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Termination Clauses in Long‐Term Contracts

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  • Arijit Sen

Abstract

Many long‐term contracts incorporate a termination clause. This paper argues that when agents have hidden information, such a clause has a beneficial incentive effect—it enables a principal to screen agents' private information at a lower cost. In a two‐period model, this paper characterizes the optimal long‐term contract with a termination clause, which specifies that the principal will switch agents in the second period when the first‐period cost is high. The analysis delineates how the optimality of this clause depends on the intertemporal cost correlation structure, on the limits to agents' liability, and on the principal's degree of commitment.

Suggested Citation

  • Arijit Sen, 1996. "Termination Clauses in Long‐Term Contracts," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 5(4), pages 473-496, December.
    • Handle: RePEc:bla:jemstr:v:5:y:1996:i:4:p:473-496
    DOI: 10.1111/j.1430-9134.1996.00473.x
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    References listed on IDEAS

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    3. Stiglitz, Joseph E & Weiss, Andrew, 1983. "Incentive Effects of Terminations: Applications to the Credit and Labor Markets," American Economic Review, American Economic Association, vol. 73(5), pages 912-927, December.
    4. James J. Anton & Dennis A. Yao, 1987. "Second Sourcing and the Experience Curve: Price Competition in Defense Procurement," RAND Journal of Economics, The RAND Corporation, vol. 18(1), pages 57-76, Spring.
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    6. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
    7. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
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    Cited by:

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    3. Armstrong, Mark & Sappington, David E.M., 2007. "Recent Developments in the Theory of Regulation," Handbook of Industrial Organization, in: Mark Armstrong & Robert Porter (ed.), Handbook of Industrial Organization, edition 1, volume 3, chapter 27, pages 1557-1700, Elsevier.
    4. Ziesemer, Thomas, 2001. "Contract Prolongation In Innovation Production As A Principal-Agent Problem With Moral Hazard," Research Memorandum 036, Maastricht University, Maastricht Economic Research Institute on Innovation and Technology (MERIT).

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