The law and economics of relational contracts

Contracts form the web of the economy. The ability of parties to enter into voluntary contractual agreements is essential for economic exchange and prosperity. There are basically two devices that govern contracts: Contract law and norms. Contract law se ts the legal rules of exchanging parties' claims to entitlement, and courts enforce these rules. Norms, such as honesty and trustworthiness, set the rules where contract law falls short, and reputation effects enforce these rules. A contract governed by contract law is what economists denote a formal contract, while contracts governed by norms are denoted informal, or relational, contracts. The aim of the research project is to analyze how the interaction between formal contracts, legal institutions and relational contracts affect incentives within and between firms and the boundaries and scope of firms. We will develop theoretical models of formal and relational contracting that incorporate legal institutions, and conduct controlled experiments in ord er to test our theoretical predictions. The research project will develop new insight on how incentive design can promote social efficiency and how incentive schemes and intuitional features affect economic behavior. The current financial crisis shows that financial incentives and its affect on economic behavior must be understood in the context of its institutional environment. The research can potentially help firms to design better incentive schemes and provide policy advice to governments who consi der regulating incentive provision in the financial industry. The project will also provide policy implications for contract law and corporate law, and elucidate governments' outsourcing/privatization decisions. The main research challenge is to keep th e analytical models simple enough so that we are able to develop testable theoretical predictions, and to develop experimental designs suitable for testing the theoretical predictions.