Relational Contracts and the Value of Loyalty

Abstract

This paper characterizes the optimal contract for a principal who repeatedly chooses among N potential agents under the threat of holdup. Over time, the principal would like to trade with different agents; however, the possibility of ex-post opportunism allows agents to collect rents and creates a fixed cost of initiating new relationships. In the optimal contract, the principal divides agents into “insiders” with whom she trades efficiently, and “outsiders” whom she is biased against. The optimal contract is self-enforcing if the principal is sufficiently patient and can be implemented by an “employment contract” that is robust to asymmetric information. JEL: C73, D82, D83, D86