Long-Term Relationships Governed by Short-Term Contracts

Abstract

This paper studies the effect of contract duration on the incentive to make relationship-specific investments, when’ the parties to the relationship are rational. with perfect information and perfect foresight. and contracts are costlessly enforceable and complete, except that short—term contracts do not allow commitments to actions taken beyond the contract period. Whether contracting for less than the entire life of the relationship suffices for efficient relationship—specific investment is shown to depend on whether parties need their relationship for consumption-smoothing, and on the predominance. in the efficient plan. of investment that involves sunk costs over investment that does not. In the absence of asymmetric-information incentive problems. the duration of contracts affects investment decisions only when the relationship plays a consumption-smoothing role, and then only when efficiency requires mainly sunk—cost investment. In this case. short-term contracting has a general, but not universal, tendency to make parties invest too little in their relationship.