Contract Renegotiation in Agency Problems

Aaron Edlin () and Benjamin Hermalin ()

Microeconomics from EconWPA

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 holdup 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.

Keywords: Contract renegotiation; double moral hazard; relationship- specific investment (search for similar items in EconPapers)
JEL-codes: D23 C78 K12 L23 (search for similar items in EconPapers)
Date: 1997-05-23
Note: Type of Document - PDF; prepared on IBM PC ; pages: 33; figures: included
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http://129.3.20.41/eps/mic/papers/9705/9705002.pdf (application/pdf)

Related works:
Working Paper: Contract Renegotiation in Agency Problems (1997)
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpmi:9705002

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