the atual sharing f the verrun nditinal n any partiular initial ntrat, may inlude a bargaining pwer effet beause the determinants f bargaining pwer will tend t be rrelated with the determinants f reputatin like age. In this sense, the evidene n the hie f the initial ntrat tends t be "leaner". This kind f nflatin f reputatin effets and ther effets is less likely t be the ase when we ar mparing internal and external ntrats. 28

repeated relatinship with their lient are abut as likely as ther firms t have fixed ntrats, but they pay signifiantly less f the verruns (20% less). Finally, amng firms wh have internal ntrats, firms pay fr mre f the verrun when they deal with external lients than when they deal with internal lients. Almst half f their external ntrats are fixed-prie ntrats (a number lse t the prprtin f fixed-prie ntrats amng ld firms), whereas nly 23% f the internal ntrats are flxed-prie ntrats. They pay a muh smaller share f the verrun (20% instead f 47%) in internal ntrats than in external ntrats. The diff'ernee nditinal n ding fixed-prie prjets is nt signifiant, but this is prbably due t the small number f fixed-prie ntrats amng internal prjets. In summary, it seems that yung firms, firms wrking with a new lient and firms wrking with an external lient bear a larger share f the verrun mpared respetively t lder firms, firms engaged in a repeated relatinship and firms wrking fr an OSDC r their mther mpany. W interpret these results as shwing that reputatin des influene the way the \'rruns are shared between the lient and the firm. We will address sme alternative explanatins belw, but the first pssible aveat t this interpretatin is that these firms d different tj'ps f prjets, whih require different types f inentives r entail different types f risk. Fr example if ld firms d mstly prjet where there is a pssibility f very large verruns, they may refuse t d the prjet unless they knw they will be vered in ase this happens."*^ In partiular, Table 4 shws that yung firms, nn ISO-ertified firms, and firms wrking fr external lients d n average smaller and simpler prjets than ld firms, ISO firms and firms wrking fr internal lients. It is therefre imprtant t hek that the simple ntrast between the grups is nt an artifat f the different mpsitin f their ntrats. In Table 6, w shw the differenes between the verrun paid fr by eah type f firm in prjet-size ells (panel B) and mplexity ells (panel D)."*^ The first panel reprdues the unntrued differene f Table 5. In panel C, we shw the "ntrlled ntrast": this is simply a weighted average f the differenes between the yung and ld firms in the prjet size ells, where the weights are given by the fratin f prjets falling int this prjet size ell. This is a rude way t take int aunt the tw fats that different tjqjs f firms hse different type f prjets and that the differenes arss yung and ld firms are nt neessarily the same fr "'W will mment mre n the hie f prjet per se belw. ''We used the subjetive mplexity measure given by the firms. 29

all prjet sizes. Firms tend t bear less f the verrun when they d mpliated jnjts than when they d simple prjets. There is als a weak relatinship between the size f the prjet and the share f the -\'rrun paid fr by the firm. Yung firms pay a larger share f the verrun than ld firms fr small and large prjets, but nt fr medium-sized prjets. The ntrlled ntrast Ijtwen yung and ld firms is slightly smaller than the simple differene, but still high. The ntrlled ntrast bemes psitive, thugh insignifiant, fr ISO-ertified firms, mainly beause the ISOertified firms ding small prjets d nt pay any f the verrun.'^*' Cntrlling fr prjet size des nt affet the difterene between repeated and new lients and between internal and external ntrats. Whatever the mplexity f the prjet, yung firms bear mre verrun than ld firms, firms wrking with a new lient bear mre verrun than firms wrking with a repeated lient, and firms tiear less verrun when they d internal prjets. The evidene fr ISO ertifiatin is, ne again, mixed. In summar}', even after taking int aunt the size f the prjets, firms with lw reputatin bear mre f the verrun than ther firms (althugh the evidene in favr f ISO ertifiatin remains less than verwhelming). A final piee f evidene is presented in Tabi 7. In this table, we examine whether the different kinds f reputatin ar substitutes. Namely, w ask in panel A whether yung firms still bear mre f the verrun when they benefit frm anther kind f reputatin. In the tabi, we present the differene between yung and ld firms in the prprtin f fixed-prie ntrats (line 1) and in the share f verrun they pay (line 2) within grups f ISO-ertified/nn ISOertified firms, repeated/new lients, internal/external ntrats (fr firms wh d sme jbs fr internal firms). The ntrasts ar interesting. Nn ISO-ertified yung firms bear 27% mre f the verrun than nn ISO-ertified ld firms, but amng ISO-ertified firms, there is n differene. Yung firms are signifiantly mre likely than ld firms t have fixed-prie ntrats if they wrk with a new lient, but nt if they have already wrked with this lient. Amng firms that d sme internal ntrats, the same ntrast appears: yung firms are mre Hkely t have fixed-prie ntrats when they wrk with an external lient and pay fr mre f the verrun, but nt when they wrk with an internal lient r an OSDC^^ In panel B, we perfrm '"'This number shuld be taken with autin, as very few ISO firms d small prjets. Jhnsn, M Millan and Wdruff (1999) reprt mparable evidene in transitin enmies. Sellers ar 30

