Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion
AbstractWe 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 buyerâ€™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 buyerâ€™s expectation management, our theory provides a rationale for â€œemployment contractsâ€ 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.
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Bibliographic InfoPaper 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 454.
Date of creation: 13 Feb 2014
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Behavioral Contract Theory; Expectation-Based Loss Aversion; Incomplete Contracts; Renegotiation;
Other versions of this item:
- Fabian Herweg & Heiko Karle & Daniel Müller, 2014. "Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion," CESifo Working Paper Series 4687, CESifo Group Munich.
- 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2014-03-08 (All new papers)
- NEP-CTA-2014-03-08 (Contract Theory & Applications)
- NEP-GTH-2014-03-08 (Game Theory)
- NEP-MIC-2014-03-08 (Microeconomics)
- NEP-UPT-2014-03-08 (Utility Models & Prospect Theory)
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