Essays on Optimal Contracts and Renegotiation

Abstract

Contract theory studies the incentives and contractual outcomes in economic interactions, and how they are influenced by given institutions and information structures. On an abstract level, a contractual relationship is characterized by the costs and obstacles that have to be faced in order to carry out the desired economic transaction. Such transaction costs include for example search and information cost, bargaining and contracting costs, and enforcement costs. Depending on the type of transaction costs, optimal contracts will take one form or another. To try to understand economic interactions at this level of detail is of course an enormous undertaking, to which this thesis makes a small contribution, focusing on the effect of renegotiation on the form of contracts.<br /> In the first chapter, we consider a repeated moral hazard problem, where both the principal and the wealth-constrained agent are risk-neutral. In each of two periods, the principal can make an investment and the agent can exert unobservable effort, leading to success or failure. Incentives in the second period act as carrot and stick for the first period, so that effort is higher after a success than after a failure. If renegotiation cannot be prevented, the principal may prefer a project with lower returns; i.e., a project may be ``too good'' to be financed or, similarly, an agent can be `overqualified.''<br /> The second chapter examines the efficiency of expectation damages as a breach remedy in a bilateral trade setting with renegotiation and relationship-specific investment by the buyer and the seller. As demonstrated by Edlin and Reichelstein~(1996), no contract that specifies only a fixed quantity and a fixed per-unit price can induce efficient investment if marginal cost is constant and deterministic. We show that this result does not extend to more general payoff functions. If both parties face the risk of breaching, the first best becomes attainable with a simple price-quantity contract.<br /> In the third chapter, we consider the case of an upstream seller who works to improve an asset that has been specialized to a downstream buyer's needs. There is no contract; instead the buyer afterwards makes a take it or leave it offer to the seller. We assume that the seller has private information about the fraction of the surplus that he can realize on his own, and show that this leads to higher investment compared to the complete information case. While a seller with a large default payoff has always strong incentives to invest, now also a seller with a low outside option can choose a large investment, trying to convey the impression of having profitable alternatives. This positive effect on investment is traded off against the occurence of inefficient separation, which results when the buyer mistakenly tries to call the seller's bluff with a low offer. <br /> The forth chapter studies infinitely repeated two player games with perfect information and side payments. Each period consists of two stages, one in which the parties simultaneously choose an action and one in which they make a onetary transfer. We show that in order to find subgame perfect or renegotiation-proof payoffs for a given discount factor one can restrict the analysis to a class of simple stationary strategies, which we call stationary contracts. We provide simple conditions that characterize renegotiation-proof stationary contracts, and apply these to a series of examples. In particular, we show that in a principal-agent game, in which only the agent chooses an action, all Pareto efficient outcomes can be made renegotiation-proof.