Transparency in relational contracts

Abstract

AbstractResearch SummaryWe model how an organization's transparency (toward employees or contractors) affects its ability to sustain relational governance. We show that transparency creates accountability: if the organization reneges on promises made to an agent, the other agents observe its defection and quit. Thus, transparency enables organizations with limited credibility to provide high‐powered incentives. However, transparency also triggers envious social comparisons that reduce profits and may erode its credibility benefit. In that case, the organization may find it optimal to appropriate a smaller share of a larger pie—that is, to elicit high effort from the envious agents by leaving them a rent. Social comparisons therefore create a tension between value creation and profitability, which may call for “sunshine laws” that force the organization to be transparent.Managerial SummaryOrganizational transparency (in pay and performance reviews) is often advocated but rarely used. Our paper provides a theoretical framework to evaluate the benefits and costs of transparency for organizations. Our model shows that transparent organizations are more accountable to their employees and partners, and hence more credible and trustworthy. At the same time, transparency triggers envious social comparisons among employees, which may reduce organizations' ability to capture value to the advantage of those employees. A managerial implication of our analysis, supported by preliminary evidence presented in the paper, is that organizations that aim to increase their employees' and contractors' trust benefit the most from transparency. A policy implication is that “sunshine laws” that impose transparency may enhance organizations' productivity, output, and value creation.