Even up: Maintaining relationships

When are economic interactions mediated by prices and transfers, and when are they mediated by variations in the continuation payoffs within a relationship? To address this question, we examine a relationship between two players who periodically face opportunities to undertake randomly generated “projects” that impose a cost on one player and a benefit on the other, as well as opportunities to make voluntary transfers to one another. We characterize the set of equilibria, with particular emphasis on the efficient frontier. In the absence of transfers, incentives are often created by adjusting the continuation values of the relationship, sometimes increasing player 1’s continuation payoff (to induce player 1 to accept a particularly costly current project) and sometimes increasing player 2’s continuation payoff. In contrast, once transfers enter the picture, continuation payoffs maximize the sum of the two players’ payoffs, no matter how asymmetric the point on the Pareto frontier under consideration. However, transfers can also be relatively rare, and in particular can occur less often than the adjustments in continuation values that occur without transfers. Players thus rely on transfers to create incentives, but manage to do so while rarely making transfers.