Designing relational sanctions in buyer–supplier relationships

Abstract

This paper explores the role of supplier performance measures (scorecards and others) in the internal design of relational contracts. We analyze a simple supplier–buyer repeated interaction in which incentives arise by the threat of terminating the relationship—temporarily or permanently. As the periods with no‐trade reduce the value of the relationship, the optimal relational contract minimizes the equilibrium punishment while preserving the supplier's incentives. We show that making the relational penalties conditional on additional supplier's performance measures increases total surplus. We also provide a rationale for “forgiveness” in relational contracting. The buyer may optimally forgive (decide not to sanction at all or to impose a lesser sanction) the supplier despite a bad outcome when some additional information is positive. We start with a binary performance measure, but we extend our analysis to more complex performance measures such as scorecards. Finally, we rank the scorecards in terms of their informativeness and we characterize the optimal investment in the design and improvement of these performance measures.