Contract Renegotiation in Agency Problems / Aaron S. Edlin, Benjamin E. Hermalin.

Format:

Book

Author/Creator:

Edlin, Aaron S.

Contributor:

National Bureau of Economic Research.

Hermalin, Benjamin E.

Series:

Working Paper Series (National Bureau of Economic Research) no. w6086.

NBER working paper series no. w6086

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1997.

Summary:

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 hold up 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.

Notes:

Print version record

July 1997.