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Loss Aversion and Ex Post Inefficient Renegotiation

Author

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  • Fabian Herweg
  • Klaus Schmidt

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.

Suggested Citation

  • Fabian Herweg & Klaus Schmidt, 2012. "Loss Aversion and Ex Post Inefficient Renegotiation," CESifo Working Paper Series 4031, CESifo Group Munich.
  • Handle: RePEc:ces:ceswps:_4031
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    References listed on IDEAS

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    1. Hart, Oliver & Moore, John, 1990. "Property Rights and the Nature of the Firm," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1119-1158, December.
    2. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    3. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
    4. Alvin E Roth, 2008. "Axiomatic Models of Bargaining," Levine's Working Paper Archive 122247000000002376, David K. Levine.
    5. Oliver Hart, 2009. "Hold-up, Asset Ownership, and Reference Points," The Quarterly Journal of Economics, Oxford University Press, vol. 124(1), pages 267-300.
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    Citations

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    Cited by:

    1. Rajkamal Iyer & Antoinette Schoar, 2015. "Ex Post (In) Efficient Negotiation and Breakdown of Trade," American Economic Review, American Economic Association, vol. 105(5), pages 291-294, May.
    2. Oliver Hart, 2013. "Noncontractible Investments and Reference Points," Games, MDPI, Open Access Journal, vol. 4(3), pages 1-20, August.
    3. Francesco Passarelli & Guido Tabellini, 2017. "Emotions and Political Unrest," Journal of Political Economy, University of Chicago Press, vol. 125(3), pages 903-946.
    4. Gine,Xavier & Jacoby,Hanan G., 2016. "Markets, contracts, and uncertainty in a groundwater economy," Policy Research Working Paper Series 7694, The World Bank.
    5. Barkaoui, Ahmed & Dragicevic, Arnaud Z., 2016. "Nash bargaining and renegotiation with social preferences: case of the roundwood log supply contracts in the French timber market," Forest Policy and Economics, Elsevier, pages 90-100.
    6. Daido, Kohei & Morita, Kimiyuki & Murooka, Takeshi & Ogawa, Hiromasa, 2013. "Task assignment under agent loss aversion," Economics Letters, Elsevier, vol. 121(1), pages 35-38.
    7. Yusuke Mori, 2013. "A Formal Behavioral Model of Firm Boundaries: Why Does Authority Relation Mitigate Ex Post Adaptation Problems?," ISER Discussion Paper 0863, Institute of Social and Economic Research, Osaka University.
    8. Maija Halonen-Akatwijuka & Oliver D. Hart, 2013. "More is Less: Why Parties May Deliberately Write Incomplete Contracts," NBER Working Papers 19001, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

    renegotiation; incomplete contracts; reference points; employment contracts; behavioral contract theory;

    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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