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Contract Renegotiation in Agency Problems

  • Aaron S. Edlin
  • Benjamin E. Hermalin

This paper studies the ability of an agent and a principal to achieve the first-best outcome when the agent invests in an asset that has greater value if owned by the principal than by the agent. When contracts can be renegotiated, a well-known danger is that the principal can hold up the agent, undermining the agent's investment incentives. We begin by identifying a countervailing effect: Investment by the agent can increase his value for the asset, thus improving his bargaining position in renegotiation. We show that option contracts will achieve the first best whenever this threat-point effect dominates the holdup effect. Otherwise, achieving the first best is difficult and, in many cases, impossible. In such cases, we show that if parties have an appropriate signal available, then the first best is still attainable for a wide class of bargaining procedures. A noisy signal, however, means that the optimal contract will involve terms that courts might view as punitive and so refuse to enforce.

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File URL: http://www.nber.org/papers/w6086.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6086.

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Date of creation: Jul 1997
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Publication status: published as Edlin, Aaron S. and Benjamin E. Hermalin. "Contract Renegotiation And Options In Agency Problems," Journal of Law, Economics and Organization, 2000, v16(2,Oct), 395-423.
Handle: RePEc:nbr:nberwo:6086
Note: LE
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  1. Rabin, Matthew, 1993. "Incorporating Fairness into Game Theory and Economics," American Economic Review, American Economic Association, vol. 83(5), pages 1281-1302, December.
  2. Gary S. Becker, 1974. "Crime and Punishment: An Economic Approach," NBER Chapters, in: Essays in the Economics of Crime and Punishment, pages 1-54 National Bureau of Economic Research, Inc.
  3. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Scholarly Articles 12375014, Harvard University Department of Economics.
  4. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August.
  5. Nöldeke, Georg & Schmidt, Klaus M., 1998. "Sequential investments and options to own," Munich Reprints in Economics 19327, University of Munich, Department of Economics.
  6. Hart, Oliver D & Moore, John, 1988. "Incomplete Contracts and Renegotiation," Econometrica, Econometric Society, vol. 56(4), pages 755-85, July.
  7. Che, Y.K. & Chung, Y.T., 1996. "Contract Damages and Cooperative Investments," UWO Department of Economics Working Papers 9612, University of Western Ontario, Department of Economics.
  8. Drew Fudenberg & Jean Tirole, 1988. "Moral Hazard and Renegotiation in Agency Contracts," Working papers 494, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. Hermalin, Benjamin E & Katz, Michael L, 1993. "Judicial Modification of Contracts between Sophisticated Parties: A More Complete View of Incomplete Contracts and Their Breach," Journal of Law, Economics and Organization, Oxford University Press, vol. 9(2), pages 230-55, October.
  10. Nöldeke, Georg & Schmidt, Klaus M., 1995. "Option contracts and renegotiation: A solution to the Hold-Up Problem," Munich Reprints in Economics 19329, University of Munich, Department of Economics.
  11. Chung, Tai-Yeong, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 1031-42, October.
  12. Ma, C.A., 1991. "Renegotiation and Optimality in Agency Contracts," Papers 29, Stanford - Institute for Thoretical Economics.
  13. Che, Y.K. & Hausch, D.B., 1996. "Cooperative Investments and the Value of Contracting: Coase vs Williamson," Working papers 9608, Wisconsin Madison - Social Systems.
  14. Hermalin, Benjamin E & Katz, Michael L, 1991. "Moral Hazard and Verifiability: The Effects of Renegotiation in Agency," Econometrica, Econometric Society, vol. 59(6), pages 1735-53, November.
  15. Joel S. Demski & David E.M. Sappington, 1991. "Resolving Double Moral Hazard Problems with Buyout Agreements," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 232-240, Summer.
  16. B. Douglas Bernheim & Michael D. Whinston, 1997. "Incomplete Contracts and Strategic Ambiguity," Harvard Institute of Economic Research Working Papers 1787, Harvard - Institute of Economic Research.
  17. Rogerson, William P, 1992. "Contractual Solutions to the Hold-Up Problem," Review of Economic Studies, Wiley Blackwell, vol. 59(4), pages 777-93, October.
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