Economics serving society

Delegating relational contracts to corruptible intermediaries

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Marta Troya Martinez and Liam Wren-Lewis

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A wide range of important economic activities depend on self-enforcing informal `relational’ contracts. For instance, a firm may buy a good knowing that it cannot sue the other firm if the quality is low – instead high quality is maintained through threat of the firm not making any future purchases. Similarly, an employer may promise an employee a bonus in return for good performance, and if the employer reneges it risks the employee resigning. Trust and repeated interactions are essential in making these relational contracts work. Responsibility for relational contracts, however, is frequently delegated to intermediaries; firms delegate to managers, governments to bureaucrats. Such intermediaries may extract kickbacks in the form of bribes or nonmonetary private benefits. These forms of corruption cannot be legally enforced, and they are therefore also sustained by relational contracts.

If intermediaries are corruptible, how and when should relational contracts be delegated? Marta Troya Martinez and Liam Wren-Lewis investigate this question in a theoretical model where a relational contract is managed by a supervisor on behalf of a principal. The principal wishes the supervisor to contract relationally with the agent to encourage performance. A first insight from the model is that the two parts of the relational contract – the corrupt part and the productive part - interact with each other in important ways.There is a positive interaction, as the expected stream of future kickbacks allows the supervisor to credibly promise higher rewards, and these rewards may then be used to motivate greater performance. But there is also a negative interaction, as the supervisor must trade off inducing performance production and sustaining bribery when self-enforcement is a binding constraint. A further important contribution of the author’s paper is to analyze the costs and benefits of delegation for the principal. They find that, because the supervisor cares less than the principal about payments to the agent, delegation enhances credibility. A supervisor who cares too little about payments, however, will overpay in exchange for kickbacks. The principal therefore faces a trade-off when deciding how much the supervisor’s payoffs should be aligned with her own. Overall, corruption makes delegation costly for the principal, but when relational contracts are difficult this cost may be more than compensated for by the supervisor’s greater credibility.
The paper also finds that the relationship between the strength of relationship and production is not straightforward. This result has important implications for policies designed to reduce fraud or corruption in contexts where relational contracts are valuable. Many such policies involve disrupting relational contracts, for instance by encouraging competition or increasing personnel rotation. The results of the analysis suggest that, in some circumstances, weakening supervisor-agent relations may simultaneously cut corruption and improve output. In other circumstances, however, there will be a trade-off, and reducing corruption may come at the cost of holding back potentially productive relationships.

Original title: “Delegating relational contracts to corruptible intermediaries”
Published in: PSE Working paper n°2016-20
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