American Economic Association

Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal

Markets
Author(s): Paul L. Joskow
Reviewed work(s):
Source: The American Economic Review, Vol. 77, No. 1 (Mar., 1987), pp. 168-185
Published by: American Economic Association
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 Contract Durationand Relationship-SpecificInvestments:
EmpiricalEvidence fromCoal Markets

By PAULL. JOSKOW*

This paper examines the importanceof specificrelationshipinvestments in

determining negotiatedbetweencoal suppliersand
thedurationof coal contracts
are usedtoperform
Data for277 coal contracts
electricutilities. theanalysis.The
resultsprovidestrongsupportfor the viewthatbuyersand sellersmake longer
commitments to thetermsoffuturetradeat thecontractexecutionstage,and rely
less on repeatedbargaining,when relationship-specific investmentsare more
important.

This paper seeks to test empiricallythe Coal markettransactions are interestingto

importance of relationship-specific invest-
ments in determiningthe durationof coal
contractsnegotiatedbetweencoal suppliers
and electricutilities.'The analysismakesuse
of informationfor a large sample of coal
contractsthatwerein forcein 1979. It takes
as a startingpoint OliverWilliamson's1983
definitionsand categorizationof relation-
ship-specificinvestmentsand applies them
to the characteristicsof coal markettrans-
actions. It also follows Williamson and
Benjamin Klein, Robert Crawford, and
ArmenAlchian (1978) and assumesthatrisk
aversionis not an important factordetermin-
ing the structureof verticalrelationships
be-
tweencoal suppliersand electricutilities.2
*Departmentof Economics,MassachusettsInstitute
of Technology,Cambridge,MA 02139. The preliminary
versionof thispaper was writtenwhenI was a Fellow at
the CenterforAdvanced Studyin theBehavioralScien-
ces. Leslie Sundt and Rafe Leeman provided valu-
able researchassistance.Keith Crocker,HenryFarber,
Oliver Hart, Scott Masten,JeanTirole,and OliverWil-
liamson read preliminaryversions and made useful
suggestions.Three anonymousrefereesprovidedhelpful
suggestions.I benefitedfromseminarpresentationsat
UCLA, Stanford,and MIT. SupportfromMIT and the
Center forAdvanced Studyin the BehavioralSciences
is gratefullyacknowledged.The views expressedhere
and anv remainin errors are mv sole resnonsibilitv
' Electric utilities account for over 80 percent of
domesticcoal consumption.
2Other empiricalworkin thistraditionincludesKirk
Monteverdeand David Teece (1982) and Scott Masten
(1984), which focus on vertical integration;Keith
Crocker and Scott Masten (1986), J. Harold Mulhem
168
focus on because thereis considerablevaria-
tion in the durationand structure of vertical
relationshipsbetweenbuyersand sellers.I
observe spot market transactions,vertical
integration,and a wide varietyof longer-
term contractual relationshipswith dura-
tions rangingfromone year to fiftyyears.3
My relatedwork (1985) suggeststhatasset-
specificityconsiderationsmay be an im-
portant factor affectingthe structureof
vertical relationshipsin coal markets.The
empirical results reported below provide
strongsupportforthehypothesisthatbuyers
and sellers make longer ex ante commit-
mentsto the termsof futuretrade,and rely
less on repeatednegotiationsovertime,when
relationship-specificinvestmentsare more
important.
and
Duration
I. Contract
Investments
Transaction-Specific
The reliance on relationship-specific
ex-
investmentsto supportcost-minimizing
(1986), and Victor Goldbergand JohnErickson(1982)
which focus on long-termcontracts;my paper (1985)
whichexaminesboth verticalintegration and long-term
contracts.
3About 15 percentof electricutilitycoal consump-
tion is accounted for by transactionswith integrated
suppliers,15 percentis accountedfor by spot market
purchases, and about 70 percentis accounted for by
contractswith durationsof one to fiftyyears. See my
paper (1985, pp. 50-54).

