Relational Contracts and the Value of Loyalty

This paper examines how relational contracting affects the pattern of trade across the economy. We suppose a firm (principal) repeatedly chooses among of a set of potential trading partners (agents) under the threat of holdup. The possibility of ex–post opportunism allows agents to collect rents, which act like a fixed cost that the principal must pay when initiating a new relationship. The principal responds by dividing agents into “insiders”, with whom she has previously traded, and “outsiders”, with whom she has never traded. If the principal is sufficiently patient, the profit–maximising contract then uses insiders efficiently, while being biased against outsiders. This optimal strategy can be implemented by a “maintenance contract” that is robust to asymmetric information.