The Burden of Past Promises
Abstract: We explore the evolution of a firm's organization and performance. The owner and her employee play an infinitely repeated trust game in which the owner benefits from delegation only if the employee honors her trust by choosing her preferred project. The owner, however, cannot observe whether the project is available. We characterize the optimal relational contract and highlight two implications. First, profits decline over time as the firm's organization evolves from flexibility to rigidity. Second, which type of rigid organization the firm converges to—and thus its long-run profitability—is determined by random events in its early history.
