Relational contracts-informal agreements sustained by the value of future relationships-are prevalent within and between firms. We develop repeated-game models showing why and how relational contracts within firms (vertical integration) differ from those between (non-integration). We show that integration affects the parties' temptations to renege on a given relational contract, and hence affects the best relational contract the parties can sustain. In this sense, the integration decision can be an instrument in the service of the parties' relationship. Our approach also has implications for joint ventures, alliances, and networks, and for the role of management within and between firms.

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory-including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic-focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model. ECONOMISTS HAVE GROWN INCREASINGLY interested in the theory of the firmin recent years.1 These efforts have focused on the relations between markets and hierarchies, the influence of organization-specific assets, corporate governance systems, and the agency problems caused by conflicts of interest among the contracting parties that make up the firm. One of the more important, but least analyzed, factors affecting organizational behavior is the internal incentive structure which includes the management of human resources in general, and compensation policies in particular. A thorough understanding of internal incentives is critical to developing a viable theory of the firm, since they largely determine how individuals behave in organizations.Our economic understanding of internal incentive structures is far from complete. There has been an enormous amount of research in the economics of 593

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