Bilateral relationships governed by incomplete contracts

Abstract

This paper explores implications of interactions between noncontractibility of quality, multidimensional hidden information, switching costs and the frequency of trade on the terms of contracts in a buyer-seller setup. Optimal contractual arrangements are shown to consist of a sequence of two contracts with nondecreasing prices and nonincreasing quality and volume of exchange. In the absence of switching costs, an increase in the frequency of trade is absorbed by the first contract. For high frequencies of trade, switching costs may enhance welfare by improving the efficiency of screening through a better allocation of time between contracts. (JEL: L 14).