Long-Term Relationships Governed by Short-Term Contracts

This paper studies the effect of contract duration on the incentive to make relationship-specific investments, when' the parties to the relationship are rational. with perfect information and perfect foresight. and contracts are costlessly enforceable and complete, except that short-term contracts do not allow commitments to actions taken beyond the contract period. Whether contracting for less than the entire life of the relationship suffices for efficient relationship-specific investment is shown to depend on whether parties need their relationship for consumption-smoothing, and on the predominance. in the efficient plan. of investment that involves sunk costs over investment that does not. In the absence of asymmetric-information incentive problems. the duration of contracts affects investment decisions only when the relationship plays a consumption-smoothing role, and then only when efficiency requires mainly sunk-cost investment. In this case. short-term contracting has a general, but not universal, tendency to make parties invest too little in their relationship.