Relational Contracts in a Persistent Environment

This paper studies relational contracts with partially persistent states, where the distribution of the state depends on the previous state. When the states are observable, with both exogenous and endogenous states, the optimal contract can be stationary, and an effort schedule can be implemented with a stationary contract if and only if it satisfies the IC constraint and the dynamic enforcement constraint. The paper shows how the joint surplus in the second best varies with the state. The paper then applies the results to study implications for markets where the principal and the agent can be matched with new partners