Relational Incentive Contracts

Abstract

Standard incentive theory models provide a rich framework for studying informational 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 or supervisors. Firms regularly use such measures for compensation and promotion decisions. In a survey of law firm compensation by the consulting firm Altman Weil, Inc., 50 percent of law firms report using

A Theory of Contracts with Limited Enforcement

“…In the present context, the bilateral incentive problems comes from the ability of either party to breach the contract. In the relational contracting literature which is closer to our framework, pooling incentives on both sides of the relationship is also a common feature as it was shown by Levin (2003) in a different informational context.…”

“…18 Second, stationarity may be required if the buyer starts trading with several potential sellers at different points in time and no third-price discrimination across sellers is possible. Finally, Levin (2003) has also shown that stationary contracts remain optimal when types are independently drawn over time even under limited enforcement. Our analysis below unveils to what extent stationarity should be taken with a word of caution when types are persistent.…”

“…Our analysis below unveils to what extent stationarity should be taken with a word of caution when types are persistent. 15 We follow here Abreu (1988) and the literature on relational contracts (Levin 2003, Halac 2012 in specifying that the worst equilibrium is played following a breach.…”

Incentive Provision When Contracting is Costly

“…The higher the discount factor, the higher is the present value of the ongoing relationship relative to the present value of reneging on the contract. When this 'punishment'from reneging increases, the parties are able implement higher-powered incentives without running the risk of opportunism (see Levin, 2003).…”

“…Moreover, the large majority of 2 Schmidt and Schnitzer (1995) and Baker, Gibbons and Murphy (1994) analyze models with both veri…able and non-veri…able variables, but the veri…ability of a given action or signal is exogenously given. Other models that address the relationship between veri…able and non-veri…able variables are Bernheim and Whinston (1998) Levin (2003) who makes a de…nite treatment of relational contracts with asymmetric information. But neither of these papers open for costly contracting and probabilistic enforcement, like we do.…”