the same exerise, but we lk at hw the differene between the share f the verrun paid fr by firms wrking with a new rather than repeated Hent varies arss different kind f firms. Interestingly, a very different pattern emerges. Tli differene between new and repeated lients persists fr ld firms and fr ISO-ertified firms, and ds nt deline. It suggests that the mehanism f reputatin frmatin is rather ineffiient: even after a firm has been in the market fr sme time, muh remains t be learned abut it. W'^ have dumented systemati differenes in the way st verruns are shared arss yung and ld firms, ntrats with repeated and new lients, ISO-ertified firms and ther firms, and firms in internal and external ntrats. This evidene is nsistent with a mdel where reputatin is an imprtant determinant f the ntrats and the sharing f the verrun. In the next subsetin, we examine the whether the ther empirial preditins f the mdel als hld. 5.3 Further Results 5.3.1 Chie f Prjet A simple extensin t ur mdel als predits that the firms with a lw reputatin will tend t hse simpler prjets where the bjetives are easier t define, whih will tend t limit the verrun generated by the lient. We present evidene relating t the hie f prjet in Table 4, and Figures 5, 6 and 7. Yung firms d smaller prjets (Figure 6), whih have smaller verrun (even expressed in prprtin f predited sts). ^" They als tend t arry mre ften "simple" prjets (Y2K, CAD, data manipulatin) (Figure 7), whih generate lwer verruns, ar easily defined, and are easier t mnitr. We have als asked them t subjetively rate the mplexity f the prjet, and even arding t this subjetive measure, yung firms d mre simple prjets (Figure 5). As a result f these tw mbined fats, the returns frm eah prjet (st multiplied by markup) is smaller n average fr yung firms than ld firms. This uld be at least partly explained by the fat that yung firms ar n average less mpetent (and that therefre lients d nt want t entrust them with large r mplex prjets). mre willing t extend trade redit t a nw ustmer if they have btained infrmatin abut him frm a sial r business netwrk than if they have nt, but the weight given t this infrmatin delines as the length f the relatinship with this buyer inreases. ' Mrever, by ding that they keep the share f verrun aunted fr by eah prjet mre r less similar arss yung and ld firms: this uld therefre be explained by adding risk aversin t the mdel. 31

