Abstract: Long-term relationships are often governed by a combination of contracts and informal agreements. When contracts are long-term, their renegotiation can become part of the implicit agreement formed in equilibrium. In a principal-agent model with observable but noncontractible effort, the first best outcome can be sustained by signing contracts with the intention of renegotiating them. Continuation contracts are used to punish deviations from the implicit agreement with arbitrary severity. If no players deviate, these contracts are renegotiated away. Two-period contracts are sufficient to implement the first best outcome regardless of the patience of the players and the output technology.
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