Contract Renegotiation and Options in Agency Problems

Edlin, Aaron S.; Hermalin, Benjamin E.

doi:10.2139/ssrn.142788

Cited by 48 publications

(75 citation statements)

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“…6 As mentioned in the Introduction, this assumption implies that option contracts with an exercise date before B invested (i.e., at date 2) do not implement the first best even if limited liability is disregarded [see Edlin and Hermalin (2000)]. Most of our subsequent results extend to the case of substitutive investments as well.…”

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confidence: 85%

“…3 Edlin and Hermalin (2000) consider a framework where party A is risk-averse, and focus on optionto-buy contracts with an exercise date after the first agent -but before the second agent -invested. For the special case of risk-neutral parties, their results imply that efficiency can then be attained if and only if the parties' investments are substitutive on the margin.…”

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confidence: 99%

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Limited Liability and Option Contracts in Models with Sequential Investments

Lülfesmann

2001

SSRN Journal

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SummaryThe paper investigates a model where two parties A and B invest sequentially in a joint project (an asset). Investments and the asset value are nonverifiable, and A is wealth constrained so that an initial outlay must be financed by either agent B or an external investor C (a bank). We show that an option contract in combination with a loan arrangement facilitates first best investments and any arbitrary distribution of surplus if renegotiation is infeasible.Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, the first best can still be attained if A's bargaining position is not too strong. In addition, either B-financing or C-financing may be strictly preferable, and a combination of multiple lenders may be optimal.

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confidence: 85%

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confidence: 99%

Limited Liability and Option Contracts in Models with Sequential Investments

Lülfesmann

2001

SSRN Journal

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“…Given the importance of the technology of trade, the analy-25 My message can be further illustrated in the context of Edlin and Hermalin's (2000) debate with Nöldeke, G. and K. Schmidt (1998). In their discussion of whether a party could let an option expire and then renegotiate from scratch, Edlin and Hermalin appeal to the "outside option principle," whereby the outside option implies an inequality constraint on the outcome of negotiation rather than serving as the disagreement point.…”

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confidence: 99%

Contract, Mechanism Design, and Technological Detail

Watson

2002

SSRN Journal

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This paper develops a theoretical framework for studying contract and enforcement in settings of complete, but unverifiable, information. The main point of the paper is that the consideration of renegotiation necessitates formal examination of other technological constraints, especially those having to do with the timing and nature of inalienable productive decisions. The main technical contributions include (a) results that characterize of the sets of implementable state-contingent payoffs under various assumptions about renegotiation opportunities, and (b) a result establishing conditions under which, when trading opportunities are durable and trade decisions are reversible, stationary contracts are optimal. The analysis refutes the validity of the "mechanism design with ex post renegotiation" program, it demonstrates the validity of other mechanism design models in dynamic environments, and it highlights the need for a more structured game-theoretic framework. JEL Classification: C70, D74, K10. * University of California, San Diego. Internet: http://weber.ucsd.edu/∼jwatson/. I thank Jesse Bull, Vince Crawford, Aaron Edlin, Oliver Hart, W. Bentley MacLeod, John Moore, Joel Sobel, and my colleagues at UC San Diego for their comments. The research reported herein is supported by NSF grant SES-0095207. 1Economic models of contract have yielded important insights regarding the nature of contractual imperfections, optimal contractual form, and contractual scope. Many of the insights derive from mechanism design analysis, which strips away institutional details to focus on just a few fundamental ingredients. Mechanism design is an abstract and elegant methodology. The mathematical elegance comes at a cost, however, to the extent that real institutions and technology limit the formation and enforcement of contracts.Researchers have rightly turned their attention to the actual constraints that institutions impose, in an attempt to clarify our understanding of contractual imperfections and to inform the design of enforcement systems. One issue that has received a great deal of attention is the possibility that parties can renegotiate in the midst of a contractual relationship. Hart and Moore's (1988) seminal article shows how renegotiation following specific investments can greatly inhibit the parties' ability to attain an efficient outcome. Recently, theorists have attempted to incorporate renegotiation constraints into otherwise standard mechanism design analysis. Maskin and Moore (1999) developed the basic mechanism design with ex post renegotiation (MDER) program, which assumes that parties can renegotiate the contractually-specified outcome after sending messages to an external enforcer. Maskin and Moore's methodology and characterization results have been widely accepted and employed. 1In this paper, I study how renegotiation opportunities interact with the productive technology of contractual relationships. Specifically, I do two things. First, I show that, in order to adequately address renegotiation, w...

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“…Parties typically cannot credibly commit not to renegotiate inefficient outcomes (cf. Edlin & Hermalin, 2000).…”

Section: Introductionmentioning

confidence: 99%

“…Second, in practice parties typically cannot threat not to renegotiate inefficient outcomes (cf. Edlin & Hermalin, 2000). Because the breach decision itself may result in an inefficient outcome, one therefore should allow for renegotiations after Seller's breach decision.…”

Section: Introductionmentioning

confidence: 99%

Breach Remedies, Reliance, and Renegotiation

et al. 2001

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Breach remedies can be used to protect specific investments and are therefore a remedy against holdup. Yet some commonly used remedies are predicted to provide too much protection, thereby inducing overinvestment. Two motives drive this prediction: the insurance motive and the separation prevention motive. This paper presents results from an experiment designed to test whether these two motives show up in practice. In contrast to previous experiments the focus is on a setting where ex post renegotiations are possible. Our results indicate that also in this case the insurance motive and the separation prevention motive are at work, as predicted. A second main finding is that there seems less need for sophisticated breach remedies based on compensatory money damages than is suggested by theory.

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Contract Renegotiation and Options in Agency Problems

Cited by 48 publications

References 10 publications

Limited Liability and Option Contracts in Models with Sequential Investments

Limited Liability and Option Contracts in Models with Sequential Investments

Contract, Mechanism Design, and Technological Detail

Breach Remedies, Reliance, and Renegotiation

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