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VOL. 77 NO. 1 JOSKOW: CONTRACTDURATION
change is frequentlyadvanced as an im-
portant factor explainingwhy we observe
the use of long-termcontractsthatestablish
the termsand conditionsof repeatedtrans-
actions between two parties ex ante.4Ac-
cording to transactionscost theory,5when
exchangeinvolvessignificant investments in
relationship-specific
capital,an exchangere-
lationshipthatrelieson repeatedbargaining
is unattractive.Once the investmentsare
sunk in anticipationof performance, "hold-
up" or "opportunism"incentivesare created
ex post which,if mechanismscannotbe de-
signed to mitigatethe parties'abilityto act
on these incentives,could make a socially
cost-minimizingtransactionprivatelyunat-
tractiveat the contractexecutionstage.6'7A
long-termcontractthat specifiesthe terms
and conditionsforsome set of futuretrans-
actions ex ante,providesa vehicleforguard-
ing againstex post performance problems.8
A coal contractgenerallyspecifiesin ad-
vance a method for determiningthe price
that the buyeris obligatedto pay for each
4Williamson(1979, 1983), Klein et al., Oliver Hart
and Bengt Holmstrom(1986, pp. 1-2; 86-101). Other
reasons for the use of long-termcontractshave also
been suggested.These includeinformation lags,income
effectsand risk aversion,and improvedmonitoringof
performance.
5I use the term"transactionscost theory"to refer
generallyto the workof Williamson(1979, 1983, 1985)
and Klein et al.
6As Klein et al. discuss,thesunkinvestments createa
streamof quasi rentsthatgivesone partyor the other
(or both) some ex post bargainingpower.
7The presenceof thesecontracting hazards and im-
perfectionsin the abilityof the transactingparties to
protectagainstthemdoes not mean thata deal will not
be made. It simplymeans thatthe costs of makingthe
transactions-the cost of thecoal in thispaper-will be
higherthan it would be if thesehazards could be fully
mitigated.Both parties have an interestin tryingto
structuretherelationshipso thata cost-minimizing deal
can be struck.
8Asdiscussedin myearlierpaper(1985), reputational
considerationsmay providea naturalmarketconstraint
on "bad behavior" ex post. Reputationalconstraints
reduce the need to writeinflexiblelong-termcontracts
to supportcost-minimizing exchangein the presenceof
asset specificity.Reputationalconstraintsare likelyto
be imperfectin coal markets,however.At the other
extreme,verticalintegration maybe chosento deal with
ex post performanceproblemsif satisfactory contractu-
al solutionscannot be found.
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All use subject to JSTOR Terms and Conditions
169
delivery(generallya formulafordetermining
prices for deliveriesat each point in time),9
quantitiesthat the selleris obligatedto de-
liver and the buyeris obligatedto purchase
at each point in time (usually monthly),10
the qualityof the coal (Btu, sulfur,ash, and
chemicalcomposition),thesourceofthecoal,
and the period of timeover whichthe con-
tractualprovisionsare to governthe terms
and conditionsof trade.11The primaryread-
ily quantifiablecharacteristics of coal con-
tracts that appear to vary widely from
contract to contract are the quantityand
characteristicsof thecoal contractedforand
the lengthof time thatthe partiesagree ex
ante to committhemselvesto the termsand
conditionsspecifiedin thecontract.It is this
length of time to which the parties agree
ex ante to abide by the termsof a contract
that I referto as the "duration"of the con-
tract.12
My hypothesisis that the more impor-
tantare relationship-specific
investments, the
longerwill be theperiodof time(or number
of discretetransactions)overwhichthe par-
ties will establishthe termsof trade ex ante
by contract. I thereforeexpect to observe
that the variationin the agreed upon dura-
tion of contractualcommitments is directly
related to variationsin the importanceof
relationship-specificinvestments.13
9See myearlierpaper (1986).
l?The typical contractspecifiesa monthlyand an-
nual deliveryschedule subject to minimumand maxi-
mum production and take obligations.The allowed
variationsfromthe contractedquantitiesin actual con-
tractsthatI have reviewedis fairlysmall.
" There are manyotherprovisionsas well,including
arbitrationprovisions,force majeur provisions,resale
provisions,etc. These provisionsare fairlystandardin
long-termcoal contracts,however.
12The actual durationof a contractcould be longer
or shorterthanthis.Buyersand sellersfrequentlyvolun-
tarily negotiate an extensionof an existingcontract.
Contractsmay also be brokenthroughbreachor mutual
agreement.As faras I can tellfromthedata thatI have
reviewed,however,coal contractsare rarelyterminated
prematurelySee my paper (1986, p. 2).
13 To the extent that there are tradeoffsbetween
contract duration and the incidenceand structureof
other contractual"protective"provisions,such as the
method for determiningprice adjustmentand quanti-
ties, these other provisionsshould be included in the
analysis as well. As indicated above, however,there
170 THE AMERICAN ECONOMIC REVIEW
Duration
andtheContractual
II. AssetSpecificity
ofCoal SupplyRelationships
Williamson (1983, p. 526) identifiesfour
distincttypes of transaction-specific invest-
ments,threeof whichappear to be relevant
to differenttypes of coal supply relation-
ships. The threetypesof relevanceto coal
markettransactionsare:"4
The buyerand seller
(a) Site Specificity:
are in a "cheek-by-jowl"relationshipwith
one another,reflecting ex ante decisionsto
minimizeinventoryand transportation ex-
penses. Once sited theassetsin questionare
highlyimmobile.
(b) PhysicalAssetSpecificity: Whenone
or both parties to the transactionmake in-
vestmentsin equipmentand machinerythat
involvesdesigncharacteristics specificto the
transactionand whichhave lower values in
alternativeuses.
(c) Dedicated Assets: General invest-
mentby a supplierthatwould not otherwise
be made but for the prospectof sellinga
significant amountof productto a particular
customer.If the contractis terminatedpre-
maturely,it would leave the supplierwith
significantexcess capacity. Although Wil-
liamsondoes not discussit,I thinkthatthere
is probably a "buyer" side analogy to the
dedicated asset storyas well. A buyerthat
relieson a singlesupplierfora largevolume
of an input may findit difficultand costlyto
quickly replace these supplies if they are
appears to be relativelylittlevariationin these provi-
sions in my data base, especiallyrelativeto the very
largevariationin contractduration.I therefore feelthat
it is safe to assume forpurposesof thisanalysisthatwe
have a sample of contractsthatessentiallyholds these
otherprovisionsconstant.In any event,we can measure
the utilizationof theseotherprovisionsonlyfora small
fractionof the contractsin the data base and therefore
cannot examine such tradeoffs directly.Note that the
coal marketis not subject to the kinds of price regu-
lationdiscussedin Masten-Crocker and Crocker-Masten
regardingnaturalgas contracts.
14The fourthis whatWilliamsoncalls "human asset
specificity"(1983, p. 526). JeanTirole has suggestedto
me that Williamson's four types of relationship-(or
transaction)specificinvestment are simplydifferentin-
stances of the same phenomenon.I believe thatthisis
correct.However, I find the distinctionsto be quite
usefulforempiricalapplications.
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MARCH 1987
terminatedsuddenly and effectively with-
drawn fromthe marketand, as a result,a
large unanticipated demand is suddenly
thrownon the market.
As discussed in more detail in the Ap-
pendix,I have put togethera data base that
includes informationfor nearly 300 con-
tractsbetweenelectricutilitiesand coal sup-
pliers that were in forcein 1979. The data
base includes informationof various kinds
regardingthe characteristicsof the individ-
ual coal contracts,the suppliers,the buyers,
and the quality and quantityof the coal
contractedfor. The strategywas to use the
informationabout the individualcontracts
in the data base and to attemptto measure,
at least ordinally,differencesin the impor-
tance of transaction-specificinvestmentsof
one or more of the typesidentifiedby Wil-
liamson foreach contract.
Williamson'snotionof "site specificity"is
the easiest to capture explicitlyfor coal
supplyrelationships.For mostelectricgener-
ating plants, coal is purchased in one of
threemajor coal-producingregionsand then
transportedby rail, barge, and/or truck
(oftenat least two of thesetransportmodes
are involved) to the powerplant whereit is
burned.However,thereare a relativelysmall
numberof plants thathave been sited next
to specificminesin anticipationof takingall
or mostof theirrequirements fromthatmine.
These "mine-mouth"plants are generally
developed simultaneouslywith the mines
themselves.This appears to be a classic case
of the cheek-by-jowlrelationshipthat Wil-
liamson has in mind when he discussessite
specificity.15The potentialfor ex post op-
portunismproblems arising if the parties
were to relyon repeatedbargainingappears
to be especiallygreatin thiscase.16I there-
15This is discussed in muchmoredetail in my 1985
paper.
16
Williamson(1983) states that commonownership
is the predominantresponseto sitespecificity. My work
with coal supply arrangements indicatesthat common
ownership(verticalintegration)is much morelikelyto
emergeformine-mouth plantsthanothertypesofplants,
but thatcontractsare also used to governexchangefor
about half of the mine-mouth plantsconstructedsince
1960. We would probablysee moreverticalintegration
VOL. 77 NO. 1 JOSKOW: CONTRACTDURATION
fore expect that contractsfor supplies for
mine-mouthplantswillbe muchlongerthan
the average contractinvolvingsupplies to
othertypesof plants,otherthingsequal."7
Let us turnnextto physicalasset specific-
ity.When coal-burningplantsare built,they
are designed to burn a specifictypeof coal
(see my 1985 paper; Richard Schmalensee
and myself,1986; mypaper withSchmalen-
see, 1985). By "type" of coal, I mean coal
with a specific Btu, sulfur,moisture,and
chemical content.The type of coal that a
generatingunitis designedto burnaffectsits
constructioncost and its design thermal
efficiency.Deviations from expected coal
qualitycan lead to a deterioration in perfor-
mance or requirecostlyretrofit investments.
Thus when a plant is designed,the operator
becomes "locked in" to a particulartypeof
coal.18
The fact that a plant is locked in to a
particulartype of coal does not necessarily
implythatthebuyeris lockedin to a specific
supplier,however.Whetheror not the plant
design/coal characteristic lock in also leads
to a lock in with the currentsupplierde-
pends on othercharacteristics of thetransac-
tion. In particular,it is likelythat the rela-
tionshipbetweenthistypeof asset-specificity
and ex post hold up or opportunismprob-
lems is related to inter-and intraregional
formine-mouthplantsif stateand federalregulationof
electric utilitiesdid not discourageit. I have argued
elsewhere(1985) that to the extentthat electricutility
regulationbiases coal supplyarrangements at all, it is
probably to make short-term purchasesmore desirable
than theymightotherwisebe. Whileutilitiesmightalso
like to integratebackwardsintocoal productionto shift
profitsfroma regulatedto an unregulatedactivity,the
regulatoryprocesshas discouragedthis.
17j have includedtwoplantsin thiscategory thatare
not technicallymine-mouthplants but have economic
characteristics thatare identicalto thoseof mine-mouth
plants. For example, if a mine and a plant are con-
nectedby a transportation facility(a slurrypipelineor a
rail line) built and owned by the supplier or buyer
specificallyto transportcoal froma specificmine to a
specificplant, the associatedcoal contractwas grouped
withthe mine-mouthplants.
l8Exactly how locked in, is a variable of choice,
however.
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171
variationsin coal quality,least cost supply
technology,and transportation alternatives.19
The characteristics of coal producedin the
United States varysystematically amongthe
three major coal-producingregions. The
easterncoal-producingdistricts producehigh
Btu coal of reasonablyuniformquality.The
midwesterncoal-producingdistrictsproduce
lower Btu coal thatgenerallyhas a veryhigh
sulfur content. Coal quality is also more
variable than that in the East. Finally,the
western coal-producing districtsgenerally
produce coal witha muchlowerBtu content
and a verylow sulfurcontent.The qualityof
the coal varies quite widelythroughoutthe
westernregion.20
In addition to variationsin coal quality
among the regions,thereare also systematic
variations in the least-costtechnologyfor
producing coal and in the transportation
alternativeavailable. In the East, relatively
small underground minesare economicaland
the supply of easterncoal can be expanded
fairlyquickly.Relativelyabundanttranspor-
tation alternatives,combinedwithrelatively
shortaverage transportdistances,mean that
transportation is not likelyto be a significant
barrier to a buyer's obtaining alternative
supplies. In the West, large surfacemines
that can be most economicallyexpanded in
large "lumps," are the least-costproduction
technology.Transportationalternativesare
poor, the average transportdistance quite
long, large unit trainshipmentsare themost
economical transportmethod,21and utilities
often must rely on one or two railroadsto
move the coal. The situationin the Midwest
lies somewherebetweenthesetwoextremes.22
19Transportationcosts are on average a large frac-
tion of deliveredcosts and liningup efficient
transporta-
tion arrangementsforlargequantitiesof coal can be a
time-consuming process.
20 The midwesternregion is sometimesbroken up
into two subregions(eastern and westerninterior)in
discussionsof coal supply.The westernregionis some-
times broken up into threeor more subregions.Texas,
where lignite coal is produced,is often considereda
separate producingregion.My data base has no con-
tractsforTexas coal and I do not discussthatarea here.
21Unit train cars are oftenowned or leased by the
utilityratherthan by the railroad.
22See MartinZimmerman(1981, pp. 17-36).
172 THE AMERICAN ECONOMIC RE VIEW
There are also systematicdifferences in
the relativeand absoluteimportanceof spot
marketsin the three supply regions.23On
average,from1974 through1982 spotmarket
transactionsaccounted for roughly15 per-
cent of total domestic coal purchases by
electricutilities.In 1982, spot marketsales
accounted forabout 10 percentof coal sup-
plies or about 60 milliontons. However,in
the westernregion,less than2 percentof the
coal deliveredto electricutilitieswas pur-
chased on the spot marketor less than 5
milliontons.24The spot marketis more ac-
tive in the Midwest,accountingforabout 8
percent of deliveriesin 1982 or about 10
million tons per year. The spot marketis
most active in the East whereabout 18 per-
cent of deliveries went throughthe spot
marketin 1982 or about 45 milliontons.25
These considerationsimplythe following:
Coal suppliersare likelyto be less able to
exploit the lock-in effectassociated with
boilers designed to burn coal with specific
characteristicsin theEast thanin theWest.26
Thus the protectionof a long-term contract
is likelyto be moredesirablefromthebuyers'
23Spot marketsales also varyfromyearto year.Spot
markettransactionstend to be higherwhencoal miner
strikes are anticipated as utilitiesseek to build up
stockpiles or after coal miningstrikesare over and
stockpilesare replenished.The volume of spot market
transactionsalso varies in response to unanticipated
changesin coal supplyand demand.
24The aggregatevolumeof spot markettransactions
forwesterncoal is quite small comparedto the annual
quantity of westerncoal contractedfor in a typical
contract.The contractsforwesterncoal in mydata base
have a mean quantityof about 1.8 milliontonsper and
a maximumquantityof over 8 milliontonsper year.
251 believe that the wide variationin the importance
of the spot marketin different regionsis largelyrelated
to the same economic considerationsthat lead me to
conclude that the importanceof asset specificity also
varies fromregionto region.
26Generating plants located along the eastern sea-
board that use coal essentiallyalwaysuse easterncoal.
These plantsare also morelikelyto have unitsthathave
multifuelcapabilitiesthanplantslocated elsewhereand
can switchback and forthbetweencoal and oil or gas
(often with some performancepenalty).See my paper
with FrederickMishkin (1977). Purchasersof eastern
coal with multifuelcapabilitieswill be less susceptible
to opportunismproblemswhen coal and oil pricesare
close together.
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MARCH 1987
(and the sellers'-see below) perspective, for
transactionsinvolvingwesterncoal relative
to transactionsinvolvingeasterncoal, with
midwesterncoal fallingsomewherein be-
tween.
Finally, let us turn to "dedicated asset"
considerations.The available information in
the data base does not make it possible for
us to know specificallywhetherthe supplier
made general investmentsthat would not
have been made but for the prospect of
selling a significant amountof productto a
particular customerand if the contractis
terminatedprematurelyit would leave the
supplier with excess capacity(see William-
son, 1983, p. 526).27 Williamson'sconceptu-
alization of dedicatedassetsimpliesthatthe
importanceof thisfactorin structuring coal
supply relationshipsshould vary with the
quantityof coal that is initiallycontracted
for,otherthingsequal. The largertheannual
quantityof coal that is contractedfor,the
more difficult it is likelyto be forthe seller
to quicklydispose of unanticipatedsupplies
(if the buyer breaches) at a compensatory
price, and the more difficult will it be fora
buyer to replace supplies at a comparable
price if the sellerwithdrawsthemfromthe
market. Thus, I expect that the greater
the annual quantityof coal contractedfor
the longerwill be the specifieddurationof
thecontract.
Because of systematicvariationsin the
optimal scale and capital intensityof coal
production across regions,dedicated asset
considerationsare also likely to be more
importantfor westerncoal than for eastern
coal. The greaterheterogeneity in coal sup-
plies and the difficulties of obtainingsuitable
transportationfor it in the West, suggest
thatdedicatedassetproblemsare likelyto be
more severein the westernthan the eastern
region. The very thin spot marketin the
27Indeed, as a practicalmatter,it is unclear to me
how one could ever go about determining thisdirectly
given the data that are likelyto be available foranaly-
sis. The coal contracts that I have reviewed do
sometimeshave language thatappears to recognizethe
dedicated asset notion directly,but the absence of an
explicit statementcannot be assumed to imply that
dedicated asset considerationsare not important.
VOL. 77 NO. ] JOSKOW: CONTRA CTDURA TION
western region should be especially prob-
lematical for both sellersand buyerswhen
large contractualcommitments are breached
because of the heterogeneity of the coal, the
characteristicsof least-costproductionand
the limitedtransportation alternatives.This
all implies again that contractsforwestern
coal should have longer contractualdura-
tions thancontractsforeasterncoal.
To summarize,if variationsin the impor-
tance of relationship-specific investments do
in fact lead to variationsin the extentto
whichthe partiesprecommitto the termsof
futuretrade ex ante,I expectto findthatthe
duration of contractualrelationshipsspec-
ifiedat thecontractexecutionstagewillvary
systematically withthreeprimaryobservable
characteristicsof coal supply transactions.
First,whetherthe plant takingthe coal is a
mine-mouth plant or not. I expectto observe
longer-termcontractsnegotiatedfor mine-
mouthplants. Second,withtheregionof the
countryin which the coal is produced. I
expectthewesternregionto have thelongest
contractsand the easternregiontheshortest
withthe midwesternregionhavingcontracts
with prespecifieddurationsthat lie in be-
tween. Third, with the annual quantityof
coal contractedfor.I expectthatcoal supply
arrangementsinvolvinglarge annual quan-
titycommitments willbe supportedby longer
contractsthan supply arrangements involv-
ing smallerquantitiesof coal.
III. ModelSpecification
andEstimation
I am primarilyinterestedin estimatinga
betweenthedura-
set of simplerelationships
tion of contractualcommitments(DURA-
TION) specifiedby the partiesat the con-
tract execution stage and, (a) the annual
quantity(QUANTITY)28 of coal contracted
28
Quantitiesare expressedin termsof the thermal
(Btu) content of the coal. The basic resultsare not
affectedwhen quantitiesare expressedin tons. For the
extensions reported in the next section, normalizing
quantities for Btu contentmakes it possible to more
accuratelyexamine theeffects, if any,of contractquan-
tities relative to total plant and utilityutilizationof
coal.
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173
for,(b) a dummyvariable(MINE-MOUTH)
that takes on a value of 1 fora mine-mouth
plant and zero otherwise,and (c) dummy
variablesthatindicatethecoal supplyregion
in whichthe supplieris located(MIDWEST
and WEST, so thatregionaleffectsare mea-
sured relativeto contractsforeasterncoal).
Additional variables are consideredin the
nextsection.
The data base thatI use includesinforma-
tion forapproximately300 coal supplycon-
tractsbetween domesticcoal suppliersand
investor-ownedelectric utilities.The con-
tractsincludedin thedata base werenegoti-
ated in various years up through1979 and
were in forceat least forpart of 1979. The
data are discussed in more detail in the
Appendix. Informationon all variables of
primaryinterestfor this studyis available
for 277 of the contractsin the data base. I
present estimates using both the full 277
observationsample as well as a subsample
consistingof 169 contractsthat involvede-
liveriesdedicated to a singlepower plant.29
Table 1 provides the mean, standarddevia-
tion, minimumand maximumvalues,and a
briefdescriptionforall of thevariablesused
in this section and subsequentsectionsfor
both theprimarysampleand thesingle-plant
subsample. Table 2 is a correlationmatrix
for all of the variables in the two samples
with the correlationsfor the 277 observa-
tion sample below thediagonaland thosefor
the 169 observation subsample above the
diagonal.
I work firstwith three simple specifica-
tions of the contractdurationequation:
(1) DURATIONJ= a0 + b1QUANTITYJ
+ b2QUANTITY7 + b3MINE-MOUTH1
+ b4MIDWESTJ + b5WEST1 + Ui
29Severalpeople suggestedto me that relationship-
specificinvestmenteffectsare mostlikelyto be revealed
forcontractsthatdedicateall suppliesto a singleplant.
I also focus on this subsample to obtain the data
necessaryto exploreissuesdiscussedin thenextsection.
174 THE AMERICAN ECONOMIC REVIEW MARCH 1987

