The Shadow of the Future in Vertical Relationships



When are firms preferred over markets? Prior literature suggests that an important dimension in which firms and markets differ is the strength of the shadow of the future—that is, incentive alignment via the promise of future business. Building on this insight, we investigate the trade-off between firms and markets by analyzing conditions favoring a weaker or stronger shadow of the future. Informed by our qualitative fieldwork, we build a formal model that defines the strength of the shadow of the future as the probability that a relationship will be terminated in response to underperformance (or ``threat level''). The model highlights a basic trade-off between providing strong incentives for the present and safeguarding relationships for the future. Under certain conditions, stable relationships from a low threat level are most important (high contractible and noncontractible value); under other conditions, strong incentives from a high threat level are most important (high noncontractible relative to contractible value and attractive outside options).
Contact information:
Dr. Merieke Stevens