Discretionary Latitude and the Nature of Relational Contracting

Relational contracts typically combine explicit terms that are third-party enforceable with implicit components that can be adjusted at the parties’ discretion. While discretionary ex post adjustments lies at the heart of relational contracting, previous empirical research has been primarily motivated by the repeat purchase mechanism (RPM) of Klein and Leffler (1981), which is a relational contract that permits only limited discretionary latitude. We use economic experiments to compare the RPM against more general forms of relational contracts, such as those that allow for discretionary bonuses/deducts. Our results suggest that trading outcomes are profoundly impacted by simple alterations in discretionary latitude. In experiments where maximum discretion is allowed (i.e. the explicit contract is highly incomplete), trading patterns more closely resemble those observed under complete contracts rather than those observed under the RPM. Thus, efficiency wages, generous rent sharing, and/or reputation based trading, which occur under the RPM, may not be general features of relational trading. Our results also provide support for the theory of strategic ambiguity of Bernheim and Whinston (1998); i.e. if there are barriers to complete contracting, then increasing the degree of contractual incompleteness may increase efficiency.