TABLE 1-SAMPLE STATISTICS

Standard
Variable Observations Description Mean Minimum Maximum Deviation

DURATION 277 ContractDuration 12.75 1.00 50 10.43

169 (years) 14.18 1.00 43 10.77
QUANTITY 277 AnnualContract 20.45 0.3696 183.00 24.62
169 Quantity 22.83 0.3696 183.00 27.05
(trillionBtu's)
PLANT PROPORTION 169 Fractionof Total 0.44 0.03 1.00 0.35
PlantUse from
Contract
UTILITY PROPORTION 169 Fractionof Total 0.19 0.003 1.00 0.23
UtilityCoal Use
fromContract
PLANT QUANTITY 169 Plant Utilizationof 51.47 2.95 172.42 41.69
Coal (trillionBtu's)
UTILITY QUANTITY 169 UtilityUtilization 221.54 2.95 919.80 270.56
of Coal (trillionBtu's)
PLANT/UTILITY 169 PlantUse as Fraction 0.455 0.007 1.00 0.323
of Total UtilityUse
MINE-MOUTH 277 Mine-MouthPlant (D = 1; 14 Observations)
169 DummyVariable (D = 1; 14 Observations)
WEST 277 WesternRegion (D = 1; 54 Observations)
169 SupplyDummy (D = 1; 44 Observations)
MIDWEST 277 MidwesternRegion (D = 1; 68 Observations)
169 SupplyDummy (D = 1; 47 Observations)
DA TE-71 277 ContractsSigned (D = 1; 43 Observations)
169 1971-73: Dummy (D =1; 29 Observations)
DA TE-74 277 ContractsSigned (D = 1; 116 Observations)
169 1974-77: Dummy (D =1; 71 Observations
DA TE-78 277 ContractsSigned (D = 1; 72 Observations)
169 1978-79: Dummy (D =1; 38 Observations)
YEAR 277 Year ContractExecuted 1974 1955 1979 4.49
169 1974 1955 1979 4.64

can be foundin the Appendix.

aData sourcesand variabledefinitions
b
The 169 observationsubsampleincludescontractsdedicatedto a singleplant.

