Rulebooks in Relational Contracts
Jin Li, Arijit Mukherjee and Luis Vasconcelos, UTS
Abstract: Firms can accrue large benefits by fostering worker initiative, but standardized work rules are still widely used. We present a model of relational incentives where the use of rules fluctuates over time as the firm faces shocks to its credibility. Worker initiative in adapting to local information can ensure production efficiency but also requires strong incentives. As shocks weaken relational incentives, the firm may adopt rules that yield satisfactory (though suboptimal) performance. Rules help the relationship survive the shocks, but the relationship becomes less efficient in the future. While the relationship may recover, its ability to weather future shocks deteriorates.