The Interaction of Explicit and Implicit Contracts: A Signaling Approach
25 Pages Posted: 2 Apr 2012 Last revised: 9 May 2014
Date Written: March 30, 2012
Abstract
We analyze the interaction of explicit and implicit contracts in a model with selfish and fair principals. Fair principals are willing to honor implicit agreements, whereas selfish principals are not. Principals are privately informed about their types. We investigate a separating equilibrium in which principals reveal their type through the contract oer to the agent. If this equilibrium is played, explicit and implicit contracts are substitutes. Since the agent learns the principal's type, a selfish principal has to rely on explicit incentives. A fair principal, by contrast, can effectively induce implicit incentives and hence does not need to use explicit incentives. Interestingly, if a selfish principal can rely on more effective explicit incentives, a fair principal becomes more likely to be able to separate from the selfish type and, hence, to make better use of implicit incentives. In this sense, there is a strategic complementarity between explicit and implicit incentives.
Keywords: explicit contracts, implicit contracts, separating equilibrium, substitutes, strategic complementarity
JEL Classification: D82, D86, M52
Suggested Citation: Suggested Citation