Relational Contracts and the Theory of the Firm

Relational contracts—informal agreements sustained by reputational concerns—are prevalent both within and between firms. This paper develops repeated-game models of relational contracts that show how and why relational contracts within firms (vertical integration) differ from those between (non-integration). We show that integration affects the parties’ temptations to renege on relational contracts, and hence affects the best relational contract the parties can sustain. In addition, our results offer new explanations for why a widely varying supply price often leads to vertical integration, and why incentives in firms are “lower powered” than in markets. Finally, our results have implications for non-standard organizations (such as joint ventures, alliances, and networks) and the role of management within and between firms. *This paper was formerly entitled “Implicit Contracts and the Theory of the Firm.” We are grateful for research support from: the Division of Research at Harvard Business School (Baker); MIT’s Sloan School and Center for Innovation in Product Development, the NSF (through grant SBR-9809107), the Center for Advanced Study in the Behavioral Sciences (through a Fellowship funded in part by NSF grant SBR-9022192), and Cornell’s Johnson School (Gibbons); and USC’s Marshall School (Murphy). We thank Alexander Dyck, Oliver Hart, Bengt Holmstrom, Edward Lazear, Patrick Legros, Bentley MacLeod, John Matsusaka, Kevin Murdoch, Canice Prendergast, Julio Rotemberg, Mike Waldman, Mike Whinston, and especially Benjamin Klein for helpful comments. Relational Contracts and the Theory of the Firm by George Baker, Robert Gibbons, and Kevin J. Murphy