Discussion Paper Details

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Title: Contracts as Threats: on a Rationale For Rewarding A while Hoping For B

Author(s): Elisabetta Iossa and Giancarlo Spagnolo

Publication Date: January 2011

Keyword(s): Governance, incomplete contracts, multi-tasking and relational contracts

Programme Area(s): Industrial Organization

Abstract: Contracts often reward inefficient tasks and are not enforced ex post. We provide a new explanation based on the relationship between explicit contracts and implicit agreements, distinguishing the ex-ante decision to sign a contract from the ex-post decision whether to apply it. We show that it is often optimal to have overcontracting - contractual clauses requiring costly, inefficient, verifiable tasks (A) - not enforced in equilibrium. Overcontracting facilitates relational contracting on efficient non-contractible tasks (B) by anticipating and strengthening punishments following defections. With adverse selection, it is optimal to choose tasks A analogous to B in terms of required skills. The model also explains why stipulated damages must be moderate in size. These results apply independently of whether B is a `productive' task or a 'bribe'.

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Bibliographic Reference

Iossa, E and Spagnolo, G. 2011. 'Contracts as Threats: on a Rationale For Rewarding A while Hoping For B'. London, Centre for Economic Policy Research.