Building Trust in Relational Contracting

Abstract

I study a relational contracting model, in which the agent's discount factor is fixed and known, whereas the discount factor of the principal is her private information. I find that, in the separating contract, information revelation is always immediate, whereas costly signaling continues for an extended period of time with at least some parameter values. I characterize the optimal separating contract. I find that, in the optimal contract of the "good" type, the bonus payment for high performance, the agent effort and the surplus in the relationship all increase gradually whereas the fixed wage decreases. Hence, optimal separation is characterized by "gradualism" in trade. There are numerous papers that generate similar results under the assumption of hidden information. However, the mechanism that gives rise to gradualism in my model is novel. Finally, I show that the optimal separating contract generates higher surplus than the optimal pooling contract regardless of the prior about the type of the principal.