Relational contracting, negotiation, and external enforcement

With Joel Watson and Trond E. Olsen

American Economic Review 110(7): 2153–2197, July 2020

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 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.

Free access: Published article and Supplementary material