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Standard incentive theory models provide a rich framework for studying informational problems but assume that contracts can be perfectly enforced. This paper studies the design of self-enforced relational contracts. I show that optimal contracts often can take a simple stationary form, but that self-enforcement restricts promised compensation and affects incentive provision. With hidden information, it may be optimal for an agent to supply the same inefficient effort regardless of cost conditions. With moral hazard, optimal contracts involve just two levels of compensation. This is true even if performance measures are subjective, in which case optimal contracts terminate following poor performance. (JEL C73, D82, L14)
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Incentive problems arise in many economic relationships. Contracts that tie compensation to performance can mitigate incentive problems, but writing completely effective contracts is often impractical.1 As a result, real-world incentives frequently are informal. Within firms, compensation and promotion often are based on difficult to verify aspects of performance such as teamwork, leadership, or initiative. Employees understand this without the precise details being codified in a formal contract and firms live up to their promises because they care about their labor market reputation.2 Similarly, firms often expect a level of flexibility and adaptation from suppliers that goes well beyond contractual requirements. The give and take of the relationship allows prices or details of delivery to adjust in response to specific circumstances.
The need for a relational contract is a matter of degree. Sovereign nations comply with trade agreements and repay foreign debt because they desire the continued goodwill of trading partners. Politicians have an incentive to assist large donors because they will need to raise money in future campaigns. On the other hand, when a firm contracts with its employees or other firms, or when a government agency regulates an industry, a formal contract may provide a reasonable starting point. In these cases, good faith allows for more flexibility and nuance in incorporating information.
Information plays the same role in relational contracting as in standard incentive theory. Better performance measures generate more effective incentives. But a relational contract can incorporate a much broader range of subjective information. For instance, the best gauge of employee performance is often the subjective evaluations of peers...