Loss Aversion and Inefficient Renegotiation

Fabian Herweg () and Klaus Schmidt ()

The Review of Economic Studies, 2015, vol. 82, issue 1, 297-332

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 renegotiated 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. Secondly, 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. Thirdly, it shows that employment contracts can be strictly optimal even if parties are free to renegotiate.

Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (36)

Downloads: (external link)
http://hdl.handle.net/10.1093/restud/rdu034 (application/pdf)
Access to full text is restricted to subscribers.

Related works:
Working Paper: Loss Aversion and Inefficient Renegotiation (2014)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:oup:restud:v:82:y:2015:i:1:p:297-332

Access Statistics for this article

The Review of Economic Studies is currently edited by Thomas Chaney, Xavier d’Haultfoeuille, Andrea Galeotti, Bård Harstad, Nir Jaimovich, Katrine Loken, Elias Papaioannou, Vincent Sterk and Noam Yuchtman

More articles in The Review of Economic Studies from Review of Economic Studies Ltd
Bibliographic data for series maintained by Oxford University Press ().