Hwever the same ntrast hlds between internal and external prjets (Tabi 4), fr prjet size and Y2K prjets. Sine we have restrited the mparisn t firms that d at least sme internal wrk, the differene between internal prjets and external prjets is nt tainted Ijy this bias. This nfirms that part f this differene between yung and ld is due t differene in behavir. 5.3.2 Overrun generated by the firm and by the Hent Our Ijaseline mdel predits that, n average, firms with a Ijetter reputatin will generate less \-rrun (and therefre, ttal verrun will als tend t be smaller fr their prjet). Hwever, ne w take int aunt nn-randm mathing and the hie f prjets, the preditin abut the relatinship between verrun generated by the firm and reputatin ar nt unambiguus. On the ther hand, these extensins predit that lients mathed with firms with lw reputatin shuld generate less verrun. Table 8 presents evidene n verruns generated Ijy the firm and the lient. ^^ There is n systemati relatinship between ttal verrun and the reputatin f the firm: ttal verrun is smaller fr \'ung firms, firms withut ISO ertifiatin, and external prjets; it is larger fr firms dealing with a new lient. Nne f these ntrasts is lse t being signifiant. Overrun generated by the firm is slightly larger fr yung firms and firms dealing with a new lient, but larger fr ISO-ertified firms and firms dealing with an internal lient. ^^ Finally, verrun generated by the lient is smaller in all ases fr less reputed firms, wliih is nsistent with ur argument that less reputed firms try t prtet themselves frm absrbing large verruns by dealing with reliable lients r by hsing prjets where the spe fr lient generated verrun is smaller. The data seems nsistent with ur mdel f hw reputatin determines ntratual utmes. In the next setin, we examine the mst bvius alternative explanatin t the bserved pattern. Overrun generated by the firm and verrun generated by the lient d nt neessarily add up t ttal verrun: amng sures f verruns prpsed t the firms, there was an 'ther' ategry, whih we left unattributd. ''"These results uld be nsistent with the idea that verrun is slightly lwer when firms have a gd reputatin. First, there is in general n mpelling evidene that ISO ertifiatin really gives a firm a reputatin. Send, as w have ntied already, verruns are less stly fr internal prjets, s they tend t be larger. 32

6 Alternative Interpretatins f the Data This setin reviews alternative explanatins t the pattern l:)srvd in the data (in partiular t the main result that yung firms bear a larger share f the verrun than ld firms). 6.1 Pure Risk Sharing One pssible interpretatin f what is ging n in this industry is pure risk sharing. Hwever, as explained in muh greater detail in a previus versin f this paper, this interpretatin very quikly runs int truble. In the ase where we assume CRRA preferenes (whih is standard in ases like this where there is substantial variatin in the size f the ntrating parties) we shwed in the previus versin f this paper that Claim 7 // the firm and the lient have CRRA preferenes, fr a fixed prjet size, the share f the risk that they eah bear will be apprximately in the inverse prprtin f their effiients f relative risk- aversin, keeping fixed the rati f their ttal revenues. It will als be apprximately in the diret prprtin f their ttal revenues, keeping fixed the rati f their risk- aversins. Given that the lient's revenues are muh bigger than that f the firm,^'' an impliatin f this prpsitin is that the lient shuld bear mst f the risk unless the lient is muh mre risk averse than the firm. In fat, the firm bears n average mre than half f the st verrun, suggesting that the lient's effiient f risk-aversin must be very large relative t the firm's. It is hwever diffiult t think f a basis fr suh differenes in risk aversin. Mrever, this result has systemati preditins abut the relatinship between firm size and the share f the risk that it bears, ntrlling fr lient size and prjet size. Tabi 9 presents the share f verrun paid by the firm by lient size, prjet size and firm age. In all prjet size-lient size ells, ld firms bear less f the verrun than yung firms. Sine ld firms are n average larger (this is shwn in Figure 4 and in lumns 2 t 4 in Table 4: ld firm's turnver is larger by $3.7 millin, ''^Mr than half f the ntrats in the sample ar with "large" lients, 26% are with medium sized lient, and 19% ar with small lients. Large lients are in general frtune 500 mpanies r equivalent. Small lients are firms with turnver belw $10 millin. In ntrast, the median turnver f the sftware mpanies in the sample is nly $1.2 millin, and the largest firm had a turnver f $47 millin. Only 27% f the firms have a turnver abve $ 10 millin. Amng the firms engaged in ntrats with small lients, the median firm has a turnver f $0.5 millin. 33