TABLE 2-CORRELATION MATRIX

169 ObservationSample
277
Observation LOG- MINE- PLANT UTILITY PLANT/ PLANT UTILITY
Sample DURATION QUANTITY QUANTITY MOUTH MIDWEST WEST YEAR PROP. PROP. UTILITY QUANTITY QUANTITY

DURA TION - 0.60 0.68 0.64 0.004 0.51 -0.57 0.58 0.43 0.05 0.29 0.02
QUANTITY 0.60 - 0.78 0.42 -0.04 0.28 -0.35 0.48 0.43 0.05 0.41 0.11
LOG-QUANTITY 0.64 0.80 - 0.30 0.02 0.32 -0.44 0.57 0.42 0.02 0.45 0.17
MINE-MOUTH 0.54 0.38 0.27 - -0.09 0.41 -0.37 0.46 0.41 0.05 0.10 -0.05
MIDWEST 0.14 0.08 0.11 -0.06 - -0.37 -0.20 0.04 -0.04 -0.06 -0.03 -0.15
WEST 0.41 0.25 0.26 0.39 -0.28 - -0.10 0.46 0.40 0.16 -0.06 0.16
YEAR -0.63 -0.39 -0.44 -0.31 -0.27 -0.08 - -0.28 -0.11 0.13 -0.16 -0.11
PLANT PROP. - - - - - - - - 0.61 -0.11 -0.24 -0.14
UTILITY PROP. - - - - - - - - - 0.66 -0.08 -0.36
PLANT/UTILITY - - - - - - - - - - 0.15 -0.57
PLANT
QUANTITY - - - - - - - - - - - 0.34
UTILITY
QUANTITY - - - - -

Note: Figuresbelow thediagonalare forthe277 observationsample,thoseabove thediagonal are forthe 169 observationsubsample.

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VOL. 77 NO. I JOSKOW: CONTRACT DURA TION
(2) DURA TION1= a0
+ b1LOG-QUANTITY1
+ b3MINE-MOUTH,
+ b4MIDWEST1 + b5WEST1 + U1
(3) log(D URA TION1) = a 0
+ b1LOG-QUANTITY1
+ b3MINE-MOUTHi
+ b4MID WEST, + b5WEST1+ log(ui)
wherei indexes contractsand ui is an error
termwhose characteristics will be discussed
further below.
I have allowed (QUANTITY) to enter
these relationshipsnonlinearlyby introduc-
ing a quadratic in quantity(QUANTITY-
SQUARED) in (1) and using the natural
logarithmof quantity(LOG-QUANTITY)
in equations (2) and (3). Since powerplants
have usefullives of roughlyfortyyearsand
the costs of breach are likelyto declineover
time as plants and minesage, I expectthat
the impact of quantityon contractualdura-
tion will diminishas quantityincreases.The
following pattern of coefficientestimates
for the three equations is implied by the
hypothesized relationship between asset
specificity and contractduration:
(i) All of the b 's should be positive,
exceptforb2, whichcould be positive,nega-
tive, or zero (no nonlinearity),althoughI
expect thatit will be negative.
(ii) b4 should be smallerthan b5.
Equations (1), (2), and (3) are estimatedin
threedifferent ways.First,I presentordinary
least squares (OLS) estimatesof each equa-
tion for both samples.Next, I presentOLS
estimates that introducedummy variables
which indicate the date that the contracts
were executed. Finally,I presentmaximum
likelihood estimatesbased on the assump-
tion thatwe have a truncatedsample drawn
froma populationwitheithera normalor a
log-normaldensityfunction.I discuss the
rationaleand resultsforeach estimationap-
proach and also present OLS results for
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175
contractswithsuppliersin each of the three
regions.
A. OLS Estimates
If we assume thatthe u1in (1), (2), and (3)
are independentlydistributedand drawn
froma normal distribution withmean zero,
thenOLS will yieldan unbiasedestimatorof
the coefficientsof interest.I proceed first
with this assumptionand provideestimates
for alternativeassumptionsabout the error
structurebelow. The OLS resultsare pre-
sented in Table 3. The firstthreecolumns
are estimatesfor the threeequations using
the 277 observationsample. Columns 4, 5,
and 6 containestimatesforthe 169 observa-
tion subsample.
The OLS estimatesare, in all cases, con-
sistent with the hypothesizedrelationship
betweenasset specificity and contractdura-
tion.The effectsof annual contractquantity,
region,and mine-mouth plantshave thepre-
dicted signs and are estimatedquite pre-
cisely. A mine-mouthplant is predictedto
have a contractthatis about 16 yearslonger
than those of other plants. Contractswith
eastern producersare 3 to 5 years shorter
than those forwesternand midwestern pro-
ducers.Contractswithwesternproducersare
2 to 3 yearslongerthanthosewithmidwest-
ern producers. The differencein duration
between the WEST and the MIDWEST is
generallynot significantat the 5 percent
level for the 277 observationsample,but is
significantfor the single-plantsubsample.
An increase in annual contractquantityof
22 trillion Btu's (roughly1 million tons)
yields about a 13-yearincreasein contract
duration.As a generalmatter,the estimates
are morepreciseforthesample of contracts
dedicated to a singleplant.
B. OLS Estimateswith
ContractDate Dummies
The desirable propertiesof the OLS esti-
mates depend on the strong assumptions
made about the errorstructure.Since the
contractsin the data base were signed at
manydifferent times,it is naturalto consider
the possibility that contractingpractices
176 THE AMERICAN ECONOMIC REVIEW MARCH 1987

TABLE3-CONTRACTDURATIONa

277 Sample 169 Sample 2SLS

LOG- LOG- Estimate
Independent DURATION DURATION DURATION DURATION DURATION DURATION DURATION DURATION Duration
Variables (1) (2) (3) (4) (5) (6) (7) (8) (9)

QUANTITY 0.4289 - - 0.4091 - - - - -

(0.0373) (0.0040)
QUANTITY-
SQUARED -0.0024 - - -0.0020 - - - - -
(0.00030) (0.00003)
LOG-QUANTITY - 4.4206 0.5057 - 4.2080 0.4942 4.2022 4.2057 5.1066
(0.3742) (0.0425) (0.4069) (0.0453) (0.4617) (0.4084) (0.812)
MINE-MOUTH 16.3300 16.4317 0.5104 15.9583 16.2300 0.4616 16.3432 16.2284 15.4391
(2.0496) (2.0045) (0.2279) (1.9106) (1.8421) (0.2050) (1.9426) (1.8477) (1.968)
MIDWEST 3.4267 3.8795 0.5154 2.7832 2.7843 0.5785 2.7317 2.7848 2.4268
(0.9682) (0.9821) (0.1116) (1.0928) (1.1032) (0.1228) (1.1295) (1.1065) (1.153)
WEST 5.3550 5.2033 0.6142 5.9856 5.6108 0.6844 5.6456 5.6391 4.8916
(1.357) (1.1641) (0.1323) (1.2346) (1.2586) (0.1401) (1.3406) (1.2751) (1.394)
PLANT
PROPORTION - - - - - - 0.9729 - -
(1.9806)
UTILITY
PROPORTION - - - - - - -2.0570 - -
(2.5832)
PLANT/
UTILITY - - - - - - - -0.2246 -
(1.4265)
Constant 3.6770 -0.7902 0.6014 3.9334 0.0155 0.6242 - 0.0146 0.1157 - 1.8922
(0.6586) (0.9579) (0.1089) (0.8109) (1.0917) (0.1215) (1.0978) (1.2665) (1.852)
Corrected
R-squared 0.61 0.60 0.51 0.71 0.70 0.61 0.70 0.70 -
Observations 277 277 277 169 169 169 169 169 169
a
OLS estimates.Standarderrorsof coefficient
estimatesare shownin parentheses.

