Lecture Note 2 Relational Contracts1

Game theory is rampant in economics. Having long ago invaded industrial organization (the sub-field of economics that studies firms and their product markets), game-theoretic modeling is now commonplace in international, labor, macro, and financial economics, and is gathering steam even in development economics and economic history. Nor is economics alone: accounting, law, marketing, political science, and even sociology are beginning similar experiences. Why is this? Broadly speaking, two views are possible: fads and fundamentals. While I believe that fads are partly to blame for the current enthusiasm for game theory, I also believe that fundamentals are an important part of the story. Simply put, many economists use game theory because it allows them to study the implications of rationality, self-interest, and equilibrium when the theory of perfect competition does not apply—such as where markets are imperfectly competitive, or where markets are only peripherally relevant (such as in the relationship between a regulator and a firm or a boss and a worker). By my armchair citation count, repeated games have been applied more broadly than any other game-theoretic model—not only in economics but also in other social sciences and management fields. I believe this is because repeated games capture the following fact of life: when people interact over time, threats and promises concerning future behavior may influence current behavior. I do not mean to imply that this logic is surprising or rare. To the contrary, I think it is simple and ubiquitous. In this note I present the simplest possible formalization of this logic. I first describe a one-shot interaction between two parties (which works out badly) and then analyze an ongoing relationship in which such interactions occur repeatedly (and work out well because of the parties ’ concerns for their reputations). The ongoing-relationship model shows how repeated games allow economists to analyze some aspect