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Contract Renegotiation in Agency Problems

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  • Aaron S. Edlin
  • Benjamin E. Hermalin

Abstract

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.

Suggested Citation

  • Aaron S. Edlin & Benjamin E. Hermalin, 1997. "Contract Renegotiation in Agency Problems," NBER Working Papers 6086, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:6086
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    References listed on IDEAS

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    Cited by:

    1. Georg Noeldeke & Klaus Schmidt, 1998. "Sequential Investments and Options to Own," RAND Journal of Economics, The RAND Corporation, vol. 29(4), pages 633-653, Winter.
    2. Amin, Mohammad & Mattoo, Aaditya, 2006. "Can guest worker schemes reduce illegal migration ?," Policy Research Working Paper Series 3828, The World Bank.

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    More about this item

    JEL classification:

    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights

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