Policies in Relational Contracts

Abstract

We consider how a firm’s policies constrain its relational contracts. A policy is a sequence of decisions made by a principal; each decision determines how agents’ efforts affect their outputs. We consider surplus-maximizing policies in a flexible dynamic moral hazard problem between a principal and several agents with unrestricted vertical transfers and no commitment. If agents cannot coordinate to punish the principal following a deviation, then the principal might optimally implement dynamically inefficient, history-dependent policies to credibly reward high-performing agents. We develop conditions under which such backward-looking policies are surplus-maximizing and illustrate how they influence promotions, hiring, and performance. (JEL D21, D82, D86, M51)

Learning to game the system

“…As the principal fails to detect such a deviation, the game continues. In the continuation game, as long as the same metric is in place, the agent is privately informed about the task identities and adapts his best-response to the 10 In principle, the payo¤ pair (u 0 ; 0 ) could be supported by multiple equilibria, giving rise to distinct values of U (u 0 ; 0 ). In such case, we select the equilibrium with the lowest value of U (u 0 ; 0 ) since it is the one for which the agent's incentive constraint is easiest to satisfy.…”

“…Rayo, 2016) and, in particular, to the recent relational contracting literature that explains why a …rm's performance may deteriorate over time (Barron and Powell, 2019;Fong and Li, 2017;and Li and Matouschek, 2013). In these papers, organizational performance declines because privately observed negative shocks in the past constrain the organization's ability to make promises to its employees and, therefore, to motivate its workforce.…”

“…Finally, to check that (SE )s are satis…ed, note that: (i) By de…nition s 1 ; and increase u 1 while preserving (IC 1 ) and all other constraints in P, contradicting the fact that is solution. Now, observe that (10) implies that if under the optimal contract (IC 1 )…”

Productivity and credibility in industry equilibrium

“…Such theories do well at explaining observed distortions both on the entry/exit margin and, especially in developing countries, on the formal/informal sector margin. Moreover, there may be important interactions between credit‐market imperfections and a firm's inability to make credible promises to its workers (see, e.g., Barron, Li, and Zator, ).…”

Experimentation in organizations

“…Prendergast (1993) shows that promotions can facilitate unobservable investments in human capital. Barron and Powell (2019) show that a principal may implement biased promotions to credibly commit to rewarding a successful agent in a relational contract. In Board (2011), a principal delays rents to economize on the provision of incentives in a setting involving a hold‐up problem.…”