The Interaction of Explicit and Implicit Contracts: A Signaling Approach

Abstract

We analyze the interaction of explicit and implicit contracts in a model with sel fish and fair principals. Fair principals are willing to honor implicit agreements, whereas sel fish principals are not. Principals are privately informed about their types. We investigate a separating equilibrium in which principals reveal their type through the contract o er to the agent. If this equilibrium is played, explicit and implicit contracts are substitutes. Since the agent learns the principal's type, a sel fish principal has to rely on explicit incentives. A fair principal, by contrast, can eff ectively induce implicit incentives and hence does not need to use explicit incentives. Interestingly, if a sel fish principal can rely on more e ffective explicit incentives, a fair principal becomes more likely to be able to separate from the selfi sh type and, hence, to make better use of implicit incentives. In this sense, there is a strategic complementarity between explicit and implicit incentives.