Continuing Contracts

Parties often regulate their relationships through “continuing” contracts that are neither long-term nor short-term but usually roll over: a leading example is a standard employment contract. We argue that what distinguishes a continuing contract from a short-term (or fixed-term) contract is that parties apply notions of fairness, fair dealing, and good faith as they revise the terms of the contract: specifically, they use the previous contract as a reference point. We show that a continuing contract can reduce (re)negotiation costs relative to a short-term or long-term contract when there is uncertainty about future gains from trade. However, fair dealing may limit the use of outside options in bargaining and as a result parties will sometimes fail to trade when this is efficient. For-cause contracts, where termination can occur only for a good reason, can reduce this inefficiency.