The Formal and Informal Aspects of an Organization

Fellow, RIETI

We tend to think that relationships between management and employees in an organization are based on formal contracts and the underlying laws and regulations thereof. However, it is wrong to see actual management-employee relationships as ones that are solely governed by formal contracts. Indeed, maintaining informal relationships of mutual trust is of greater importance in reality. Also, formal and informal relationships interact with one another. A developing field of economic theories is now casting light on such interactions.

Importance of trustful relationship within an organization

There is a substantial difference in the behavior of parties to a contract between when they pursue their interests solely based on the formal contract in the absence of mutual trust and when there exists an informal relationship of mutual trust. To illustrate this, Levin (2003) cites the labor-management dispute of UAL Corp. (United Airlines) that broke out in the summer of 2001. While negotiations with the management from 2000 to 2001 were coming to a dead end, UAL's pilots' union called on its members to work "to the letter of our agreement." Thus, UAL pilots (rightfully) refused to work overtime and implemented stricter security checks, which resulted in the delays and cancellations of a number of flights and forced UAL to rack up $700 million in losses in a single summer (Lowenstein, 2002). Quite a few readers might remember that there used to be a labor union tactic called a "work-to-rule strike." It is a well-known fact that this strategy caused huge losses to the now-defunct Japanese National Railways (predecessor of the seven Japan Railways companies). Meanwhile, it is also true that there are many couples who remain formally married even if their relationships have gone so sour that they hardly see or talk to one another; although this is a bit of a deviation from labor-management relationships.

Certainly, it is quite normal for an employer and an employee to sign a formal contract. However, when both parties to a contract expect their relationship to be maintained into the future, they usually carry out tasks based on trust in each other rather than in accordance with the contract. As shown in the example cited above, the performance of parties to a contract when they act only within the scope of "not contradicting a formal contract" is much poorer than when it is sustained by mutual trust. In other words, for both parties, a situation in which they carry out tasks by relying on their informal relationship of mutual trust is more favorable than a situation in which they carry out tasks solely based on their formal contract. Usually, a formal contract only begins to matter when an informal relationship of mutual trust has collapsed. Settling a dispute in accordance with a contract is meant to be a "last resort."

Formal contracts versus relational contracts

In economics, not only formal written contracts but also certain behavioral patterns that are reasonably expected - though not explicitly stipulated in the contract - based on the long-term relationship between parties are regarded as a "contract," with the latter referred to as "relational contract" or "implicit contract." What is the difference between formal contracts and relational contracts?

The range of what can be stipulated in a formal contract includes specific actions that can be taken by parties to the contract when an event "verifiable" to third parties, such as a court, occurs. Let us say that the parties have agreed on and written in their contract concerning the handling of a certain event that is not verifiable to third parties. When such an event actually occurs and one party fails to act in accordance with the contract, the chances are that a court will be unable to make any judgment. Meanwhile, the monthly sales performance of a sales employee can be considered to be a verifiable variable. A contract under which a scale of remuneration based on sales figures is set beforehand and each sales person is to receive a wage according to his or her sales performance would be enforceable. The enforceability of a formal contract is underpinned by a legal system such as a court that can enforce the contract. In economics, a theory dealing with such contracts is called "complete contract theory."

A relational contract is based on the premise that fixed relationships between the parties concerned will be maintained for a long period of time (see note 1). Under such a contract, variables that are not verifiable to third parties can be included as contractual provisions if they are observable by both parties. Unlike a formal contract, compliance to a relational contract is not reliant on the kind of enforceability ultimately supported by the legal system. The enforceability of a relational contract is secured by the expectation that when one party breaks its promise the breached party will terminate the relationship or take action to penalize the breaching party without contradicting the terms of their formal contract. This kind of enforceability that is not reliant on third parties such as a court is referred to as being "self-enforcing." In this kind of situation, all that is needed is for each party to check whether or not the other party is acting in accordance with their agreement. Therefore, even unverifiable variables can be included in such an agreement as long as they are observable by both parties.

When one party to a relational contract breaks its promise, the other party does not usually seek to terminate the relationship immediately. Instead, both parties would revert to a relationship based on their formal contract. As mentioned above, a relationship based on a formal contract is unfavorable for both parties compared to that sustained by a relational contract. It is not wise for either party to break its promise when the anticipated response from the breached party is to return to the formal contract-based relationship. The breaching party might make temporary gains but would end up losing in the long run.

What insights can be drawn?

Viewing the activities of an organization in such a manner is a relatively new approach in the development of economic theories. Here, I would like to discuss some of the findings that have been derived using this approach. Up to this point, I have explained formal and informal relationships using employer-employee relationships as examples. But it should not be hard to imagine that such formal and informal relationships exist in many other contexts. For instance, there are formal transactions strictly in compliance with the legal system and informal (and relational) transactions. Likewise, there are arm's-length banking and relational banking, and so forth.

