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Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion

  • Herweg, Fabian
  • Karle, Heiko
  • Müller, Daniel

We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer’s expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer’s expectation management, our theory provides a rationale for “employment contracts†in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.

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Paper provided by Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich in its series Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems with number 454.

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Date of creation: 13 Feb 2014
Date of revision:
Handle: RePEc:trf:wpaper:454
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  1. J. Luis Guasch, 2004. "Granting and Renegotiating Infrastructure Concessions : Doing it Right," World Bank Publications, The World Bank, number 15024.
  2. John A. List, 2011. "Does Market Experience Eliminate Market Anomalies? The Case of Exogenous Market Experience," American Economic Review, American Economic Association, vol. 101(3), pages 313-17, May.
  3. Karle, Heiko & Kirchsteiger, Georg & Peitz, Martin, 2013. "Loss Aversion and Consumption Choice: Theory and Experimental Evidence," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79943, Verein für Socialpolitik / German Economic Association.
  4. John A. List, 2003. "Does Market Experience Eliminate Market Anomalies?," The Quarterly Journal of Economics, Oxford University Press, vol. 118(1), pages 41-71.
  5. Hoppe, Eva I & Schmitz, Patrick W, 2009. "Can Contracts Solve the Hold-Up Problem? Experimental Evidence," CEPR Discussion Papers 7205, C.E.P.R. Discussion Papers.
  6. David Gill & Victoria Prowse, 2012. "A Structural Analysis of Disappointment Aversion in a Real Effort Competition," American Economic Review, American Economic Association, vol. 102(1), pages 469-503, February.
  7. Herweg, Fabian, 2013. "The expectation-based loss-averse newsvendor," Economics Letters, Elsevier, vol. 120(3), pages 429-432.
  8. 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.
  9. Botond Koszegi & Matthew Rabin, 2005. "A Model of Reference-Dependent Preferences," Levine's Bibliography 784828000000000341, UCLA Department of Economics.
  10. 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.
  11. 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.
  12. Karle, Heiko & Peitz, Martin, 2012. "Competition under Consumer Loss Aversion," Working Papers 12-08, University of Mannheim, Department of Economics.
  13. Heiko Karle, 2013. "Creating Attachment through Advertising: Loss Aversion and Pre–Purchase Information," CER-ETH Economics working paper series 13/177, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
  14. Klein, Benjamin & Crawford, Robert G & Alchian, Armen A, 1978. "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics, University of Chicago Press, vol. 21(2), pages 297-326, October.
  15. Rosato, Antonio, 2013. "Selling Substitute Goods to Loss-Averse Consumers: Limited Availability, Bargains and Rip-offs," MPRA Paper 47168, University Library of Munich, Germany.
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