DP12645 | Supervising Relational Contracts

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Relational contracts are often studied as being between a principal and agent, such as an employer and an employee. But what happens when the relationship is managed by a supervisor, such as a manager? We develop a theory of supervised relational contracts and show that relational side payments between the supervisor and agent change the equilibrium contract in important ways. First, side payments facilitate the supervisor's commitment, potentially enabling levels of effort the principal could not achieve directly. Second, more valuable relationships may sustain more collusion, and hence produce less effort. We also analyze how the principal should bound the supervisor's discretion, and show that the principal benefits from entrusting a relationship to a supervisor when relational contracts are difficult.