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A Theory of Ex Post Inefficient Renegotiation

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  • Herweg, Fabian
  • Schmidt, Klaus M.

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 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 390.

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Date of creation: 04 Oct 2012
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Handle: RePEc:trf:wpaper:390

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Keywords: Renegotiation; Incomplete Contracts; Reference Points; Employment Contracts; Behavioral Contract Theory.;

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  1. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
  2. Oliver Hart & John Moore, 1988. "Property Rights and the Nature of the Firm," Working papers 495, Massachusetts Institute of Technology (MIT), Department of Economics.
  3. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  4. Alvin E Roth, 2008. "Axiomatic Models of Bargaining," Levine's Working Paper Archive 122247000000002376, David K. Levine.
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