changedover time.Not onlymightthedura- 1979. Since a separatevariableforcontracts

tion of a typicalcontracthave changedover
time,but such changesmayhave been corre-
lated with changes in contractquantities,
supply location, and the developmentof
mine-mouthplants over time.Failing to in-
clude variablesindicatedcontractdatescould
thenlead to a correlationbetweenthe inde-
pendent variables and the errorterm.The
OLS estimates would then be biased. To
check to see if the estimatesare sensitiveto
the presenceof a left-outvariablereflecting
the contractingdate, in Table 4, I report
estimatesof equations (1), (2), and (3) that
have contractdate dummiesincluded.These
contractdate dummyvariablesare DA TE-71,
whichis equal to one forall contractssigned
between1971 and 1973 inclusive,DA TE-74,
which equals one for contractssigned be-
tween 1974 and 1977, and DATE-78 which
equals one forcontractssignedin 1978 and
signed prior to 1971 is not included, the
coefficientestimatesare all relativeto pre-
1971 contracts(i.e. the constantterm).This
aggregationof signingdates was made to
reflectmajor shocks to coal supply and/or
demand.30
30The 1971-73 periodis just afterthe Clean Air Act
Amendmentsof 1970 werepassed, the 1974-77 period
is the period afterthe Arab oil embargoand includes
the subsequent increases in fossil fuel prices. The
1978-79 period coincides with the beginningof a
slowdown in utilitycapacity additions.These periods
are discussed in more detail in my paper (1986). The
aggregationchosen is the same used to analyzepricing
behaviorin thatpaper. The resultsreportedhereare not
sensitiveto thisaggregation,
however.The same qualita-
tive resultsare obtained if separate dummyvariables
are used foreach yearduringthe 1970's plus a separate
dummyvariable forpre-1965and 1966-70 contracts.

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VOL. 77 NO. I JOSKOW: CONTRACT DURATION 177

TABLE4-CONTRACTDURATIONa

LOG- LOG-
Independent DURATION DURATION DURATION DURATION DURATION DURATION DURATION DURATION
Variables (1) (2) (3) (4) (5) (6) (7) (8)

QUANTITY 0.3120 - - 0.3355 - - - -

(0.03547) (0.0406)
QUANTITY-SQUARED -0.0018 - - -0.0018 - - - -
(0.00027) (0.00029)
LOG-QUANTITY - 3.0482 0.3245 - 3.3485 0.3631 3.2847 3.3461
(0.3655) (0.0380) (0.4330) (0.0446) (0.4923) (0.4344)
MINE-MOUTH 13.9437 13.6701 0.3140 14.6494 14.6907 0.3792 14.5742 14.6800
(1.8482) (1.8260) (0.1899) (1.8495) (1.8347) (0.1891) (1.9423) (1.8403)
MIDWEST 1.6814 1.9761 0.3029 1.4906 1.6405 0.4083 1.5543 1.6323
(0.8785) (0.8952) (0.0931) (1.0544) (1.0786) (0.1112) (1.1083) (1.0821)
WEST 4.8429 4.8662 0.4831 5.1054 5.1731 0.5137 5.0697 5.1258
(1.0301) (1.0549) (0.1097) (1.2183) (1.2524) (0.1291) (1.3338) (1.2676)
PLANT PROPOR TION - - - - - - 0.9930 -
(1.8907)
UTILITY PROPORTION - - - - - - -0.9138 -
(2.4975)
PLANT/UTILITY - - - - - - - 0.3785
(1.3660)
CONSTANT 12.0145 9.4184 1.7205 9.2341 6.1982 1.4220 6.1583 6.0806
(1.2526) (1.5307) (0.1592) (1.5185) (1.8612) (0.1918) (1.8853) (1.9142)
DA TE- 71 -2.3734 -2.4564 -0.0988 -0.7282 -0.9103 -0.0311 -0.9389 -0.9455
(1.2715) (1.2876) (0.1339) (1.4890) (1.5057) (0.1552) (1.5290) (1.5154)
DA TE- 74 -6.6815 -7.3044 -0.5098 -3.9714 -4.3786 -0.3149 -4.3848 -4.4134
(1.2647) (1.1446) (0.1190) (1.3483) (1.3685) (0.1410) (1.3789) (1.3781)
DATE-78 -10.5052 -10.6151 -1.3926 -7.0789 -6.5193 -1.0317 -6.4995 -6.5749
(1.2647) (1.2976) (0.1349) (1.5540) (1.6324) (0.1682) (1.6702) (1.6493)
CorrectedR-squared 0.70 0.69 0.67 0.74 0.73 0.69 0.73 0.73
Observations 277 277 277 169 169 169 169 169
a OLS/Contract date dummies.Standarderrorsof
coefficient
estimatesare shownin parentheses.

While the introductionof these contract contractingbehavior over time, we would

date dummyvariablesmay help to control
for contract date related correlationsbe-
tween the error termand the independent
variables,the estimatedcoefficients of these
variables themselveshave no obvious eco-
nomic meaning.This is because of the na-
ture of the sample. Recall that I observe
contractsinforcein 1979. If we thinkof the
populationas consistingof contractswritten
for particularplants (i) in a particularyear
(t), we can observea contractonlyif
(4) DURA TIONIt
2 (1979-Contract YEAR)
This means thatof thosecontractssignedin
1970, I can observe,in 1979,only thosethat
had durationsof at least 9 years,whileI will
inevitablyfind that the coefficients of the
contract date dummies indicate that the
average lengthof a contractin the sampleis
negativelycorrelatedwith the date of the
contract.31 The coefficients
of the contract
date variables can thereforetell us nothing
directlyabout the changes in contracting
behaviorover time.
With theseconsiderations in mind,we can
turnto the resultsreportedin Table 4, col-
umns 1 through6. The resultsobtainedare
again consistentwith the hypothesizedre-
lationshipbetweenasset specificity and con-
tractduration.The coefficientsof the quan-
tity, mine-mouth,and regional variables
In the sample, the simplecorrelationbetweencon-
31

observeshortercontractsthatweresignedin tract date (YEAR) and DURATION is about -0.60.

lateryears.Even if therewereno changesin See Table 2.

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178 THE AMERICAN ECONOMIC REVIEW MARCH 1987

continue to be of the predictedsigns and The resultsare again quite consistentwith

relativemagnitudes.The onlyinteresting dif- the hypothesizedrelationshipbetween as-
ferencebetween these resultsand those re- set specificityand contractduration. The
ported in Table 3 is that the differencebe- signs and magnitudesof the coefficients of
tweenthe durationsof contractssignedwith QUANTITY, MINE-MOUTH, WEST, and
westernand midwesternproducersis now MIDWEST are again as predicted.Withthe
generallystatistically at the5 per-
significant exception of the mine-mouthdummy in
cent level forboth samples. equation (3), the coefficients are estimated
quite precisely.The magnitudesof the esti-
C. MaximumLikelihoodEstimates matedcoefficients in thistableare difficult to
compare directlywiththosein Tables 3 and
A third alternativefor estimatingthese 4 because of the need to incorporatethe
equations is to follow Keith Crocker and truncationeffectsinto estimatesof contract
Scott Masten (1986), who workwitha sam- duration.33Correctingfor the sample trun-
ple of naturalgas contractswithsimilarsam- cation, the estimatesreportedin Table 5,
pling properties,and assume that the sam- column 5, for example,yield the following
pling procedurewhichchooses contractsin expected durations: The expected duration
forcein a single year (1981 in theirpaper) evaluated at the means of the independent
represents a classical sample truncation variablesis 10.5 years(comparedto a mean
problem as discussed by G. S. Maddala of 14.2 years forthe truncated169 observa-
(1983, pp. 165-170). The populationof con- tion sample). Mine-mouthplants have con-
tractsthenimplicitly consistsof all contracts tractswithan expecteddurationthatis about
writtensince theearliestcontractin thedata 12 years longer than the averagenon-mine-
base. We obtain a truncatedsamplebecause mouthplant.Midwesterncontractsare about
we observecontractsonlyif the durationof 3.5 years longer than eastern contracts.
the contractis greaterthan or equal to L1, Westerncontractsare about 11 yearslonger
whereLi is equal to 1979 minusthecontract than eastern contractsand 6 years longer
date. In thiscase, OLS estimatesof (1), (2), than midwesterncontracts.The difference
and (3) would be biased, because the sam- betweenwesternand midwestern contractsis
plingprocessis likelyto inducea correlation generallysignificant at the5 percentlevel.34
between the independentvariablesand the
errorterm. D. EstimatesforIndividualCoal
We can obtain estimateswith desirable SupplyRegions
asymptoticpropertiesby specifying thelike-
lihood functionof the sample, given the Finally, in Table 6, I report estimates
natureof the samplingtruncation, and then of the relationshipbetween DURA TION,
solve for the maximumlikelihoodestimates LOG-QUANTITY, and MINE-MOUTH for
(MLE) of thecoefficients of interest.Follow-
ing Maddala (p. 166), I assume that the
population relationship between contract
durationand theindependentvariableshas a thatrequiretakingthelogarithm of Li = (1979- YEAR)
normallydistributederrorand thateach ob- which is zero for contractswrittenin 1979. Since the
shortestcontractin thedata base has a durationof one
servationis truncatedat Li. This leads to a year,we can impose a lowerbound betweenzero and 1
standardmaximumlikelihoodestimator. on Li to include all observations.Estimatesobtained
The maximumlikelihoodestimatesare re- using differentlower bounds does not change the re-
ported in Table 5, columns 1 through6.32 sults,so I simplyreportresultsforthesampleexcluding
the small numberof contractsin thedata base executed
in 1979.
32
The estimateswereobtainedusingtheMLE routine 33See Maddala (p. 167).
in the StatisticalSoftwareTools package (Version1.0 as 34I have also produced maximumlikelihood esti-
of October 1986) developed by Jeffrey Dubin and mates of equation (2) for subsamples consistingof
R. Douglas Rivers runningon an IBM XT. The esti- pre-1974contractsand thosesignedbetween1974 and
mates in cols. 3 and 6 assume thatthedensityfunction 1979. The hypothesizedrelationshipbetweencontract
is log-normal.Contractsexecutedin 1979 have been duration and the variables representing variationsin
dropped since the likelihood functionincludes terms persistsforboth subsamples.
asset specificity

