Relational Incentive Contracts
01 May 2003-The American Economic Review (American Economic Association)-Vol. 93, Iss: 3, pp 835-857
TL;DR: In this paper, the authors study the design of self-enforced relational contracts and show that optimal contracts often can take a simple stationary form, but that self-enforcement restricts promised compensation and affects incentive provision.
Abstract: Standard incentive theory models provide a rich framework for studying informational problems but assume that contracts can be perfectly enforced. This paper studies the design of self-enforced relational contracts. I show that optimal contracts often can take a simple stationary form, but that self-enforcement restricts promised compensation and affects incentive provision. With hidden information, it may be optimal for an agent to supply the same inefficient effort regardless of cost conditions. With moral hazard, optimal contracts involve just two levels of compensation. This is true even if performance measures are subjective, in which case optimal contracts terminate following poor performance. (JEL C73, D82, L14)
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01 Jan 2006TL;DR: In this article, the authors present a multi-disciplinary perspective to study endogenous institutions and their dynamics, including the influence of the past, the ability of institutions to change, and the difficulty to study them empirically and devise a policy aimed at altering them.
Abstract: It is widely believed that current disparities in economic, political, and social outcomes reflect distinct institutions. Institutions are invoked to explain why some countries are rich and others poor, some democratic and others dictatorial. But arguments of this sort gloss over the question of what institutions are, how they come about, and why they persist. They also fail to explain why institutions are influenced by the past, why it is that they can sometimes change, why they differ so much from society to society, and why it is hard to study them empirically and devise a policy aimed at altering them. This 2006 book seeks to overcome these problems, which have exercised economists, sociologists, political scientists, and a host of other researchers who use the social sciences to study history, law, and business administration. It presents a multi-disciplinary perspective to study endogenous institutions and their dynamics.
1,809 citations
1,361 citations
TL;DR: In this article, the authors develop repeated-game models showing why and how relational contracts within firms (vertical integration) differ from those between (nonintegration) and show that integration affects the parties' temptations to renege on a given relational contract, and hence affects the best relational contract the parties can sustain.
Abstract: Relational contracts—informal agreements sustained by the value of future relationships—are prevalent within and between firms. We develop repeated-game models showing why and how relational contracts within firms (vertical integration) differ from those between (nonintegration). We show that integration affects the parties' temptations to renege on a given relational contract, and hence affects the best relational contract the parties can sustain. In this sense, the integration decision can be an instrument in the service of the parties' relationship. Our approach also has implications for joint ventures, alliances, and networks, and for the role of management within and between firms.
1,311 citations
TL;DR: In this paper, a continuous-time principal-agent model is proposed, in which the output is a diffusion process with drift determined by the agent's unobserved effort, and the optimal mix of short-term and long-term incentives depend on the contractual environment.
Abstract: This paper describes a new continuous-time principal–agent model, in which the output is a diffusion process with drift determined by the agent’s unobserved effort. The risk-averse agent receives consumption continuously. The optimal contract, based on the agent’s continuation value as a state variable, is computed by a new method using a differential equation. During employment, the output path stochastically drives the agent’s continuation value until it reaches a point that triggers retirement, quitting, replacement, or promotion. The paper explores how the dynamics of the agent’s wages and effort, as well as the optimal mix of short-term and long-term incentives, depend on the contractual environment. The understanding of dynamic incentives is central in economics. How do companies motivate their workers through piece rates, bonuses, and promotions? How is income inequality connected with productivity, investment, and economic growth? How do financial contracts and capital structure give incentives to the managers of a corporation? The methods and results of this paper provide important insights to many such questions. This paper introduces a continuous-time principal–agent model that focuses on the dynamic properties of optimal incentive provision. We identify factors that make the agent’s wages increase or decrease over time. We examine the degree to which current and future outcomes motivate the agent. We provide conditions under which the agent eventually reaches retirement in the optimal contract. We also investigate how the costs of creating incentives and the dynamic properties of the optimal contract depend on the contractual environment: the agent’s outside options, the difficulty of replacing the agent, and the opportunities for promotion. Our new dynamic insights are possible due to the technical advantages of continuous-time methods over the traditional discrete-time ones. Continuous time leads to a much simpler computational procedure to find the optimal contract by solving an ordinary differential equation. This equation highlights the factors that determine optimal consumption and effort. The dynamics of the agent’s career path are naturally described by the drift and volatility of the agent’s pay-offs. The geometry of solutions to the differential equation allows for easy comparisons to see how the agent’s wages, effort, and incentives depend on the contractual environment. Finally, continuous time highlights many essential features of the optimal contract, including the agent’s eventual retirement. In our benchmark model a risk-averse agent is tied to a risk-neutral principal forever after employment starts. The agent influences output by his continuous unobservable effort input. The principal sees only the output: a Brownian motion with a drift that depends on the agent’s effort. The agent dislikes effort and enjoys consumption. We assume that the agent’s utility function has the income effect, that is, as the agent’s income increases it becomes costlier to compensate him for the effort. Also, we assume that the agent’s utility of consumption is bounded from below.