r ini than 100%, than yung firms), this ntradits the basi imphatin f the risk-sharing mdel. One miglit als speulate that ld and new firms generate different risk prfiles and that this explains why ld firms bear less risk: perhaps ld firms simply generate less risk. Hwever, the evidene n the standard deviatin f ttal verrun presented in Table 8 shws that this is nt the ease. The standard deviatins f ttal prjet verrun are very similar arss all types f firms. There is therefre n evidene t supprt the view that yung firms are systematially mre risky t deal with. Anther pssibility, hwever, wuld be that the underlying distributin f \'errun is different fr yung and ld firms (despite the fat that mean and standard de\'iatin are nt different), and that the partiular frm f the risk faed by ld firms made this partiular risk sharing rule ptimal. We examined the entire distributin f verrun generated fr bth yung and ld firms (Figure 8). The tw distributins ar very similar, exept fr fur ld firms whih generated very large verrun (150% and higher). These fur ld firms are hwever nt driving the results, sine all f them paid 100% f the verrun. Mrever, as we have shwn abve, the differene between ld and yung firms is maintained when we ntrl fr prjet type (mplexity r size), whih ar presumably gd indiatrs f prjet-speifi risk. The evidene we give abve stritly nly applies t the ase f CRRA preferenes. There ar, f urse, many lasses f risk preferenes whih d nt fall int this ategry. Hwever, there are tw basi intuitins whih suggest that these ther preferenes will nt wrk partiularly well either: n the ne side, if the effiient f abslute risk aversin falls faster than a CRRA, it is very hard t explain why the firm bears any risk at all. On the ther side, if the effiient falls slwer than a CRRA (s that the preferenes apprah the CARA mdel), it an be shwn that prjet size and lient size effets als beme smaller and this leaves very little t explain the inter-firm differenes.^'* 6.2 Virying Levels f Cmpetene Our mdel has assumed that bth lients and firms ar risk-neutral. Suppse we nw assume that firms and lients make mistakes whih lead t verrun but that these mistakes an be ntrated upn. In this ase, ne pssible first best ntrat is ne in whih firms take the '' In the extreme ase f CARA preferenes neither prjet size nr hent size affets risk-sharing. 34

' full respnsibility f any mistake that they make.^^ Nw if yung firms^'' ar n average less mpetent, then it is t be expeted that they wuld pay n average fr mre f the verrun. The first pint against this explanatin is simply that risk-neutrality is a very extreme assumptin. If the firm was at all risk-averse then the ptimal ntrat wuld try t insure the firm against all sures f risk that are beynd its ntrl. Therefre, sine yung firms d nt hse t be inmpetent, they shuld be insured against verrun that results frm their mistakes. Of urse, the extent f suh insurane may well be limited by the lient's willingness t bear risk, but as we have already argued, the lient is in a muh better psitin t Ijear risk than the firm, and in partiular small firms shuld nly bear a small part f the risk. Of urse, this assumes that the mistakes are nt made deliberately. The ase f varying levels f mral hazard will be examined belw. There are als sme simple empirial arguments against tliis view: first (and mst imprtantly), firms pay muh mre f the verrun than the share fr whih they are respnsible: as shwn in Table 3, even when the lient is fully respnsible fr the verrun, the firms still pay n average 51% f it. Send, t explain the differenes in the share f verrun paid by the firms entirely by difi'rns in the share f verrun that is aused by the firm, it wuld have t be the ase that yung firms ause substantially mre verrun than ld firms d. Reall that the ttal verrun is, if anything, larger fr ld firms than yung firms. The differene between the share f verrun due t yung firms and the share f verrun due t ld firms is learly nt large enugh t explain the differene in the sharing f these additinal sts. Differenes in sures f the verrun are shwn in Table 8. The differene between the fratin f verrun due t yung firms and that due t ld firms is nly 1.18%, but they pay 20% mre f the verruns. Finally, even within firms that d sme internal wrk (and are therefre mre hmgeneus), it is the ase that firms bear mre f the verrun in external ntrats than in internal ntrats. Therefre it des nt seem t be the ase that the differenes in the share f the verrun brne by yung firms an be explained by systemati differenes in mpetene between yung and ld firms. '' Of urse the atual ntrats d nt say anything abut dividing the verrun. Therefre what we ar referring t here is a fully effiient impliit ntrat. ''''Or mre generally, firms that w have alled s far "lw reputatin" firms. 35