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VOL. 77 NO. I JOSKOW: CONTRA CT DURA TION 179

TABLE 5-CONTRACT DURATION a

2SLS
LOG- LOG- ESTIMATE
Independent DURATION DURATION DURATION DURATION DURATION DURATION DURATION DURATION DURATION
Variables (1) (2) (3) (4) (5) (6) (7) (8) (9)
QUANTITY 0.7948 - - 0.5807 - - - - -
(0.1046) (0.0717)
QUANTITY-
SQUARED -0.0043 - - -0.0030 - - - - -
(0.00061) (0.0004)
LOG-QUANTITY - 11.8527 0.6733 - 8.4367 0.6340 8.2709 8.4505 8.5737
(1.5663) (0.0897) (1.0816) (0.0816) (1.0854) (1.0815) (3.5777)
MINE-MOUTH 16.5557 13.8763 0.2407 15.5484 14.4004 0.2736 14.1237 14.3841 15.4508
(4.2407) (3.8955) (0.5714) (2.9435) (2.7764) (0.4614) (3.0120) (2.7650) (2.1083)
MIDWEST 8.3650 8.1377 0.4493 5.0050 4.7042 0.5376 4.4397 4.7468 2.4404
(2.8188) (2.5461) (0.2281) (2.5018) (2.4511) (0.2763) (2.5221) (2.4820) (2.1797)
WEST 15.4864 13.8045 1.0500 11.7771 10.5506 1.0522 10.1238 10.4730 6.9477
(4.1940) (3.4244) (0.0500) (3.0124) (2.4220) (0.2416) (2.6136) (2.4095) (1.8329)
PLANT
PROPORTION - - - - - - 2.4401 - -
(3.7927)
UTILITY
PROPORTION - - - - - - -2.0043 - -
(3.1937)
PLANT/
UTILITY - - - - - - - 1.4626 -
(2.1945)
Constant -18.4532 - 35.6427 - 0.4699 - 6.9510 -19.0118 - 0.2789 -19.0377 - 19.7755 - 36.1521
(5.7203) (7.2690) (0.26709) (3.4094) (4.6758) (0.2448) (4.8545) (4.8645) (6.9717)
Log-Likelihood - 781.08 - 769.29 -174.29 - 475.17 - 466.99 - 101.60 - 466.68 - 466.83 - 451.38
Observations 277 277 255 169 169 160 169 169 169
aMaximum likelihood
estimates.
Standard ofcoefficient
errors estimates
areshownin parentheses.

TABLE 6-CONTRACT DURATION a

DependentVariable: DURATION
Independent WEST MIDWEST EAST EAST WEST MIDWEST EAST EAST
Variables (1) (2) (3) (4) (5) (6) (7) (8)

LOG-QUANTITY 3.4825 5.1249 4.2362 4.2968 3.5878 4.0269 4.408 4.4992

(1.0714) (0.7646) (0.4668) (0.4661) (1.0992) (0.6538) (0.5798) (0.5786)
MINE-MOUTH 18.4179 11.8107 - 17.6804 17.616 12.8372 - 17.0887
(2.5064) (5.1695) (3.7348) (2.3183) (3.6363) (3.8111)
Constant 6.819 1.365 - 0.3975 - 0.5265 7.2101 3.4075 0.4106 - 0.6028
(3.1610) (5.1695) (1.1159) (1.1151) (3.3441) (1.8264) (1.4256) (1.4246)
CorrectedR-squared 0.68 0.42 0.35 0.43 0.73 0.52 0.42 0.54
Observations 54 68 155 158 44 47 78 81
a OLS by region.Standarderrorsof coefficient
estimatesare shownin parentheses.

each coal supply region.35The samples do DURATION and LOG-QUANTITY. There

not include any mine-mouthplants using
eastern coal, so columns 3 and 7 simply
report the estimated relationshipbetween
35I reportonly this variantof equation (2) to con-
servespace. It should be clear by now thatthe alterna-
tive specificationsof (1), (2), and (3) do not yield any
importantdifferences in results.
are in fact a few mine-mouth plants in the
East and I have some information forthree
of them. These were not included in the
sample because the data base did not have
informationon annual contractquantities
for them. However, I was able to obtain
informationfordeliveredquantitiesforthree
eastern mine-mouthplants and have aug-

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180 THE AMERICAN ECONOMIC REVIEW MARCH 1987

mented the sample to include these plants, dependenton suppliesprovidedpursuantto

using deliveredquantitiesratherthan con- a specificcontract.These argumentsimply
tractquantitiesas thevalues forthe QUAN- thatvariablesmeasuringplantand/or utility
TITY variable.These resultsare reportedin "dependence" on a specificcontractshould
columns4 and 8 of Table 6.36 be introducedinto the contractdurationre-
The effectsof contractquantityand the lationship.
mine-mouthdummy on contractduration To examine this possibility,I have in-
are clearly not simplyassociated with the cluded variables in (2)37 that measure the
contractingbehaviorforcoal froma particu- fractionof a plant's requirements (PLANT
lar region.The expectedeffectsare foundin PROPORTION) and thefractionof thetotal
each of the threeregions.The coefficients
of coal requirementsof the utility(UTILITY
QUANTITY and MINE-MOUTH are of the PROPORTION) that operates the plant
expectedsignsand are estimatedpreciselyin whichare accountedforby a particularcon-
in the
all cases. While thereare differences tract. As an alternative,I also estimate(2)
magnitudesof the coefficientsof thesevari- introducinga variablethatis equal to total
ables betweenthe threeregions,theyare not plant utilization of coal divided by total
very large numericallyand equality of the utilityutilization of coal (PLANT/UTIL-
coefficientsof QUANTITY and MINE- ITY). I can estimatetheserelationships only
MOUTH across regionscannot be rejected for the contractsthat are for deliveryto a
at standard significancelevels. Contracts singleplant because it is onlyforthesecon-
basically simplyget longeras we move from tractsthatI can constructa meaningful mea-
East to West,otherthingsequal. sure of plant specificdependence(i.e., the
169 observationsubsamplemustbe used).
IV. AltemativeMeasureofAssetSpecificity The resultsare reportedin columns7 and
8 of Tables 3, 4, and 5. The coefficient
Clearly,the hypothesizedrelationshipbe- estimatesfor PLANT PROPORTION and
tween contract duration and the variables UTILITY PROPORTION are veryimpre-
that I have chosen to capturevariationsin cise. They are of opposite signs and are
asset specificity
is quite robustto alternative neitherindividuallynorjointlysignificant at
specifications,samples,and estimatingtech- conventionalsignificancelevels. The coeffi-
nique. Nevertheless,it is natural to ask cient of PLANT/UTILITY is also veryim-
whetherthere are alternativeor additional precise and varies in sign depending on
factorsthatmightexplaintheobservedvari- estimatingtechnique.Introducingthesevari-
ations in contractduration.One argument ables has no effecton the estimatesfor the
thathas been suggestedto me is thatit is not primaryvariables of interest.These results
only the size of the contractualcommitment implythat a plant or utilitythatrelieson a
that is likelyto be important,but also the single supplier for a large fractionof its
fractionof a plant's,and perhapstheutility's, requirements,or that depends heavilyon a
requirementsobtained froma specificcon- specificplant,does not encountersignificant
tract.The argumentis thatas a largerfrac- hold-up problemsper se. The lock-ineffect
tion of a plant's requirements is associated associated with designingplants to burn a
with a specific supplier, " physical asset particulartype of coal becomes a potential
specificity"attributesare likelyto be more contractualproblemonly to the extentthat
importantand lead to longer contracts.It the otherasset specificity are
characteristics
has also been suggestedto me that op- active.
portunismproblems are likely to be less
severeif the utilityas a whole is not heavily

37Includingthese variablesin (1) and (3) does not

36The inclusion of these three additional observa- change the results and I reportthe resultsfor (2) in
tions does not change the aggregateresults. order to conservespace.

