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Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion

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  • Herweg, Fabian
  • Karle, Heiko
  • Müller, Daniel

Abstract

We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer’s expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer’s expectation management, our theory provides a rationale for “employment contracts†in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.

Suggested Citation

  • Herweg, Fabian & Karle, Heiko & Müller, Daniel, 2014. "Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 454, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  • Handle: RePEc:trf:wpaper:454
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    Cited by:

    1. Kohei Daido & Takeshi Murooka, 2016. "Team Incentives and Reference‐Dependent Preferences," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 25(4), pages 958-989, December.
    2. Kohei Daido & Tomoya Tajika, 2020. "Abstention by Loss-Averse Voters," Discussion Paper Series 205, School of Economics, Kwansei Gakuin University.
    3. Freeman, David J., 2017. "Preferred personal equilibrium and simple choices," Journal of Economic Behavior & Organization, Elsevier, vol. 143(C), pages 165-172.
    4. Canidio, Andrea & Karle, Heiko, 2022. "The focusing effect in negotiations," Journal of Economic Behavior & Organization, Elsevier, vol. 197(C), pages 1-20.
    5. Fabian Herweg & Klaus M. Schmidt, 2015. "Loss Aversion and Inefficient Renegotiation," Review of Economic Studies, Oxford University Press, vol. 82(1), pages 297-332.
    6. Dato, Simon & Grunewald, Andreas & Müller, Daniel, 2015. "Expectation-Based Loss Aversion and Strategic Interaction," Bonn Econ Discussion Papers 02/2015, University of Bonn, Bonn Graduate School of Economics (BGSE).
    7. Benjamin Balzer & Antonio Rosato, 2021. "Expectations-Based Loss Aversion in Auctions with Interdependent Values: Extensive vs. Intensive Risk," Management Science, INFORMS, vol. 67(2), pages 1056-1074, February.
    8. Balzer, Benjamin & Rosato, Antonio & von Wangenheim, Jonas, 2022. "Dutch vs. first-price auctions with expectations-based loss-averse bidders," Journal of Economic Theory, Elsevier, vol. 205(C).
    9. Dato, Simon & Müller, Daniel & Grunewald, Andreas, 2015. "Expectation-Based Loss Aversion and Strategic Interaction," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 112947, Verein für Socialpolitik / German Economic Association.

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    More about this item

    Keywords

    Behavioral Contract Theory; Expectation-Based Loss Aversion; Incomplete Contracts; Renegotiation;
    All these keywords.

    JEL classification:

    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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