Costly Contracting in a Long-Term Relationship

We examine a model of contracting where parties interact repeatedly and can contract at any point in time, but writing enforceable contracts is costly. A contract can describe contingencies and actions at a more or less detailed level, and the cost of writing a contract is proportional to the amount of detail. We consider both formal (externally enforced) and informal (self-enforcing) contracts. The presence of writing costs has important implications both for the optimal structure of formal contracts, particularly the tradeo¤ between contingent and spot contracting, and for the interaction between formal and informal contracting. Our model sheds light on these implications and generates a rich set of predictions about the determinants of the optimal mode of contracting. JEL classi…cation: D23, C73. KEYWORDS: writing costs, contingent vs spot contracting, formal vs informal contracts. Corresponding author: Giovanni Maggi, Department of Economics, Princeton University, Princeton NJ 08544. We thank Luca Anderlini, Mariagiovanna Baccara, Arnaud Costinot, Avinash Dixit, K…r Eliaz, Leonardo Felli, Edoardo Grillo, Eric Maskin, Bentley McLeod, Fabio Michelucci, Fausto Panunzi, David Pearce, Ludovic Renou, Joel Watson, the participants in conferences at Siena, Venezia, Ischia, Gertzensee and Lousanne, and the participants in seminars at Northwestern University, PUC Rio de Janeiro, the European University Institute, Bocconi University, DELTA, INSEAD, and the universities of Arizona, Helsinki, Jerusalem and Tel Aviv for helpful comments and discussions. Pierpaolo Battigalli thanks Bocconi University for …nancial support. Giovanni Maggi gratefully acknowledges …nancial support from the National Science Foundation. Both authors thank the NYU Stern School of Business for its hospitality during part of this project.