Relational Contracts and the Value of Relationships

Relational contracts can be used to provide incentives if the future value of a relationship between contracting parties is sufficiently large. But what happens if the relationship’s value is not commonly known? This paper studies optimal relational contract design in a principal-agent setting where the principal’s outside option is her private information. I show that incentive provision is always less efficient than under symmetric information. The source of the inefficiency depends on the allocation of bargaining power. If the principal has strong bargaining power, the high-outside-option-type wants to mimic the low-outside-option-type to provide strong incentives and then renege and walk away. If the agent has strong bargaining power, the low type wants to mimic the high type to receive a high transfer when the agent proposes compensation. Both types may want to mimic the other type simultaneously under some bargaining power distributions. I characterize when separation of types is optimal, how it occurs in equilibrium, and how this depends on the parties’ bargaining positions. Information may be revealed through default or rejection, which may occur immediately or gradually, and may be delayed.

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