Policies in Relational Contracts

We consider how a firm’s policies constrain its relational contracts. A policy is a sequence of decisions made by a principal; each decision determines how agents’ efforts affect their outputs. We consider surplus-maximizing policies in a flexible dynamic moral hazard problem between a principal and several agents with unrestricted vertical transfers and no commitment. If agents cannot coordinate to punish the principal following a deviation, then the principal might optimally implement dynamically inefficient, history-dependent policies to credibly reward high-performing agents. We develop conditions under which such backward-looking policies are surplus-maximizing and illustrate how they influence promotions, hiring, and performance. (JEL D21, D82, D86, M51)