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

  • Elisabetta Iossa

    (Brunel University; University of Rome 'Tor Vergata', CMPO, CEDI, EIEF)

  • Giancarlo Spagnolo

    (University of Rome 'Tor Vergata', SITE, EIEF, and CEPR)

Contracts often reward inefficient tasks and are not enforced ex post. We provide an explanation based on the relationship between explicit contracts and implicit agreements. We show that signing but then ignoring contractual clauses requiring costly, inefficient, verifiable tasks (A) may facilitate relational contracting on efficient noncontractible 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. We also explain 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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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1022.

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Length: 31 pages
Date of creation: 2008
Date of revision: Dec 2010
Handle: RePEc:eie:wpaper:1022
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