672 citations
Additional excerpts
...[26] Levin, J....
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TL;DR: In this paper, the authors define and compare elemental versions of four theories of the firm, which are distilled from important contributions by Hart, Holmstrom, Klein, Williamson, and others.
Abstract: In this essay, I define and compare elemental versions of four theories of the firm. These elemental theories are distilled from important contributions by Hart, Holmstrom, Klein, Williamson, and others. Although these contributions have been widely cited and much discussed, I have found it difficult to understand the commonalities, distinctions, and potential combinations of these seemingly familiar contributions. In this essay, therefore, I attempt to clarify these issues, in three steps: I begin with informal summaries of the theories, then turn to simple but formal statements of each elemental theory, and finally nest the four elemental theories in an integrative framework.
573 citations
Cites background from "Relational Incentive Contracts"
...A common approach to modeling such relational contracts is to use a repeated game, just as models of tacit collusion in industrial organization have used repeated games for several decades; see Levin (2003) for the state of the art....
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References
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8,910 citations
TL;DR: In this paper, a theory of costly contracts is presented, which emphasizes the contractual rights can by of two types: specific rights and residual rights, and when it is costly to list all specific rights over assets, it may be optimal to let one party purchase all residual rights.
Abstract: Our theory of costly contracts emphasizes the contractual rights can by of two types: specific rights and residual rights. When it is costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchases firm 2 when firm 1's control increases the productivity of its management more than the loss of control decreases the productivity of firm 2's management.
8,850 citations
TL;DR: In this article, the role of imperfect information in a principal-agent relationship subject to moral hazard is considered, and a necessary and sufficient condition for imperfect information to improve on contracts based on the payoff alone is derived.
Abstract: The role of imperfect information in a principal-agent relationship subject to moral hazard is considered. A necessary and sufficient condition for imperfect information to improve on contracts based on the payoff alone is derived, and a characterization of the optimal use of such information is given.
7,964 citations
TL;DR: In this paper, the potential of post-contractural apportunistic behavior for improving market efficiency through intra-firm rather than interfirm transactions is examined under the assumption that vertical costs will increase less than contracting costs as specialized assets and appropriable quasi rents increase.
Abstract: The potential of post-contractural apportunistic behavior for improving market efficiency through intrafirm rather than interfirm transactions is examined under the assumption that vertical costs will increase less than contracting costs as specialized assets and appropriable quasi rents increase. Vertical integration protects against the risk of contract cancellation and can create market power which is not generally referred to as monopoly. Contracts used as a alternative provide economically enforceable protection against opportunistic behavior. Solutions to opportunistic behavior problems can include joint ownership of common assets and condominium ownership of services. Economies of scale are major factors in some businesses, such as insurance. The complexities of ownership relations makes it difficult to assign higher costs to either the contract or vertical-integration approach. This suggests that economic analysis should be used to identify which is most advantageous for specific kinds of activities.
5,728 citations
TL;DR: In this article, a principal-agent model that can explain why employment is sometimes superior to independent contracting even when there are no productive advantages to specific physical or human capital and no financial market imperfections to limit the agent's borrowings is presented.
Abstract: Introduction In the standard economic treatment of the principal–agent problem, compensation systems serve the dual function of allocating risks and rewarding productive work. A tension between these two functions arises when the agent is risk averse, for providing the agent with effective work incentives often forces him to bear unwanted risk. Existing formal models that have analyzed this tension, however, have produced only limited results. It remains a puzzle for this theory that employment contracts so often specify fixed wages and more generally that incentives within firms appear to be so muted, especially compared to those of the market. Also, the models have remained too intractable to effectively address broader organizational issues such as asset ownership, job design, and allocation of authority. In this article, we will analyze a principal–agent model that (i) can account for paying fixed wages even when good, objective output measures are available and agents are highly responsive to incentive pay; (ii) can make recommendations and predictions about ownership patterns even when contracts can take full account of all observable variables and court enforcement is perfect; (iii) can explain why employment is sometimes superior to independent contracting even when there are no productive advantages to specific physical or human capital and no financial market imperfections to limit the agent's borrowings; (iv) can explain bureaucratic constraints; and (v) can shed light on how tasks get allocated to different jobs.
5,678 citations
"Relational Incentive Contracts" refers background or methods in this paper
...That situation is captured by Schmidt and Schnitzer (1995) using the multitask agency approach of Holmstrom and Milgrom (1991). Suppose qt = (q t , q 2 t ) has two components, q t measuring quantity that is verifiable and q 2 t measuring quality that is not, with ct (q t , q 2 t ) increasing in each argument....
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...Hörner (2002) focuses on non-revealing equilibria in which consumers leave a supplier as soon as they experience a bad outcome, all suppliers who have been supplying for the same length of time have the same price, and newly-entering good suppliers earn zero expected profits....
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