Dynamic Relational Contracts under Complete Information

Jonathan Thomas and Timothy Worrall

Edinburgh School of Economics Discussion Paper Series from Edinburgh School of Economics, University of Edinburgh

Abstract: This paper considers a long-term relationship between two agents who both undertake a costly action or investment that together produces a joint benefit. Agents have an opportunity to expropriate some of the joint benefit for their own use. Two cases are considered: (i) where agents are risk neutral and are subject to limited liability constraints and (ii) where agents are risk averse, have quasi-linear preferences in consumption and actions but where limited liability constraints do not bind. The question asked is how to structure the investments and division of the surplus over time so as to avoid expropriation. In the risk-neutral case, there may be an initial phase in which one agent overinvests and the other underinvests. However, both actions and surplus converge monotonically to a stationary state in which there is no overinvestment and surplus is at its maximum subject to the constraints. In the risk-averse case, there is no overinvestment. For this case, we establish that dynamics may or may not be monotonic depending on whether or not it is possible to sustain a first-best allocation. If the first-best allocation is not sustainable, then there is a trade-off between risk sharing and surplus maximization. In general, surplus will not be at its constrained maximum even in the long run.

Keywords: relational contracts; self-enforcement; limited commitment; risk sharing (search for similar items in EconPapers)
JEL-codes: C61 C73 D86 D91 L14 (search for similar items in EconPapers)
Pages: 53
Date: 2014-06
New Economics Papers: this item is included in nep-cta and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Journal Article: Dynamic relational contracts under complete information (2018)
Working Paper: Dynamic Relational Contracts under Complete Information (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:edn:esedps:253

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