SELF-ENFORCING AND DYNAMIC RELATIONAL CONTRACTS

The purpose of the research is to examine the methods and models used to study self-enforcing and relational contracts where economic relationships are not governed by an explicit, legally binding contract. In these circumstances agreements must be designed so that parties do not have an incentive to renege. The existing literature has developed somewhat separately across a range of areas and has made important contributions to the understanding of debates in the areas of development economics, capital structure theory, the equity premium puzzle, wage dynamics and political theory. There are two main strands to this literature, one concerned with risk-sharing and another that abstracts from risk aversion and studies the case where one of two agents can take some action which will affect joint payoffs. The aim of the project is to clarify and consolidate the existing theory and in particular to provide and develop a general and unifying theory that can be used to extend existing results The research will bring together these two strands and focus on the interaction between risk-sharing and effort incentives, a matter which plays a central role in standard contract theory. In addition it will allow for actions to be taken by each part and provide a much more general specification of what happens in the event of contract breach. It will therefore extend the recent relational contracts literature which looks at dynamic property rights by incorporating both uncertainty and limited liability and provide a richer and more detailed analysis of the contract dynamics. A range of applications will be considered.

Working relationships between parties that rely on trust rather than a legal contract tend to backdate payments to the party more likely to renege on the deal. Where both parties can vary the actions they take, one tends to invest too much at the early stages and the other too little. However the relationship

Contracts that depend on implicit understanding are key to economics
• In many areas of economics, relationships are not governed by an explicit, legally binding contract, but are subject to implicit understandings. Such contracts are said to be relational
• Agents will adhere to these implicit understandings if they can be structured in such a way that they become self-enforcing - the future benefits of adherence outweigh the short-term benefits from reneging
• The issue has relevance in areas such as wage dynamics in which workers have fairly stable wages while firms bear much of the risk associated with market fluctuations.
Back loading the rewards can act as a carrot for sticking to the deal
• Where one party (A) is more likely to renege on the contract, the payments are back loaded to the future to provide an incentive for A to stick to the deal
• The other party (B) is likely to limit their investment to reduce the incentive A has to back out. This has a knock-on effect on the efficiency of the contract
• Back loading in its strongest form – zero rewards for one player - only ever applies to one agent and only for an initial period. Eventually the contract should converge to a point where it is most efficient
• The second-best outcome is that the interests of the parties converge to a point where each is indifferent as to whether they adhere to or renege on the contract.
Over investment is an unexpected outcome
• Despite the pressure on one player to cut back on their investment to reduce the incentive of the other party to renege, the research shows that the other agent will
typically over-invest
• Even though it is more efficient to cut consumption than to increase investment, at the margin over-investment can enable to the other party to increase its investment sooner
• If one party ever finds itself over-investing, then their rewards will turn out to have back loaded.
Contracts converge to the self-enforcing state over time
• The contract converges over time to a stationary phase where the benefits depend on the current state and which maximises the net surplus for each party
• This convergence holds true even where the payments for default on the deal and production technologies vary over time, and even where the parties take action at different times from each other rather than simultaneously.
About the Study
This two-year study was carried out by Professor Jonathan Thomas of the Management School & Economics at the University of Edinburgh and Professor Tim Worrall of Keele University. Two papers based on the research are being disseminated as working papers and the research has been presented at nine conferences and seminars.
Key Words
Relational contracts, self-enforcing, back loading, convergence.