The Role of Bargaining Power in Relational Contracts

Abstract

This paper studies the effect bargaining power has on self-enforcing contracts. Optimal contracts are characterized under three enforcement regimes. When enforcement is absent, I show that as the agent's bargaining power increases, her incentive payments decrease even though her total compensation increases. Thus, efficiency wage contracts are more likely to be observed than contingent performance contracts in markets where agents have bargaining power. Self-enforcement is sustainable for any distribution of bargaining power when contracts are partially enforceable. Yet, when contracts are too costly to enforce or not enforceable at all good faith agreements collapse if the agent holds all bargaining power. In this case, the agent is better off exercising less bargaining power than what she has.

Keywords: contracts, incomplete enforcement, bargaining power, distribution, institutions

JEL Classification: D86, K12, L14, O12, Q13