Loss Aversion and Inefficient Renegotiation

Klaus Schmidt () and Fabian Herweg ()

VfS Annual Conference 2014 (Hamburg): Evidence-based Economic Policy from Verein für Socialpolitik / German Economic Association

Abstract: We propose a theory of inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegoti- ated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to rene- gotiate.

JEL-codes: C78 D03 D86 (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-cta, nep-gth, nep-mic and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Journal Article: Loss Aversion and Inefficient Renegotiation (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:vfsc14:100485

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