DP8195 Contracts as Threats: on a Rationale For Rewarding A while Hoping For B

Author(s):	Elisabetta Iossa, Giancarlo Spagnolo
Publication Date:	January 2011
Keyword(s):	Governance, incomplete contracts, multi-tasking, relational contracts
JEL(s):	C73, D86, L14
Programme Areas:	Industrial Organization
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=8195

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'.