Role of Information Rents in Relational Contracts

• Date: 01 December 2016
• Author: Akifumi Ishihara
• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/jems.12168

Role of Information Rents in Relational Contracts

AKIFUMI ISHIHARA

National Graduate Institute for Policy Studies

7-22-1, Roppongi, Minato, Tokyo, 106-8677, Japan

a-ishihara@grips.ac.jp

We study a repeated contracting model in which the agent has private information and the

performance measure is unverifiable. In an optimal stationary contract, when the discount factor

is not high, the principal’s objective shifts from purely reducing the information rent toward

increasing the total surplus to sustain the relational contract. As a result, the total surplus is

not monotonically increasing in the discount factor and could decrease when the unverifiable

performance measure becomes verifiable.

1. Introduction

Contracting parties in a long-term relationship often use relational contracts to resolve

incentive problems. Relational contracts are self-enforced, so that agreements do not

require terms to be verifiable. Nevertheless, the temptation to renege on agreements

causes a commitment problem, which limits the benefits of relational contracts.

When a party has private information, the following question arises from the

interplay between asymmetric information and relational contracting. On the one hand,

the literature of contract theory shows that a contract designer (principal) attempts to

screen asymmetric information, which generates an information rent for another party

holding private information (agent). In order to reducethe information rent, the principal

induces a socially inefficient (second best) outcome. On the other hand, sustainability of

relational contracts depends on the future benefits shared by the parties. In addition to

the theoretical argumentin the relational contracting model, recent empirical evidence by

Macchiavello and Morjaria (2015) argues that in the Kenyan rose industry, transacting

parties relying on informal agreements seriously concerned with the future benefits

to sustain relational contracts. Therefore, asymmetric information and commitment to

informal agreements have the opposite effects on the aggregate benefit. As a result,

asymmetric information has an ambiguous influence on social efficiency when parties

must also pay attention to the temptation to renege on relational contracts.

The aim of this paper is to clarify the trade-off between reduction in informa-

tion rent and sustainability of relational contracts. To address this issue, we develop an

infinitely repeated principal–agent model. In our model, the agent has ex ante private in-

formation on the cost that is independently drawn each period. The private information

affects the value of the relationship between the parties. In addition, the relationship is

valuable only when the agent makes an effort. The performance measure of the effort

This paper previously circulated under the title “The Interaction of Formal and Implicit Contracts with

Adverse Selection” and is a substantially revised chapter of my Ph.D. dissertation, submitted to London

School of Economics and Political Science. I am greatly indebted to Leonardo Felli and Andrea Prat for their

excellent supervision. I am grateful to the Co-Editor, anonymous referees, and the many persons who gave

me valuable suggestions and participants of the conferences and seminars where I presented this research.All

errors are my own.

C2016 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 4, Winter 2016, 936–957

Information Rents in Relational Contracts 937

is unverifiable so that it cannot be assessed by a third party. Hence, formal contracts

that can be enforced by a court cannot be contingent on the performance measure of the

effort. Thus, the parties use self-enforcing informal agreements based on unverifiable

measurements to overcome the incentive problem of the effort.

We characterize the principal’s optimal stationary equilibrium in which on the

equilibrium path, the principal offers the same contract repeatedly and the agent makes

a decision depending only on the current type.1Our analysis highlights the interaction

between the following two concerns held by the parties. First, the principal must deal

with information rents caused by the agent’s private information. Second, both parties

are concerned with the temptation to renege on the informal agreement. Since the prin-

cipal cares about both the value of the relationship and the incentive problem of the

effort, the degree of temptation to renege caused by the latter concern directly interacts

with the amount of the information rent generated by the former concern.

The principal’s optimal equilibrium can be classified into three categories: high,

intermediate, and low discount factor. In equilibrium, the principal optimizes her own

payoff subject to sustaining the relational contract. The informal agreements can be

honored if the sum of the discounted future total surplus shared by the parties exceeds

the agent’s current benefit generated by deviation from the equilibrium effort. If the

discount factor is low, then relational contracts are ineffective: there is no value in

the relationship between the parties because there is no way to provide the agent with

the incentive to make an effort. Conversely, if the discount factor is high, then relational

contracts work well enough to provide the right incentive for effort. Nevertheless, the

principal is still faced with hidden information and attempts to reduce the rent caused by

the agent’s private information. As in standard adverse selection problems, this concern

leads to the second best outcome, which is distorted from the first best.

Interestingly, the total surplus in the case of an intermediate discount factor is

greater than that for a high discount factor. When the discount factor is intermediate,

the outcome implemented in case of a high discount factor cannot be supported because

the sum of the discounted future total surplus is not sufficient to sustain the relational

contract. Hence, to ensure the credibility of relational contracts, the principal increases

the future total surplus by mitigating the inefficiency caused by the information rent

problem. In other words, when the discount factor shifts from a high to an intermediate

level, the principal’s objective changes from purely reducing the information rent to

sustaining the relational contract. This leads to a more efficient outcome than the second

best achieved in the case of a high discount factor.

Furthermore, we show that unverifiability improves the total surplus when the dis-

count factor is intermediate. Specifically, we compare the equilibrium described above

with one in which the performance measure of the effort is also verifiable. In the latter

case, the principal’s concern for sustaining the relational contract vanishes, and conse-

quently, the second best outcome can be implemented regardless of the discount factor.

It follows that for intermediate discount factors, the total surplus shared by the parties

is greater when the effort is unverifiable than when it is verifiable.2

In the analysis, we restrict our attention to the principal’s optimal equilibrium

in a class of trigger strategies of stationary mechanisms. One may cast a question on

the robustness of our result, especially, when the principal can offer a nonstationarity

1. In this strategy,the players use Nash reversion if they have previously reneged on an informal bonus.

2. The second best outcome is optimal for the principal although it is not socially efficient. Hence, the

payoff for the principal is greater in the verifiable case than in the unverifiable case.