The threat of future exclusion impacts implicit contracting

What is it about?

Principal-agent relationships in labor, credit and product markets often suffer from moral hazard. Implicit contracting can help overcome moral hazard through the threat of exclusion: the agent fears that he will lose future income if the principal breaks off the relationship. This threat may be very weak in environments where an agent can appropriate income-generating resources provided by the principal. For example, in credit markets with weak creditor protection, borrowers may be able to appropriate borrowed funds and generate investment income without requiring further loans. We examine implicit contracting in an experiment where the threat of exclusion is exogenously varied. We find that weak exclusion undermines implicit contracting: it leads to a more frequent breakdown of credit relationships as well as to smaller loans.

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Why is it important?

A large literature has studied implicit contracting theoretically and experimentally. The first contribution of our study is to provide evidence for an important condition for the success of implicit contracts: the threat of exclusion. The second contribution is to study the time-structure of implicit contracts: we find that relationships often "start small", but that such time pattern does not depend on the threat of exclusion.