Relational Adaptation in Contracts, Firms, and Other Governance Structures

Economic performance depends crucially on how parties adapt to changing circumstances. We therefore study how the organization of economic activity can facilitate such adaptation. We focus on settings where spot transactions would produce inefficient adaptation, so we ask whether alternative governance structures (allocations of control) facilitate relational contracts that improve on spot adaptation. In a general model, we show that the optimal governance structure for implementing a given relational contract minimizes the maximum aggregate reneging temptation created by that relational contract. In specific settings, we solve for the optimal relational contract (and hence governance structure), including in a setting where adaptation can be achieved by formal contract but at a cost. Our models explore why and how parties use formal governance structures to support self-enforcing relationships. We study this issue principally in contracts between firms, but the model also sheds light on “forebearance” within firms and relational contracting in “hybrid” governance structures.