An Active-Contracting Perspective on Equilibrium Selection in Relational Contracts

Miller andWatson (2013) introduced contractual equilibrium for repeated games with recurrent bargaining, axiomatizing how parties in a relational contract interpret the outcome of their negotiation. We show that modeling elements the previous literature used to study negotiation – elements that would seem to capture bargaining power and impose structure on equilibrium- actually do not affect the set of equilibrium payoffs, so that predictions depend on arbitrary equilibrium selection by the analyst. In contrast, contractual equilibrium puts equilibrium selection in the parties' hands, leading to sharp predictions. In a principal-agent setting, increasing the agent's bargaining power causes the equilibrium effort to rise, and play under disagreement depends on the history of effort choices.