Simple relational contracts and the dynamics of social capital

Abstract

This article proposes a dynamic model to examine the structure of “simple” relational contracts, obeying realistic properties that can be easily understood and audited by both parties. In such relationships, the need to offer each supplier a large enough share of future business to deter cheating limits the number of relationships a buyer can sustain. Trade is thus restricted to durable relationships, a form of social capital. Nevertheless, exogenous stochastic shocks sometimes prevent suppliers from fulfilling their promises and relationships are constantly dissolving and later renewed. Moreover, the coming of a crisis, where stochastic shocks are more probable, can lead to the quick rupture of some relationships as there is less expected future business to incentivize all suppliers. New relationships can later be formed, but this takes time due to search frictions. This suggests new connections between the theory of relational contracting and the macroeconomic analysis of recessions.