6.2.1 Underbidding by Yung Firms One uld imagine that even in a wrld where ntrats are eftetively mplete, yung firms might systematially underbid (qute a prie based n intentinally lw estimates) t win the prjet. Of urse the lient knws this, and in the ptimal ntrat rrets fr it by hlding them respnsible fr the extra verrun resulting frm the underbidding.^^ Yung firms therefre end up paying fr a higher share f the verrun. Hwever it shuld be easy t see that the same bjetins that we list abve t the mpetene-based explanatin als apply in this ase. 6.2.2 Varying Level f Mral Hazard The arguments against the tw previus alternatives are based n the assumptin that the mistakes (r preditin errrs) are deliberate. One we allw fr suh mral hazard, the lient may well nt be willing t insure the firm. Old firms uld be less prne t mral hazard than yung firms, and therefre bear less risk than yung firms. The evidene we have presented n mean and variane f the verrun annt respnd t this kind f ritiism, sine they ar endgenus: yung firms uld be generating the same level f verruns as ld firms, preisely beause they fae higher punishments. Nte hwever that this wuld be a real alternative t ur view nly if the levels f mral hazard were mmn knwledge (i.e., if there was n learning abut the type f the firm r the lient - if there was learning, it wuld just be a variant f ur reputatin mdel). Mrever, it is nt lear why, in this alternative senari, it shuld make any differene that a firm is wrking with a repeated lient. The level f mral hazard is unlikely t hange very muh between the first and the send ntrats fr a speifi lient. The fat that firms ar treated differently the send time arund must therefre indiate that there is learning ging n abut the harateristis f the firm. 6.2.3 Dynami Mral Hazsird The fat that repeat ntrats are different frm first time ntrats uld perhaps be explained in terms f the evlutin f a dynami inentive ntrat, in the absene f any learning. Hwever this wuld nt explain the ntrast between the first-time ntrats faed by yung and ld firms. Mrever it is nt easy t see why, in this view, the age effet wuld be smaller when it is a "Again \v ar referring here t a fully effiient impliit ntrat. 36

repeated ntrat. 6.2.4 Varying Levels f Hnesty Yung firms uld als differ frm ld firms in their prpensity t reprt sts hnestly. They uld be mre prne t try t reprt inflated sts, r t pretend that hanges due t their wn inmpetene are due t the lient hanging his mind. If the lient uld nt tell the heaters apart, then the analysis f suh a mdel wuld be similar t the analysis f the mdel we prpse, and lead t the same nlusin (the reputatin f ld firms wuld be a reputatin fr hnesty instead f a reputatin fr reliability). As w mentined earlier, ur mdeling hie was t mdel a reputatin fr reliability, but it is lear that the analysis uld be arried ut with a different reasn fr the imprtane f reputatin. Nte hwever that if lients uld tell apart heaters and hnest firms, and punish heaters by impsing them t pay mre f the verrun, then we wuld als bserve that yung firms wuld pay n average mre f the verrun (but this wuld nt result in any sial st, unlike in ur mdel r a versin f the mdel with a reputatin fr hnesty). Assuming that firms reprt in the questinnaire what they have reprted t the lient, then the evidene that yung firms pay mre ften than ld firms verruns reprtedly aused by the lient wuld simply reflet the fat that they are lying mre ften than ld firms. Beause this argument rests n the fat that firms are lying in what they reprt t us as well as in what they say t their lient, it is nt easily verified r invalidated in the data. Nte hwever that this argument implies that the lients never make any mistake in telling apart heaters and hnest firms. It is therefre self-defeating: why wuld firms heat in the first plae if they knw that they are ging t be fund ut? Mrever three fats are diffiult t renile with this explanatin: First, firms pay n average 50% f the verrun when they reprt that the lient is fully respnsible fr it. The suggested explanatin wuld therefre imply an implausibly high fratin f heaters amng Indian sftware mpanies (yung and ld). Mrever, if the lient has perfet infrmatin and an enfre any sharing ex pst, there shuld be n variatin in the ntratual frm, r at least it shuld nt be related t the final utme. Hwever, firms pay mre f the verrun when they have fixed-prie ntrats than when they have time and material ntrats. Furthermre, yung firms have mre ften fixedprie ntrats. Therefre the ex ante ntrats seem bth t be relevant and t be used by the 37

