Exit Options in Incomplete Contracts with Asymmetric Information

Helmut Bester and Daniel Krähmer ()
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Daniel Krähmer: University of Bonn, Hausdorff Center for Mathematics and Institute for Theoretical Economis, Adenauer Allee 24-42, D-53113 Bonn (Germany)

No 251, Discussion Papers from SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich

Abstract: This paper analyzes bilateral contracting in an environment with contractual incompleteness and asymmetric information. One party (the seller) makes an unverifiable quality choice and the other party (the buyer) has private information about its valuation. A simple exit option contract, which allows the buyer to refuse trade, achieves the first–best in the benchmark cases where either quality is verifiable or the buyer’s valuation is public information. But, when unverifiable and asymmetric information are combined, exit options induce inefficient pooling and lead to a particularly simple contract. Inefficient pooling is unavoidable also under the most general form of contracts, which make trade conditional on the exchange of messages between the parties. Indeed, simple exit option contracts are optimal if random mechanisms are ruled out.

Keywords: Incomplete Contracts; Asymmetric Information; Exit Options JEL Classification No.: D82; D86; L15; Incomplete Contracts; Asymmetric Information; Exit Options (search for similar items in EconPapers)
JEL-codes: D82 D86 L15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec and nep-cta
Date: 2008-11
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Related works:
Working Paper: Exit options in incomplete contracts with asymmetric information (2008)
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