Making and Breaking Promises when their Costs Are Private Information

We discuss how to maintain trust when promise-makers are privately informed about the costs of keeping their promises and efficient transfers are not feasible. To this end, we present a simplified version of the model in Li and Matouschek (2013) in which a principal and an agent are in an infinitely repeated relationship. The agent's effort and output are observable but not contractible and the principal is privately informed about the cost of paying the agent. We characterize the optimal relational contract, illustrate the methods used in solving games with one-sided asymmetric information and inefficient transfers, and discuss further applications.