lients, whih is nt nsistent with the wrld we just desriljed. Finally, nte that suh a mdel wuld nt explain the diftrne between ntrats with repeated and new hents, r the differene between internal and external ntrats: if the lient has perfet infrmatin, then it is nt easy t explain why firms wuld behave differently when dealing with different types f lients. 7 Cnlusin We set ut in this paper t lk fr evidene that reputatin plays an imprtant rle in determining ntratual utmes. We find that the evidene seems t strngly supprt this view, thugh given that the evidene is indiret (we d nt atually bserve peple lking at reputatin when deiding n ntrats) and there are imprtant firm harateristis that ar ptentially rrelated with ur measures f reputatin, sme dubts learly remain. The nlusin that reputatin matters is f urse imprtant in itself: it gives supprt t a range f theries that ar based n limitatins f ntrating. Mrever, it might suggest an explanatin f why the Indian sftware industry is nt muh larger (Indian sftware exprts were nly wrth 3.4% f the 1995 wrldwide utsuring business) given its bvius labr-st advantage'^*' and the fat that this is a very labr-intensive industry. Or, t state the same pint differently, why is it an equilibrium fr sftware prfessinals in India t get paid s muh less than their U.S. unterparts? Reputatin at the firm level is ne pssible explanatin: mst Indian firms are simply nt trusted enugh t be given imprtant ntrats. While ur evidene annt diretly substantiate this view, the fat that reputatin is imprtant within the Indian industry suggests that it als ught t be imprtant when an Amerian lient is deiding whether t g t a firm in India r t ne in the U.S. T add supprt t this view, ur results als suggest that the press f reputatin frmatin is rather ineffiient. This is refleted in the fat that after ntrlling fr age, whether r nt a firm is dealing with a repeat buyer still makes a substantial differene t the ntrat. In ther wrds, repeat buyers learly knw muh mre abut the firm than the market des. In ther wrds, the fat that a firm perfrmed well in the past vis a vis ne firm takes time t beme '''The U.S. imprts a very large number f Indian sftware prfessinals fr shrt-term assignments at a st f mre than twie what they wuld earn in India. 38

publi infrmatin. This is f urse nsistent with ratinal behavir n the part f the lient but it learly hurts the firm. The pliy impliatin f this view is that a redible system fr rating firms mdeled n redit rating systems may play an imprtant rle in the evlutin f industries suh as the sftware industry where ntrating is inherently prblemati, by making it pssible fr the market t effiiently aggregate all that is knwn abut eah firm. Referenes [1] Bajari. Patrik and Steven Tadlis (1999), "Prurement Cntrats: Fixed Prie vs. Cst Plus", MIMEO, Stanfrd University. [2] Baker C, R. Gibbns and K. Murphy (1997) "Impliit ntrats and the thery f the firm" NBER Wrking Paper #6177. [3] Barrn J. and Jhn Umbek (1984) "The effet f different ntratual arrangements: the ase f retail gasline market" Jurnal f Law and Enmis 27:313-328. [4] Crker K. and K. Reynlds (1993) "The effiieny f inmplete ntrats: an empirial analysis f air fre engine prurement" RAND Jurnal f Enmis 24-1:127-146. [5] Gnesv D. (1993) "Adverse seletin in the whlesale used ar market" Jurnal f Plitial Ennuj 101-4:644-665. [6] Greif A. (1994) "Cultural behefs and the rganizatin f siety: A histrial and theretial refletin n lletivist and individuahst sieties" Jurnal f Plitial Enmy 102-5:912-950. [7] Heks R. (1996) India's Sftware Industry. State Pliy, Liberalisatin and Industrial Develpment, Sage Publiatin, New Delhi, Thusand Oaks, Lndn. [8] Hlmstrm, Bengt (1982) "Mral Hazard in Teams" Bell Jurnal f Enmis 13-2:324-40. [9] Jhnsn, S., J. MMillan and C. Wdruff, (1999) "Cntrat Enfrement in Transitin", IvlIMEO, MIT. 39

