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. The optimal contracts have properties similar to those of stationary contracts in Levin (Am Econ Rev 93:835–857, 2003), but stationary contracts are no longer optimal. This paper characterizes the optimal contracts. Then, the paper considers two types of persistent states and shows that in both cases the joint surplus in the second best increases with the state. A sufficient condition for stationary contracts to be optimal is provided.