Reiche, Sonje
(2001)
Contract renegotiation under asymmetric information: On the foundations of incomplete contracts.
PhD thesis, London School of Economics and Political Science.
Abstract
The dissertation explores the effect of limited contractual commitment on the form of contracts and studies its welfare implications. The main focus is on foundations of incomplete contracts. The thesis studies to what extent incompleteness of contracts can be linked to contract renegotiation. Particular emphasis is put onto explaining the absence of a contract from a relationship. Chapter 1 reviews the literature on contract renegotiation and incomplete contracting. Chapter 2 is based on a version of the hold-up problem. It shows that contracts that are vulnerable to renegotiation cannot provide better investment incentives than no contract. The main driving force is that investment, although beneficial from a total surplus point of view, has an ambivalent effect on the investing party's payoff. It increases the benefit of an efficient action and decreases the benefit of an inefficient action. An example is investment into human capital, such as additional job training. It increases personal satisfaction in a challenging job but may also increase the frustration from a job that consists only of repetitive tasks. If an exact job description is not feasible ex-ante and if the non-investing party has all the bargaining power ex-post, contracts cannot compensate for the cost of investment. Chapter 3 formalizes the intuition that contracting involves a cost because a contract constitutes a less flexible status quo for ex-post bargaining than no contract. For this, asymmetric information is introduced. With asymmetric information contracting is potentially costly because an inefficient outcome is not necessarily undone by an ex-post bargain. For example, during the renegotiation of the contract between General Motors and Fisher Body, the latter adopted a cost intensive production technology in order to convince its partner to renege on the former agreement. In the model of this chapter, parties weigh the benefit of a contract against lost flexibility. If these effects are similar, no contract is written. The possibility that a contract might be strictly dominated by no contract is explored in chapters 4 and 5. Such a strict dominance result is interesting because it is a more forceful advocate for the incomplete contract assumption. Chapter 4 contains a version of the durable good monopoly model with no discounting but costly contracting. These could be writing or legal costs. Early contracting is less costly than late contracting which highlights the idea that bargaining at a deadline is more costly. But also, early contracting suffers from the ratchet effect because it releases information. The main result says that the costs of the ratchet effect outweigh the cost savings, even if initial contracting costs are of order of magnitude smaller than late contracting costs. The seller strictly prefers to offer no contract. In chapter 5, a sequential screening model endogenizes the fixed contracting cost. The buyer is privately informed about one part of the good's value but ignores the second part, which is revealed later. Early contracting is beneficial because it suffers less from asymmetric information than does late contracting. Nevertheless, if uncertainty with respect to the first variable is greater than uncertainty with respect to the second variable, the seller cannot take advantage of this fact and he strictly prefers to wait. Moreover, if this is not the case, contracts are partially incomplete because they are not conditioned on the second variable. Finally, the thesis reports the new effect that all contracts are renegotiated in equilibrium. This is in contrast to the renegotiation proofness principle, which states that in models of contracting with renegotiation one can restrict attention to renegotiation proof contracts.
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