Relational Contracts: Public versus Private Savings

We study relational contracting with a risk-averse agent who thus has preferences for smoothing consumption over time. The agent has the ability to save to defer consumption (or to borrow). We compare principal-optimal relational contracts in two settings. The first where the agent’s consumption and savings decisions are private, and the second where these decisions are publicly observed. In the first case, the agent smooths his consumption over time, the agent’s effort and payments eventually decrease over time, and the balances on his savings account eventually increase. In essence, the relationship eventually deteriorates with time. In the second case, the relational contract can specify the level of consumption by the agent. The optimal contract calls for the agent to consume earlier than he would like, consumption and balances on the account fall over time, and effort and payments to the agent increase. We suggest that modeling informal/relational incentives on consumption/savings decisions is a pertinent alternative to the approach in existing literature on formal contracts in dynamic moral hazard.

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