Loss Aversion and Inefficient Renegotiation

Herweg, Fabian; Schmidt, Klaus M.

doi:10.1093/restud/rdu034

Cited by 69 publications

(75 citation statements)

References 42 publications

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“…As a result, rather than negotiating, parties might in some cases just not engage in trade. Herweg and Schmidt (2012) take a somewhat different approach and propose that buyers and sellers are loss-averse, and the contract serves as a reference point for the ex post outcomes. Since a party evaluates a worse-than-contracted term (e.g., a drop in price for the seller) as a loss, parties are reluctant to compromise and renegotiate contracts optimally due to loss aversion.…”

mentioning

confidence: 99%

Ex Post (In)Efficient Negotiation and Breakdown of Trade

Iyer

Schoar

2012

SSRN Journal

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The last decade has seen a growth of new approaches in contract theory that go beyond the traditional models of complete and incomplete contracting to incorporate some of the most prominent psychological biases when modeling the behavior of contracting partners. Many of the traditional contracting models have been expanded to incorporate behavioral dimensions such as loss aversion, time inconsistency, or over-optimism, which allows researchers to more realistically explain the observed contracting behavior in the economy. 1The property rights and incomplete contracting literature has only very recently started to embrace these new extensions. One of the central building blocks of incomplete contracting theories is the assumption that parties to a contract will always engage in ex post efficient renegotiation in the case of (un)foreseen shocks (Hart and Moore 1988, 1990). As long as the valuation of the good is higher for the buyer than the seller, mutually beneficial trade should occur. However, the risk that contracting partners will extract surplus in renegotiations (hold up) leads to underinvestment ex ante, especially when investments are relationship-specific. While these models have been very influential, several recent theories have raised doubts about whether it is a reasonable assumption that ex post renegotiation will always reach efficient outcomes. Hart and Moore (2008) and Hart (2009) argue that contracts act as a reference point for the feelings of entitlement of contracting parties. They show that rigid contracts (fixed price) work well in normal times. However, when a 1 See Koszegi (2014) for an excellent overview of these new theories.

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confidence: 99%

Ex Post (In)Efficient Negotiation and Breakdown of Trade

Iyer

Schoar

2012

SSRN Journal

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“…However, as noted in Section 3, if the L H = 1 outcome in (53) is strictly superior to specific performance, then the first inequality in (27) holds. Hence by (27), (20) does indeed hold.…”

Section: More General Contractsmentioning

confidence: 83%

“…Thus (27) guarantees that, whenever "efficient trade" is strictly superior to specific performance, (20) holds. Note that (27) is automatically satisfied if is close to (and certainly if r = r ).…”

Section: Asset Ownership and Outside Optionsmentioning

confidence: 99%

“…Then it is easy to check that the outcomes in (53) and (54) can both be implemented by allowing the seller to choose between H , p H ) L , p L ) at date 1 with the buyer able to say no, i.e., to quit without penalty. For the argument to work in the case of (53) we need to be sure that (20) holds since otherwise the buyer will quit in the good state. However, as noted in Section 3, if the L H = 1 outcome in (53) is strictly superior to specific performance, then the first inequality in (27) holds.…”

Section: More General Contractsmentioning

confidence: 99%

“…In a recent paper, Herweg and Schmidt [20] develop a model of contracts as reference points based on loss aversion rather than aggrievement and shading. Among other things, they show that parties may prefer not to write specific performance contracts but instead to rely on asset ownership to reduce hold-up problems.…”

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Noncontractible Investments and Reference Points

Hart

2013

Games

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Abstract:We analyze noncontractible investments in a model with shading. A seller can make an investment that affects a buyer's value. The parties have outside options that depend on asset ownership. When shading is not possible and there is no contract renegotiation, an optimum can be achieved by giving the seller the right to make a take-it-or-leave-it offer. However, with shading, such a contract creates deadweight losses. We show that an optimal contract will limit the seller's offers, and possibly create ex post inefficiency. Asset ownership can improve matters even if revelation mechanisms are allowed.

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Loss Aversion, Moral Hazard, and Stochastic Contracts

2024

Manage Decis Econ

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I examine whether stochastic contracts benefit the principal under moral hazard and loss aversion. Incorporating the agent's expectation‐based loss aversion and allowing for stochastic contracts, I find that stochastic contracts reduce the principal's cost as compared with deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized but also with a positive probability after the realization of bad signals. The findings have an important implication for designing contracts for loss‐averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.

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Loss Aversion and Inefficient Renegotiation

Cited by 69 publications

References 42 publications

Ex Post (In)Efficient Negotiation and Breakdown of Trade

Ex Post (In)Efficient Negotiation and Breakdown of Trade

Noncontractible Investments and Reference Points

Loss Aversion, Moral Hazard, and Stochastic Contracts

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