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VOL. 77 NO. ] JOSKOW: CONTRACT DURATION 181

Quantity
V. Contract I estimatethe followingrelationshipusing
the single-plant(169 observation)subsample
Before concluding,it is usefulto explore to determineempiricallywhetherand how
the role of asset specificity in determining these considerationsaffectannual contract
annual contractquantitiessincethisvariable quantities.
plays such an importantrole in the contract
duration equation. A relationshipbetween (5) QUANTITY = c0
contractquantityand asset specificity poten-
tiallyemergesbecause of thepresenceof all + d1PLANT-QUANTITY
three types of asset specificity. First,other + d2PLANT-QUANTITYI
things equal, physical asset specificity
considerationssuggestthata plant operator + d3UTILITY-QUANTITY,
would like to rely on a specific supplier
producing a particulartype of coal at a + d4UTILITY-QUANTITY7
particularlocationto thegreatestextentpos-
sible.38This implies that contractquantity + d5MINE-MOUTHi
should vary directlywith the coal require-
ments of the individual plant (PLANT + d6MIDWEST, + d7WEST, + Vi-
QUANTITY).39 On theotherhand,themore
a utilitycomes to relyon a single supplier I expect d1, d3, d5, d6, and d7 to be
the morecostlya breachof contractmaybe. greaterthan zero, and d7 should be larger
This suggeststhata utilitymaybe willingto than d6.
relymoreon a singlesupplierforan individ- Equation (5) is estimatedin two different
ual plant the largeris totalutilityutilization ways. First, OLS estimatesare presented.
of coal (UTILITY QUANTITY) given the Second, OLS estimateswitha correctionto
utilizationof a specificplant. reflectthe possibilitythatI have a censored
Second, in the case of mine-mouth plants, sample are also presented.The OLS esti-
the nature of the ex ante location/invest- matesof the coefficients of (5) maybe biased
ment decision involvesthe mutualexpecta- as a result of the samplingproceduredis-
tion that all or most of a plant's require- cussed earlier.We observecontractquantity
ments will be taken from the proximate only if contractdurationis greaterthan or
supplier.This impliesthat the quantityper equal to (1979-contract YEAR), so we have
contractwillbe largerformine-mouth plants, a censored sample. This implies that the
otherthingsequal. random error (v) in the contractquantity
Finally,as discussedabove, whenutilities equation (5) may be correlatedwiththeran-
design plants to closely matchspecificcoal dom error(u) in thecontractdurationequa-
quality attributestheywill have an interest tion. If thisis the case, therandomerror(v)
in relyingmoreheavilyon a specificsupplier in the contractquantityequation will be a
who contractsto supply coal froma seam functionof the independentvariablesin the
withthesecharacteristics. This is likelyto be contract duration equation. The OLS esti-
an especially importantconsiderationfor mates of the coefficientsof the independent
coal suppliesfromthewesternregion. variablesin the quantityequation (5) would
thenbe biased if theyare correlatedwiththe
independentvariablesin the durationequa-
38One mightalso argue that,other thingsequal, a tion.In particular,independent variablesthat
buyerwould ratherrelyon a singlesupplierto conserve
on moretraditionaltypesof transactions cost associated appear in the contract duration equation
with negotiating,monitoring,and enforcingcontracts may appear to be significantwhen intro-
withmultiplesupplies. duced as independentvariablesin equation
39Ideally,we would like to look at specificgenerating (8) when in fact theyare not.40Since three
unitsratherthanspecificgeneratingplantswhereplants
have multipleunitswithdifferentdesigncharacteristics.
Unfortunately, coal supplyinformationis not available 40See George Judgeet al. (1985, pp. 610-13) and
at the generatingunitlevel. JamesHeckman (1976, 1979).

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182 THE AMERICAN ECONOMIC REVIEW MARCH 1987

TABLE 7-CONTRACT QUANTITYa

DependentVariable: QUANTITY
OLS OLS/H
IndependentVariables (1) (2) (3) (4)

PLANT QUANTITY 0.2501 0.3133 0.2128 0.2827

(0.0441) (0.1573) 0.0489 (0.1578)
PLANT QUA NTITY-
SQUA RED - -0.00066 - -0.00067
(0.0010) (0.00099)
UTILLITY QUANTITY 0.00349 0.0672 0.00393 0.06376
(0.00689) (0.0311) (0.00685) (0.03104)
UTILITY QUA NTITY-
SQUA RED - -0.00007 - -0.000063
(0.00003) (0.000032)
MINE-MOUTH 29.7932 27.1594 30.3261 27.775
(6.8591) (6.8997) (6.8251) (6.879)
WEST 13.5416 13.5865 8.4955 8.9738
(4.6437) (4.6259) (5.4680) (5.4597)
MIDWEST 5.2469 4.856 2.5832 2.4749
(4.1841) (4.1708) (4.4371) (4.4193)
H - - -66.7618 -60.6647
(38.7474) (38.5749)
Constant 1.7329 - 4.2283 10.6708 4.0997
(3.5879) (5.0515) (6.2951) (7.3027)
Corrected
R-Squared 0.33 0.34 0.34 0.35
Observations 169 169 169 169

estimatesare shownin parentheses.

aStandard errorsof coefficient

variables that appear in the quantityequa- sults are generallyconsistentwithmyexpec-

tion (5) also appear in thedurationequation,
thisis a potentialproblemhere.
We can obtain consistentestimatesof the
coefficientsof (5) by obtainingmaximum
likelihcodestimatesof a reduced-form con-
tractdurationequation41to generatea sam-
ple selectioncorrectionH foreach observa-
tion,adding theestimatedvalues of H to (5)
and thenestimatingtheaugmentedequation
(5) usingOLS. The coefficient of H is thena
consistentestimateof the covariance of u
and v.
The resultsare reportedin Table 7.42 The
OLS resultsappear in columns1 and 2 and
theOLS resultswithH introducedappear in
columns 3 and 4. In both cases, estimates
with and withoutquadratic termsin plant
and utilityquantitiesare reported.The re-
41QUANTITY and LOG-QUANTITY are treatedas
being endogenous.
42
The mean value forH is 0.076.
tations. Larger plants tend to place larger
ordersand utilitieswithlargeraggregatere-
quirementsdo so as well,althoughtheutility
effectis generallysmall. The quadratic in
plant quantityis not significantly different
fromzero.The coefficients of themine-mouth
dummyhas the predictedsign and is esti-
mated fairlyprecisely.Mine-mouthplants
have contractsthat are nearly 1.5 million
tons larger (30 trillionBtu's) than other
plants ceterisparibus.Regionaldifferencesin
supply characteristicslead to larger con-
tractswithwesternsuppliersthan withsup-
pliers elsewhere. The coefficientof the
correctionvariable H is negative,although
not quite significantat the 5 percentlevel
(two-tailedtest),implyingthatthe errorsin
the durationand quantityequationare nega-
tively correlated.Including this correction
does not have dramaticeffects on theresults
for the coefficientsof interest,
however.The
primaryeffectis to reduce the magnitude
and significance of thecoefficient
of WEST.