[10] Jskw, P., (1987) "Cntrat duratin and relatinship speifi investment: empirial evidene frm al markets" Amerian Enmi Review 77-1:168-185. [11] Kandri, M. (1992) "Sial nrms and mmunity enfrement" Review f Enmis Studies 59:63-80. [12] Lafntaine F. and K. Shaw (1996) "The dynamis f franhise ntrating: evidene frm panel data" NBER Wrking Paper #5585. [13] Mastn S. and K. Crker (1985) "Effiient adaptatin in lng-term ntrats: Take-r-pay prvisins fr natural gas" Amerian Enmi Review 75-5:1083-1093. [14] Mnteverde K. and D.J. Teee (1982) "Supplier swithing sts and vertial integratin in the autmbile industry" Bell Jurnal f Enmis 13:206-213. [15] NASSCOM (1997) Indian Sftware Diretry, CD-ROM. [16] Pittman R. (1991) "Speifi investment, ntrats and pprtunism: the evlutin f railrad sidetrak agreements" Jurnal f Law and Enmis 34:565-589. [17] Pressman, Rger S.(1997) Sftware Engineering, A Pratitiner's Apprah, 4d editin, MaGraw Hill Internatinal editins, Sftware Engineering Series. [18] Rauh, James and Jel Watsn, "Starting Small in an Unfamihar Envirnment", MIMEO, University Of Califrnia at San Dieg. [19] Shepard, A. (1993) "Cntratual frm, retail gashn, and asset harateristi in gasun retailing" RAND Jurnal f Enmis 24-1:58-77. [20] STPI (1997) Sftware Tehnlgy Parks f India, MIMEO, Bangalre. [21] Tirl, Jean (1996) "A Thery f Clletive Reputatins (with Appliatins t the Persistene f Crruptin and t Firm Quality)" Review f Enmi Studies 63.1:1-22. 40

Figure 1 Prprtin f fixed st ntrats 1988 r befre 1989 1990 1991 1992 1993 Fundatin date f the firm 1994 1995 1996 1997 Figure 2 Sfiare f verrun paid fr bytliefirm 100 1988 r befre 1989 1990 1991 1992 1993 1994 1995 1996 1997 Fundatin date f the firm

Figure 3: Mean f prjet verrun (perentage f initial evaluatin) 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 r befre Fundatin date t the firm Figure 4 Average Firm Turnver in 1997/98 (Millins $US) 1988 r befre 1989 1990 1991 1992 1993 1994 Fundatin date f the tirm 1995 1996 1997

Figure 5: Subjetive mplexity measure 1988 r befre 1989 1990 1991 1992 1993 Fundatin date 1994 1995 1996 1997 Figure 6: Size f tlie prjet (In man-mnths) 1988 r befre 1989 1990 1991 1992 1993 Fundatin date 1994 1995 1996 1997 Figure?: Prprtin f "simple" prjet (ad, y2k, web pages, data manipulatin) 1988 1989 r befre 1990 1991 1992 1993 Fundatin date 1994 1995 1996 1997

Figure 8: Cumulative distributin f verrun A: Yung firms J 50 B: Old firms

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Table 2 Share f verrun fr paid by the firm as a funtin f initial ntrat Prprtin paying 100% Prprlin paying between and 100 % Prprtin paying 0% Average share f the verrun paid fr by the firm (1) (2) (3) (4) PANEL A: ALL CONTRACTS All ntrats 39.29 17.85 42.86 47.4 (3.58) Time and material n.i 11.12 77.78 15.6 ntrats (4.92) Mixed ntrats 34.29 25.71 40 51.6 (7.69) Fixed st ntrats 54.12 PANEL B: EXTERNAL CONTRACTS All ntrats 47.58 18.82 27.06 20.97 31.45 63.1 (4.83) 57.1 (4.06) Time and material 17.65 23.53 58.82 28.2 ntrats (9.56) Mixed ntrats 40.62 25 34.38 50.9 (8.08) Fixed st ntrats 56.76 18.92 24.32 65.8 (5.07)

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Table 9 Share f verrun paid by the firm, by prjet and lient size Yuns firms Old firms Size f prjet Size f prjet All <median >mdian All <median >median (1) (2) (3) (4) (5) (6) All lients Small r medium lients Big lients 68.7 72.5 63.3 (5.15) (8.17) (9.82) 77.5 79.9 73.2 (7.93) (10.0) (13.7) 59.8 63.5 55.8 (9.49) (13.5) (13.9) 46.6 54.7 45.7 (6.25) (8.34) (6.60) 65.4 61.1 68.2 (7.5) (12.7) (9.5) 37.6 50.2 29.3 (6.56) (11.2) (7.72)

DEC <^np Date Due Lib-26-67

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