No. 217: Authority in Relational Contracts with Asymmetric Information

This paper studies the allocation of decision rights in relational contracts where the agent privately observes his costs in each period. When the agent has authority to select the action, the presence of an adverse selection problem typically reduces the attainable surplus from the relationship, relative to the case of symmetric information. In contrast, under principal authority, we show that private information has zero impact on the attainable surplus. Specifically, the optimal action schedule derived under symmetric information remains implementable with private information. Accordingly, when contracts must be self-enforcing and are necessarily second best, private information reduces the attainable surplus if and only if the informed party has authority.