FOR 08 2018 ISSN : 1500-4066 May 2018 Relational Contracting , Negotiation , and External Enforcement

We study relational contracting and renegotiation in environments with external enforcement of long-term contractual arrangements. An external, long-term contract governs the stage games the contracting parties will play in the future (depending on verifiable stage-game outcomes) until they renegotiate. In a contractual equilibrium, the parties choose their individual actions rationally, they jointly optimize when selecting a contract, and they take advantage of their relative bargaining power. Our main result is that in a wide variety of settings, in each period of a contractual equilibrium the parties agree to a semi-stationary external contract, with stationary terms for all future periods but special terms for the current period. In each period the parties renegotiate to this same external contract, effectively adjusting the terms only for the current period. For example, in a simple principal-agent model with a choice of costly monitoring technology, the optimal contract specifies mild monitoring for the current period but intense monitoring for future periods. Because the parties renegotiate in each new period, intense monitoring arises only off the equilibrium path after a failed renegotiation. ∗Miller: University of Michigan; Olsen: NHH Norwegian School of Economics; Watson: UC San Diego. For helpful comments and encouragement, the authors thank Daniel Barron, Andy Skrzypacz, Nageeb Ali; organizers and participants at the 2016 Econometric Society Winter Meetings, the 2016 Stanford Institute for Theoretical Economics summer conference, the Northwestern Third Annual Conference on Relational Contracts (2017), and the 2018 American Economic Association Winter Meetings; as well as seminar participants at Cambridge INET Institute, Florida International University, Indiana University, Johns Hopkins Cary Business School, Kellogg, Konstanz, Michigan, NHH Norwegian School of Economics, Penn State, Princeton, Seoul National University, Shanghai Jiaotong University, Tulane, UCSD, and Washington. Watson thanks the NSF (SES-1227527) and UCSD for grant support. Long-term contractual relationships are typically governed by a combination of selfenforced arrangements (the parties’ coordinated behavior to reward and punish each other over time) and recourse to some degree of external enforcement such as provided by a court system. Macaulay (1963) famously observed that contractual relationships between U.S. firms were often structured with loosely specified legal terms that persisted over time, suggesting the importance of self-enforcement as well the expectation that parties would work things out should disagreements arise (Malcomson 2013). While the literature on relational contracting has generated insights on the self-enforced aspects of ongoing contractual relationships, it is important to also investigate the roles of external enforcement and the ever-present opportunity for parties to renegotiate all contractual terms. This paper presents the first model of ongoing relationships that explicitly accounts for recurring negotiations, self-enforcement, and external enforcement of long-term contractual provisions.1 We provide a general framework and foundational results for a wide range of settings with moral hazard. The modeling exercise identifies key features of optimal contracting and explains some actual practices, such as the interplay of long-run and shortrun contractual provisions, stationary contract terms, and the allocation of control rights. We view the contract between parties as having two components. The externally enforced part, which we call the external contract, prescribes how a court or other external referee is to intervene in the relationship. The self-enforced part, which we call the regime, specifies the parties’ individual productive actions over time, as well as their anticipated revisions of the external contract.2 Both the external contract and the regime are renegotiable. Though the productive technology is stationary, the parties’ ability to write an arbitrary long-term external contract introduces endogenous non-stationarity: In the current period, the external contract terms agreed upon previously can be changed only by mutual agreement and thus constitute a payoff-relevant state variable. A key question is whether the external contract should specify only stationary terms or should be non-stationary. The prior literature establishes that, without external enforcement, if the parties can pay monetary transfers that enter their payoffs linearly, then optimal behavior on the equilibrium path is stationary (see, e.g., Levin 2003; Miller and Watson 2013). 3 Introducing external A recent paper along the same lines, Kostadinov (2017), is discussed below. In the literature, external and self-enforced (internal) contractual elements are variously differentiated with words such as “explicit/implicit,” “formal/informal,” and “legal/relational. ” The terminology we prefer focuses attention on the source of the enforcement power. While the “legal/relational” terminology does so as well, we prefer to think of a “relational contract” as encompassing both an external contract and regime. In a stationary environment without external enforcement, a relational contract is defined as either a perfect public equilibrium (e.g., Levin 2003) or a contractual equilibrium (Miller and Watson 2013) of an infinitely repeated game. The latter concept explicitly incorporates bargaining and a theory of disagreement.