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VOL. 77 NO. I JOSKOW: CONTRACT DURA TION
Finally,for the record,I reporttwo-stage
least square (2SLS) estimatesof equation
(2) in Table 3, column9, and the equivalent
of two-stageleast squares forthe maximum
likelihoodestimatesof equation(2) in Table
5, column 9.43 The estimatesdo not change
in any importantway fromthose obtained
using the other estimatingtechniques in
eithercase.
VI. Conclusions
The purpose of this paper has been to
examine empiricallyhypothesesabout the
relationshipbetween the duration of coal
contractsand thepresenceof thethreetypes
of relationshipspecificinvestments
discussed
by Williamson
(1983).4 I arguethatas rela-
investmentsbecome more
tionship-specific
important,the partieswill findit advanta-
geous to rely on longer-termcontractsthat
specifythe termsand conditionsof repeated
43I assumed that LOG-QUANTITY is endogenous,
and use the right-handside variablesin (5) as instru-
mentsforthe 2SLS resultsreportedin Table 3, col. 9.
Obtainingtheequivalentof 2SLS estimatesforthecase
in whichI treatthe sample as being truncatedand use
maximumlikelihood techniques,is more complicated.
Following Maddala (pp. 234-40) and L. S. Lee et al.
(1979), I proceeded in the followingway. First,I esti-
mate a reduced-form durationequationusingmaximum
likelihood techniques.This allows me to obtain con-
sistentestimatesof Hi which can in turnbe used to
obtain consistentestimatesof a contractquantityequa-
tion as discussed above. I use these estimatesof the
quantityequation to obtainpredictedvalues of QUAN-
TITY or LOG-QUANTITY which are then used in
place of QUANTITY and LOG-QUANTITY to esti-
mate equations (1) and (2) using maximumlikelihood
techniques. The results reportedin Table 5, col. 9,
assume that log(PLANT QUANTITY), log(UTILITY
QUANTITY), MIDWEST, WEST, and MINE-
MOUTH are exogenousvariables.These variablesare
used to estimatea reduced-form durationequationusing
themaximumlikelihoodtechniquedescribedearlier.An
equation forlog(QUANTITY) is thenestimatedusing
log( PLA NT QUANTITY), log(UTILITY QUA N-
TITY), MIDWEST, WEST, MINE-MOUTH, and H
(generatedfrom the reduced-form durationestimates)
using OLS. The predictedvalues fromthisequationare
thenused insteadof LOG-QUANTITY in (2) to obtain
the maximumlikelihoodestimatesreported.Specifica-
tion (1) has also been estimatedusing this approach.
The resultsappear to be robust.
"As well as similar considerationsof transaction-
specificinvestments identified
by Klein et al.
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All use subject to JSTOR Terms and Conditions
183
transactionsex ante, ratherthan relyingon
repeated bargaining.I make use of a large
sample of coal contractsto examine this
hypothesis.The empiricalresultsobtained
provide fairlystrongsupport for this hy-
pothesis.They are quiterobustto alternative
model specifications,samples,and estimat-
ing techniques.The resultsthereforeprovide
additional empirical support for the view
that the structureof verticalrelationships
between buyers and sellers is stronglyaf-
fected by variationsin the importanceof
relationship-specific
investments.
APPENDIX
Here I discuss the sources of the data and the
constructionof the variables.The data base thatI rely
on was constructedfroma varietyof sourcesforuse in
a research project focusingon vertical relationships
betweenelectricutilitiesand coal suppliers.This is one
of threepapers thathas been producedso farfromthis
project.
The constructionof the data base began with the
choice of contractsto use in the analysis. Contracts
werechosenif theyappearedin boththe1981 and 1983
editionsof The Guideto Coal Contracts(Pasha Publica-
tions) and for which informationnecessary for the
project was reported.Contractshad to appear in both
publicationsbecause some information thatwas desired
appeared in one or the otherpublication,but not both.
This also made it possible to check for errorsand
inconsistenciesin the contractcharacteristicsreported.
To appear in both publications,contractshad to be in
forcein 1979. In fivecases, actual contractswere used
to supplement the data available from the primary
sources.
This collectionprocedureresultedin a sampleof 296
contracts(of which 277 had enoughinformation to be
used here) which generallyhad the followinginforma-
tion, some of whichis used in thispaper and some of
whichI am usingin relatedwork:
1. Informationrequired to calculate the agreed
upon durationof the contract(see discussionbelow).
2. Contractquantitiesfor1979,1980, and/or 1981
in tons.
3. The contractspecifications forthe Btu content
and the sulfurcontentof thecoal.
4. The identityof thesellerand thelocationof the
mine.
5. The identityof thebuyerand thedestinationof
the coal.
6. The base price for the coal at the time the
contractwas signed.
7. The actual price for the coal in 1979, 1980,
and/or 1981.
8. Deliveredquantitiesin 1979,1980,and/or 1981.
9. Actual Btu and sulfurcontentof thecoal.
Once the contractsample was selected,individual
contractswere matchedwithspecificutilitiesand power
184 THE AMERICAN ECONOMIC REVIEW
plants (wherepossible). Two publicationswere utilized
to obtain coal quantityand quality(Btu content)infor-
mation by plant and utility:Cost and Qualityof Fuels
for the Electric UtilityIndustry(U.S. Departmentof
Energy,variousyears)and Steam ElectricPlant Factors
(National Coal Association,variousyears). For public
utility holding companies, coal utilization for sub-
sidiaries was aggregated.Jointlyowned plants were
assignedto the operatingcompany.
The threecoal supplyregionsrepresentaggregations
of smallerU.S. Bureau of Mines (BOM) districts.The
West was definedas includingBOM districts16 through
23. The MidwestincludedBOM districts5, 9, 10, 11, 12,
14, and 15. BOM district15 includesTexas, but we have
no contracts for coal produced in Texas. The East
includes coal fromthe remainingBOM districts,pri-
marilyin Appalachia. The differences betweenregions
is discussed in more detail in my 1985 paper. The
KeystoneCoal IndustryManual (Mining Information
Services)and an atlas wereused to help locate minesin
specificBOM districts.
The variable definitionsand construction are as fol-
lows:
DURATION: Contract Duration: The contract
data base generallyprovidesinformationfor the date
the contractwas executed,the terminationdate and
(less frequently)the date of firstdeliveryof coal. A
specificmonth and year is oftenprovided,but some-
times the source specifiesonly years.Because the con-
tractexecutiondate was available moreoftenthan the
date of firstdeliveryand because the two are generally
quite close together,contractdurationwas measuredas
contractterminationyear minusexecutionyear. Initial
experimentation withdurationmeasuredusingthe date
of firstdeliveryor usingmonthand yearindicatedthat
the resultswere unaffected, so the definitionthatpre-
servedthe largestnumberof contractswas used.
QUANTITY: Annual contractquantityin trillion
Btu's. The contractedtonnagereportedfor1980 (if that
was not available,or obviouslynot representative, 1979
or, alternatively,1981 wereused instead)was multiplied
by the contractedBtu contentof the coal to arriveat
the contractquantityvariable.
MINE-MOUTH: Mine-mouthdummy variable
thatis equal to one if the plant is a mine-mouth plant
and zero otherwise.The information in my 1985 paper
combined with the coal destinationinformation in the
Guide To Coal Contractswas used to constructthis
variable.The Navajo and Mohave plantswereincluded
in thiscategoryas well since theyhave economicchar-
acteristicsverymuchlike a mine-mouth plant.
MID WEST: A regional dummy variable that
equals one if the coal is froma midwesternmine (as
definedabove) and zero otherwise.The contractdata
base providesinformation on minelocation.
WEST: A regional dummyvariable that equals
one if coal is froma westernmine (as definedabove)
and zero otherwise.
PLANT QUANTITY: Annual plant utilizationof
coal. Coal utilizationby a plant to which a specific
contractis dedicated (at least 90 percentof the coal
deliveredto a single plant) for 1980 (1979 or 1981 if
necessaryto match QUANTITY) in trillionBtu's. Ob-
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MARCH 1987
tained fromthe Departmentof Energyand National
Coal Associationpublicationsidentifiedabove.
UTILITY QUANTITY: Annual utilityutilization
of coal. Coal utilizationin 1980 (or 1979 or 1981 if
necessaryto matchotherdata) by theutilityoperatinga
plant to which a contractis dedicated.Obtained from
the Departmentof Energyand National Coal Associa-
tion publicationsidentifiedabove.
PLANT PROPORTION: Delivered contract
quantityin Btu's divided by plant utilizationin Btu's.
Delivered contractquantityin tonswas pulled fromthe
contractinformationfor1980 (or 1979 if 1980 was not
available), and multipliedby the deliveredBtu content
of the coal to obtain quantitiesdeliveredto a specific
plant under a contractdedicated to that plant. This
figurewas thendividedby PLANT QUANTITY.
UTILITY PROPORTION: Delivered contract
quantity in Btu's (as definedabove in definitionof
PLANT PROPORTION) dividedby utilityutilization
of coal in Btu's for1980 (1979 or 1981 otherwise).
PLANT/UTILITY: PLANT QUANTITY divided
by UTILITY QUANTITY.
YEAR: The yearspecifiedas theexecutiondate of
the contract.
DATE-71: A dummyvariablethatequals one for
contractssignedin 1971, 1972, and 1973.
DATE-74: A dummyvariablethatequals one for
contractssignedin 1974, 1975, 1976, and 1977.
DA TE-78: A dummyvariablethatequals one for
contractssignedin 1978 and 1979.
The mean, standarddeviation,minimum,and maxi-
mum values of these variablesforthe 277 observation
sample and the 169 observation(singledeliverypoint)
subsampleare containedin Tables 1 and 2. The data for
the variables used in this paper are available upon
request.
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