First of all, one general advantage of this approach is that an organization can be perceived as a domain where formal and informal aspects interact with each other. And this has led to another perspective that the formal aspects of an organization are designed to facilitate the functioning of informal aspects.

Secondly, based on the perspective that formal relationships are designed in a way to enable informal relationships to function properly, we have come to see some rationale behind intentionally leaving certain ambiguities in a formal contract rather than working everything out in detail (see note 2). Also, we now understand that the impact of incentive wages under an employment relationship is inevitably weaker (as exemplified by a fixed wage that is independent from performance) than that of incentive remunerations under a market-oriented relationship (see note 3).

Thirdly, the lower the utility that can be derived from a formal contract, the greater is the likelihood that "cooperation" (compliance to promises in the case of the example above) between the parties concerned will be secured in the long run. This is because both parties to the contract know that they would return to a formal relationship once promises are broken and the decreased utility that accompanies such formal relationships means that there is more to lose, or greater "penalty," for breaking promises. This may provide a particular insight regarding the major shift in economic system that Japan is confronting today (Dixit 2004). For instance, concerning Japan's conventional employment system, it has been often pointed out that Japanese employees, once hired by one company, find their external opportunities extremely limited with the job market for mid-career workers nearly nonexistent, creating a situation that provides further incentives for maintaining the traditional lifetime employment system. With the gradual establishment of a labor market, however, external opportunities are expanding for those already holding a job and this may pose an obstacle to maintaining informal relationships within a company on a long-term basis. Though in a general sense, it may be the case that the establishment of a labor market is making it difficult to maintain trust-based employment relationships.

The fourth insight concerns the way of looking at the role of management within an organization. From this approach, it is derived that the basic role of the management lies in the maintenance of relational contracts with employees. For instance, an important management task would be to decide what variables (eg measures of performance) should be introduced and monitor such variables by bearing the necessary costs. Also, the management needs to design formal contracts by taking into consideration their impact on relational contracts. Furthermore, there may be occasions where the management has to decide to break the relational contracts. However, as is generally perceived, the management would face substantial difficulties in rebuilding a new trustful relationship after reneging on the old contract (Baker, Gibbons, and Murphy 2002).

Most of these insights have been taken as "common sense" in the fields of sociology and business science. Meanwhile, in the field of economics, where incentive theories have developed rapidly over the past several decades, too much emphasis has been placed on how to design an incentive system within an organization from the viewpoint of reinforcing incentives. Today, however, economics is gradually catching up with sociology and business science. Various factors that were formerly perceived as being too "soft" (that is, difficult to handle in mathematical models) can now be analyzed using a model thanks to the various innovative ideas of researchers.

May 18, 2004

(Note 1) A relational contract, a concept formalized by the theory of repeated games, is also applicable to a situation where transactions are to be continued for another term at a given probability. While Party A, one of the parties to a contract, remains intact, a different party may serve as its transaction partner for each term provided that those taking turns completely share information as to how Party A has behaved in each term.

(Note 2) Refer to Bernheim and Whinston (1998). However, their model is not based on the repeated games discussed above.

(Note 3) The presence of such a phenomenon has been pointed out by Willamson. Refer to Baker, Gibbons and Murphy (2002). Various theoretical explanations have been presented concerning the fact that, unlike the theoretical conclusion of complete contract theories, fixed wages are often observed in reality. For instance, Holmstrom and Milgrom (1991) derived such a result by analyzing principal-agent relationships in a situation where the agent allocates his or her efforts among a multiple number of tasks. More recently, Benabou and Tirole (2003) have created a model to analyze their theory that excessive incentive wages may lower employees' true motivation coming from within.


Baker, G., R. Gibbons, and K. J. Murphy (2002), "Relational Contracts and the Theory of the Firm," Quarterly Journal of Economics, Vol. 117, pp.39-84.

Benabou, R. and J. Tirole (2003), "Intrinsic and Extrinsic Motivation," Review of Economic Studies, Vol. 70, pp.489-520.

Bernheim, D. and M. Whinston (1998), "Incomplete Contracts and Strategic Ambiguity," American Economic Review, Vol. 88, pp.902-932.

Dixit, A. (2004), Lawlessness and Economics: Alternative Modes of Governance (Gorman Lecture), Princeton University Press.

Holmstrom, B. and P. Milgrom (1991), "Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," Journal of Law, Economics, and Organization, No. 7, pp.24-52.

Levin, J. (2003), "Relational Incentive Contracts," American Economic Review, Vol.93, pp.835-857.

Lowenstein, R. (2002), "Into Thin Air," New York Times Magazine, February 17, pp.40-45.

May 18, 2004

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