DP16697 Contracts versus Communication

Author(s): Andreas Blume, Inga Deimen, Sean Inoue
Publication Date: November 2021
Keyword(s): authority allocation, cheap talk, communication, Contractual incompleteness, language constraints
JEL(s): D82, D83
Programme Areas: Organizational Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16697

We consider the trade-off a principal faces who has to choose between either controlling an agent's action through an incomplete contract or guiding him through non-binding communication. The principal anticipates receiving private information and must hire an agent to take an action on her behalf. Contracts can only specify a limited number of actions as a function of the state. The principal is at liberty not to specify actions for some of the states. States not covered by the contract induce a communication game. We show that close alignment of interests favors communication and, thus, ceding authority to the agent, while strong misalignment favors reliance on contracts. In the uniform-quadratic environment whenever an optimal contract induces influential communication, it splits the communication region: there are at least two communication actions separated by contract actions. For sufficiently closely aligned interests, it is also the case that communication splits the contract region: there are at least two contract actions separated by a communication action. The separation of distinct communication events relaxes incentive compatibility constraints and, therefore, helps equalize the size of communication events. This highlights the dual role of contracting as both substituting for and facilitating communication -- the principal uses contracts not only to impose her favorite actions, but also to structure communication.