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Exit Options in Incomplete Contracts with Asymmetric Information

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  • Bester, Helmut
  • Krähmer, Daniel

Abstract

This paper analyzes bilateral contracting in an environment with contractual incompleteness and asymmetric information. One party (the seller) makes an unverifiable quality choice and the other party (the buyer) has private information about its valuation. A simple exit option contract, which allows the buyer to refuse trade, achieves the first–best in the benchmark cases where either quality is verifiable or the buyer’s valuation is public information. But, when unverifiable and asymmetric information are combined, exit options induce inefficient pooling and lead to a particularly simplecontract. Inefficient pooling is unavoidable also under the most general form of contracts, which make trade conditional on the exchange of messages between the parties. Indeed, simple exit option contracts are optimal if random mechanisms are ruled out.

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Paper provided by Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich in its series Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems with number 251.

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Date of creation: Nov 2008
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Handle: RePEc:trf:wpaper:251

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Keywords: Incomplete Contracts; Asymmetric Information; Exit Options;

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Citations

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Cited by:
  1. Bester, Helmut & Münster, Johannes, 2013. "Subjective Evaluation versus Public Information," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 399, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  2. Tercieux, Olivier & Aghion, Philippe & Fudenberg, Drew & Holden, Richard & Kunimoto, Takashi, 2012. "Subgame-Perfect Implementation Under Information Perturbations," Scholarly Articles 11224965, Harvard University Department of Economics.
  3. Bester, Helmut & Krähmer, Daniel, 2013. "Exit options and the allocation of authority," Discussion Papers 2013/5, Free University Berlin, School of Business & Economics.
  4. Gilberto SERAVALLI, 2011. "Conflict, Contract, Leadership and Innovation: An Interdisciplinary View," Journal of Knowledge Management, Economics and Information Technology, ScientificPapers.org, vol. 1(6), pages 48, October.

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