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Discretionary Latitude and Relational Contracting

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Author Info
Steven Y. Wu () (Ohio State University and IZA)
Brian E. Roe () (Ohio State University)

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Abstract

We use economic experiments to examine the nature of relational trading under a menu of incomplete contracts ranging from the repeat purchase mechanism of Klein and Leffler (1981) to highly incomplete contracts that are completely unenforceable by third-parties. Our results suggest that, with barriers to complete contracting, increasing the degree of contractual incompleteness can enhance efficiency. Intuitively, more incomplete contracts provide parties with greater discretionary latitude to reward and punish unenforceable performance factors. Moreover, trading under moderately incomplete contracts is characterized by efficiency wages, rent sharing and high levels of cooperation, whereas fully incomplete contracts that permit maximum discretion yield trading patterns that are closer what is observed under a perfectly complete contract. Our results are consistent with the theory of strategic ambiguity of Bernheim and Whinston (1998) and can be rationalized by a simple model of relational contracting that embeds different degrees of discretionary latitude.

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Publisher Info
Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 2879.

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Length: 47 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:iza:izadps:dp2879

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Related research
Keywords: relational contracts; implicit incentives; experimental economics; cooperation; incomplete contracts;

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Find related papers by JEL classification:
C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
K12 - Law and Economics - - Basic Areas of Law - - - Contract Law

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References listed on IDEAS
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  1. Ernst Fehr & Alexander Klein & Klaus M Schmidt, 2007. "Fairness and Contract Design," Econometrica, Econometric Society, vol. 75(1), pages 121-154, 01. [Downloadable!] (restricted)
    Other versions:
    • Ernst Fehr & Alexander Klein & Klaus M. Schmidt, 2005. "Fairness and Contract Design," Discussion Papers 67, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
  2. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-32, September. [Downloadable!] (restricted)
    Other versions:
  3. Georg Nöldeke & Klaus M. Schmidt, 1992. "Option Contracts and Renegotiation - A Solution to the Hold-Up Problem," Discussion Paper Serie A 417, University of Bonn, Germany, revised Aug 1993.
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  4. Daron Acemoglu & Simon Johnson, 2005. "Unbundling Institutions," Journal of Political Economy, University of Chicago Press, vol. 113(5), pages 949-995, October.
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  5. Kreps, David M. & Milgrom, Paul & Roberts, John & Wilson, Robert, 1982. "Rational cooperation in the finitely repeated prisoners' dilemma," Journal of Economic Theory, Elsevier, vol. 27(2), pages 245-252, August. [Downloadable!] (restricted)
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  9. Rubinstein, Ariel, 1991. "Comments on the Interpretation of Game Theory," Econometrica, Econometric Society, vol. 59(4), pages 909-24, July. [Downloadable!] (restricted)
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  12. George Baker & Robert Gibbons & Kevin J. Murphy, 2002. "Relational Contracts And The Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 39-84, February. [Downloadable!] (restricted)
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  14. Andreoni, James A & Miller, John H, 1993. "Rational Cooperation in the Finitely Repeated Prisoner's Dilemma: Experimental Evidence," Economic Journal, Royal Economic Society, vol. 103(418), pages 570-85, May. [Downloadable!] (restricted)
  15. Ginger Zhe Jin & Phillip Leslie, 2003. "The Effect Of Information On Product Quality: Evidence From Restaurant Hygiene Grade Cards," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 409-451, May. [Downloadable!] (restricted)
  16. MacLeod, W Bentley & Malcomson, James M, 1989. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Econometrica, Econometric Society, vol. 57(2), pages 447-80, March. [Downloadable!] (restricted)
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  17. John A. List, 2006. "The Behavioralist Meets the Market: Measuring Social Preferences and Reputation Effects in Actual Transactions," Journal of Political Economy, University of Chicago Press, vol. 114(1), pages 1-37, February. [Downloadable!] (restricted)
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  18. Schwartz, Alan, 1992. "Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies," Journal of Legal Studies, University of Chicago Press, vol. 21(2), pages 271-318, June.
  19. Avinash Dixit, 2003. "On Modes of Economic Governance," Econometrica, Econometric Society, vol. 71(2), pages 449-481, March. [Downloadable!] (restricted)
    Other versions:
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