Costly contracting in a long‐term relationship

Abstract

We examine a model of contracting where parties interact repeatedly and can contract at any point in time, but writing enforceable contracts is costly. A contract can describe contingencies and actions at a more or less detailed level, and the cost of writing a contract is proportional to the amount of detail. We consider both formal (externally enforced) and informal (self-enforcing) contracts. The presence of writing costs has important implications both for the optimal structure of formal contracts, particularly the trade-off between contingent and spot contracts, and for the interaction between formal and informal contracting. Our model sheds light on these implications and generates a rich set of predictions about the determinants of the optimal mode of contracting.

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