Relational Contracting, Negotiation, and External Enforcement

Abstract

We study relational contracting and renegotiation in environments with external enforcement of long-term contractual arrangements. A long-term contract governs the stage games that the contracting parties will play in the future (depending on verifiable stage-game outcomes) until they renegotiate. In a contractual equilibrium, the parties choose their individual actions rationally, jointly optimize when selecting a contract, and exercise their relative bargaining power. Our main result is that in a wide variety of settings, the optimal contract is semi-stationary, with stationary terms for all future periods but special terms for the current period. In each period the parties renegotiate to this same contract. For example, in a simple principal-agent model with a choice of costly monitoring technology, the optimal contract specifies mild monitoring for the current period but intense monitoring for future periods. Because the parties renegotiate in each new period, intense monitoring arises only off the equilibrium path after a failed renegotiation. (JEL C73, C78, D23, D86)

Theoretical Foundations of Relational Incentive Contracts

“…Then b * is the transfer function that maximizes the players' joint value in the induced game in which all continuation values are inŴ (b). Kostadinov (2020), in work contemporaneous with Watson, Miller, and Olsen (2020), proved a similar result for a principal-agent setting with risk aversion, utilizing the PPE solution concept. In Kostadinov's model, the parties form a semistationary external contract specifying one bonus scheme for the first period and a second bonus scheme for all future periods.…”

“…Miller and Watson (2013) added an explicit account of bargaining and defined "contractual equilibrium" in general settings with self-enforcement. Finally Watson, Miller, and Olsen (2020) extended the theory to settings with external enforcement of long-term contracts. 3…”

“…The literature contains a variety of modeling exercises in which self-enforced and externally enforced terms interact, but most studies substantially limit the extent of external enforcement and/or make ad hoc assumptions about equilibrium selection. Here I'll sketch a special case of the general model of Watson, Miller, and Olsen (2020), which does not have such limitations and has the added benefit of including a recursive formulation of equilibrium values. It is a setting of active contracting and the solution concept is contractual equilibrium.…”

“…Fortunately, Watson, Miller, and Olsen (2020) provide a characterization result that applies to the model sketched here (their model is more general), greatly simplifying the analysis and helping to answer the questions just now posed. The optimal continuation contract c * , which the players select to achieve the level L * , is semistationary.…”

Balanced Scorecards: A Relational Contract Approach

“…Watson, Miller and Olsen (2020) analyse long term renegotiable court-enforced contracts, and show that it wil generally be optimal to renegotiate these contracts each period when in combination with relational contracts.…”