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Loss Aversion and Ex Post Inefficient Renegotiation

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  • Fabian Herweg
  • Klaus Schmidt

Abstract

We propose a theory of ex post inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegotiated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to renegotiate.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 4031.

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Date of creation: 2012
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Handle: RePEc:ces:ceswps:_4031

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Related research

Keywords: renegotiation; incomplete contracts; reference points; employment contracts; behavioral contract theory;

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References

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  1. Oliver Hart, 2009. "Hold-Up, Asset Ownership, and Reference Points-super-," The Quarterly Journal of Economics, MIT Press, vol. 124(1), pages 267-300, February.
  2. Alvin E Roth, 2008. "Axiomatic Models of Bargaining," Levine's Working Paper Archive 122247000000002376, David K. Levine.
  3. Hart, Oliver D. & Moore, John, 1990. "Property Rights and the Nature of the Firm," Scholarly Articles 3448675, Harvard University Department of Economics.
  4. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  5. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
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Cited by:
  1. Oliver Hart, 2013. "Noncontractible Investments and Reference Points," Games, MDPI, Open Access Journal, vol. 4(3), pages 437-456, August.
  2. Kohei Daido & Kimiyuki Morita & Takeshi Murooka & Hiromasa Ogawa, 2013. "Task Assignment under Agent Loss Aversion," Discussion Paper Series 103, School of Economics, Kwansei Gakuin University, revised Mar 2013.
  3. Maija Halonen-Akatwijuka & Oliver D. Hart, 2013. "More is Less: Why Parties May Deliberately Write Incomplete Contracts," NBER Working Papers 19001, National Bureau of Economic Research, Inc.
  4. Yusuke Mori, 2013. "A Formal Behavioral Model of Firm Boundaries: Why Does Authority Relation Mitigate Ex Post Adaptation Problems?," ISER Discussion Paper 0863, Institute of Social and Economic Research, Osaka University.

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