This dissertation applies relational contract theory to study the optimal incentive provision in situations when formal enforcement is too costly. Essay one considers a theoretical redistribution of bargaining power among business partners who trade repeatedly and that traditionally hold asymmetric power to negotiate contract terms. I included a bargaining process in a relational contracts model to analyze the economic consequences of shifting bargaining power under different enforcement regimes. The model predicts that as the agent's bargaining power increases, her incentive payments decrease even though her total compensation increases. Thus, efficiency wage contracts are more likely to be observed than contingent performance contracts in markets where agents have bargaining power. In contexts where enforcement is weak, a transfer of bargaining power can erode market efficiency in a dynamic relational contracting environment. If principals lose power coupled with the absence of enforcement, they may find the short-term gains of reneging on contractual promises more attractive than long-term benefits of faithfully executing a contract where they hold less power. As a consequence trade is more likely to break down. In this case, the agent is better off exercising less bargaining power than she has. Nonetheless, the model also predicts that such a collapse in good-faith execution of contracts in the light of such a power shift may not occur if some minimum payment for contract participation is enforced. Essay two provides experimental evidence on the theoretical predictions from essay one. I implement an experimental design that adjusts the bargaining power of sellers (agents) and the enforceability of the contract. I find that the vast majority of contracts take the form of efficiency wage contracts instead of contingent performance contracts when enforcement is partially incomplete and sellers have more bargaining power than buyers. The total contracted and actual compensation increase with the bargaining power of the sellers. However, sellers' profits are found to increase only if a part of the total payment is third-party enforceable. In this case, observed surplus and efficiency are lower than predictions. When no part of a contract is third-party enforceable, more cooperative relationships emerge, exhibiting higher quality provision resulting in higher surplus and efficiency while rent sharing is lower. The result is explained by the stronger buyer's deviation, confirming predictions from essay one. Essay three considers the application of relational contracts as a mechanism for the reduction of carbon emissions from deforestation and forest degradation (REDD). I compared the structure of the optimal relational contract in the presence of purely self-interested participants to the optimal structure when participants are motivated by other preferences including altruism, spite, inequality aversion or warm-glow concerns. I find that the optimal contract structure only differs from the benchmark case of self-interested agents when seller preferences are different than only profit-maximizing preferences or if either party is inequality averse. Moreover, I also show that the presence of other regarding preferences increases or decreases the likelihood of cooperation in the long-term relationship relative to the case of self-interested participants.
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