Consider a firm developing an innovative product. Due to market pressures, production must begin soon after the product development effort is complete, which requires that an upstream supplier invests in capacity while the design of the product and production process are in flux. Because the product is ill-defined at this point in time, the firms are unable to write court-enforceable contracts that specify the terms of trade or the supplier's capacity investment. However, the firms can adopt an informal agreement (relational contract) regarding the terms of trade and capacity investment. The potential for future business provides incentive for the firms to adhere to the relational contract. We show that the optimal relational contract may be complex, requiring the buyer to order more than her demand to indirectly monitor the supplier's capacity investment. We propose a simpler relational contract and show that it performs very well for a broad range of parameters. Finally, we identify characteristics of the business environment that make relational contracting particularly valuable.
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