Policy Commitments in Relational Contracts

How should an organization choose policies to strengthen its relationships with employees and partners? We explore how biased policies arise in relational contracts using a flexible dynamic game between a principal and several agents with unrestricted vertical transfers and symmetric information. If relationships are publicly observed, then optimal policies are never biased– they are always chosen to maximize total continuation surplus. In contrast, if relationships are bilateral– each agent observes only his own output and pay– then the principal may systematically choose backward-looking, history-dependent policies to credibly reward an agent who performed well in the past. We first show that biased policies are prevalent in a broad class of settings. Then we argue that biases can manifest in interesting ways in a variety of simple examples. For instance, hiring may lag demand following a recession, investments may be delayed and awarded ineffi ciently, and allocation decisions may "stick with" an ineffi cient worker.