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Contracts as Reference Points

We argue that a contract provides a reference point for a trading relationship: more precisely, for parties' feelings of entitlement. A party's ex post performance depends on whether he gets what he is entitled to relative to outcomes permitted by the contract. A party who is shortchanged shades on performance. A flexible contract allows parties to adjust their outcome to uncertainty, but causes inefficient shading. Our analysis provides a basis for long-term contracts in the absence of noncontractible investments, and elucidates why "employment" contracts, which fix wage in advance and allow the employer to choose the task, can be optimal.

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Paper provided by Edinburgh School of Economics, University of Edinburgh in its series ESE Discussion Papers with number 170.

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Length: 66
Date of creation: Nov 2006
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Handle: RePEc:edn:esedps:170
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