Relational Contracts, Multiple Agents and Correlated Performances

Ola Kvaløy (University of Stavanger)
Trond E. Olsen (Norwegain School of Economics)

Abstract: We analyze relational contracts between a principal and a set of risk neutral agents whose outputs are correlated. We first consider the case where individual outputs are non-observable, but where the agents' aggregate output can be observed. In this case, a team incentive scheme is optimal, where each agent is paid a bonus for aggregate output above a threshold. We show that if the team members' outputs are negatively correlated, more agents in the team can improve efficiency since the performance measure becomes more precise. We then consider the case where individual outputs are observable. A tournament scheme with a threshold is then optimal, where the threshold depends on an agent's relative performance. Finally, we compare the two cases and show that the principal may deliberately choose to organize production as a team where only aggregate output is observable. The team alternative is more likely to be superior under negatively correlated outputs.