How Do Informal Agreements and Revision Shape Contractual Reference Points?

Abstract

The notion of contracts as reference points provides the basis for a deeper understanding of important phenomena such as the employment contract, vertical integration, firm scope, authority, and delegation. Previous experiments lend support to this notion but they ignore realistic aspects of trading relationships such as informal agreements and ex‐post renegotiation or revision. Here we show that the central behavioral mechanism underlying contractual reference points is robust to such considerations. Our data reveal that informal agreements can mitigate the trade‐off between rigidity and flexibility but they do not fully resolve the problem of misaligned reference points. Our experiments also show that contract revision is a more nuanced process than the previous literature has recognized. We find, for example, that it is sometimes better for parties to write a simple (rigid) contract and then revise it ex post if needed, rather than to anticipate and include future contingencies in a (flexible) contract from the outset.

Reference Points, Social Norms, and Fairness in Contract Renegotiations

“…The contract also serves as a reference point. This general insight is very much in line with the complementary work by Fehr, Hart, and Zehnder (, , ).…”

“…Thus, it is not clear whether it is competition or voluntary agreement that is driving the treatment effect. Fehr, Hart, and Zehnder (2014) ask whether the tradeoff between flexibility and shading disappears if the parties can renegotiate the rigid contract. They consider a very specific form of renegotiation, called "repudiation", in which the buyer can change the price of the contract unilaterally (without asking for the seller's agreement).…”

Contributions of Oliver Hart and Bengt Holmström to Contract Theory

“…Fehr et al . (, , ) and Bartling and Schmidt () offer some experimental evidence showing that contracts form reference points that affect behavior.…”

“…Hart and Holmström (2010) use it to explain the allocation of decision rights and firm scope. Fehr et al (2009Fehr et al ( , 2011Fehr et al ( , 2015 and Bartling and Schmidt (2015) offer some experimental evidence showing that contracts form reference points that affect behavior.…”

Let's Talk: How Communication Affects Contract Design

“…This project is related to HM and the Fehr, Hart, and Zehnder (, , ) experiments, henceforth denoted FHZb, FHZa, and FHZc; a,b,c reflects the order of writing. These experiments provide some evidence that flexibility without communication has negative consequences.…”