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Contract Renewal

Consider a contract between two players, describing the payment an agent obtains from the principal, in exchange for a good or service supplied. At each point in time, either player may unilaterally demand a renegotiation of the contract, involving renegotiation costs for both players. Players’ payoffs from trade under the contract, as well as from a renegotiated contract, are stochastic, following the exponential of a L´evy process. It is argued that the optimal strategy for each player is to require a renegotiation when the contract payment relative to the outcome of a renegotiation passes a certain threshold, depending on the stochastic processes, the discount rate, and the renegotiation costs. There is strategic substitutability in the choice of thresholds, so that if one player becomes more aggressive by choosing a threshold closer to unity, the other player becomes more passive. If players may invest in order to reduce the renegotiation costs, there will be over-investment compared to the welfare maximizing levels.

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File URL: http://www.sv.uio.no/econ/english/research/unpublished-works/working-papers/pdf-files/2004/Memo-20-2004.pdf
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Paper provided by Oslo University, Department of Economics in its series Memorandum with number 20/2004.

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Length: 44 pages
Date of creation: 28 Oct 2004
Date of revision:
Handle: RePEc:hhs:osloec:2004_020
Contact details of provider: Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway
Phone: 22 85 51 27
Fax: 22 85 50 35
Web page: http://www.oekonomi.uio.no/indexe.htmlEmail:


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  1. Holden, Steinar, 1997. "Wage Bargaining, Holdout, and Inflation," Oxford Economic Papers, Oxford University Press, vol. 49(2), pages 235-55, April.
  2. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Econometrica, Econometric Society, vol. 62(2), pages 257-82, March.
  3. Oliver Hart & John Moore, 1985. "Incomplete Contracts and Renegotiation," Working papers 367, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Andersen, Torben M. & Stampe Christensen, Morten, 2002. "Contract renewal under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 26(4), pages 637-652, April.
  5. Martin J. Osborne & Ariel Rubinstein, 2005. "Bargaining and Markets," Levine's Bibliography 666156000000000515, UCLA Department of Economics.
  6. Lebow David E & Saks Raven E & Wilson Beth Anne, 2003. "Downward Nominal Wage Rigidity: Evidence from the Employment Cost Index," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-30, October.
  7. Danziger, Leif, 1983. "Price Adjustments with Stochastic Inflation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 24(3), pages 699-707, October.
  8. Caplin, A. & Leahy, J., 1992. "Aggregation and Optimization with State-Dependent Pricing," Harvard Institute of Economic Research Working Papers 1595, Harvard - Institute of Economic Research.
  9. repec:cup:cbooks:9780521637329 is not listed on IDEAS
  10. Caplin, Andrew S & Spulber, Daniel F, 1987. "Menu Costs and the Neutrality of Money," The Quarterly Journal of Economics, MIT Press, vol. 102(4), pages 703-25, November.
  11. Macleod, W.B. & Malcomson, J.M., 1991. "Investments, Hold Up and the Reform of Market Contracts," Cahiers de recherche 9114, Universite de Montreal, Departement de sciences economiques.
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