Policies in Relational Contracts
Abstract: How should a firm set policies--public decision plans that determine the roles of its employees, divisions, and suppliers--to strengthen its relationships? We explore whether and how a principal might bias the decisions she makes to foster relational contracts with her agents. To this end, we examine a flexible dynamic game between a principal and several agents with unrestricted vertical transfers and symmetric information. We show that if relationships are bilateral--each agent observes only his own output and pay--then the principal may optimally make decisions in a systematically backward-looking, history-dependent way in order to credibly reward agents who performed well in the past. We first show that these backward-looking policies are prevalent in a broad class of settings. Then we show by example how such policies might affect firm performance: for example, hiring might lag increases in demand or investment might be awarded in a biased tournament. In contrast to the game with bilateral relationships, we show that if monitoring is public, optimal policies never involve biased decisions.
