Renegotiation of long‐term contracts as part of an implicit agreement

Abstract

I study a repeated principal–agent game with long‐term output contracts that can be renegotiated at will. Actions are observable but not contractible, so they can only be incentivized through implicit agreements formed in equilibrium. I show that contract renegotiation is a powerful tool for incentive provision, despite the stationarity of the environment. Continuation contracts are designed to punish deviations in noncontractible behavior. If the equilibrium actions are observed, these contracts are renegotiated away. This form of anticipated renegotiation results in welfare improvements over outcomes attainable by one‐period contracts or by long‐term contracts that are not renegotiated. When the principal is not protected by limited liability, first‐best outcomes are attainable regardless of the impatience of the players. Equilibrium strategies are shown to satisfy various concepts of renegotiation‐proofness.

Firm innovation and covenant tightness

“…For example, Gibbons and Henderson (2012) argue that because the success of innovation requires that contracting parties make optimal decisions contingent upon the information that emerges at interim stages, the parties can improve efficiency by supplementing formal contracts with informal ones, based on the value of the future relationship. Strict debt covenants-a component of the formal contract-compel the parties to renegotiate their relationali.e., informal-contract based on relevant new information (Watson et al 2020;Kostadinov 2021). In other words, covenants play a unique role in debt contracting because they increase the self-enforcing range of the relational contract and thereby improve the efficiency of a contractual relationship.…”

“…Recently, theoretical studies extend the incomplete contracting framework by focusing on the relational-i.e., informalcontracts that complement formal (incomplete) contracts. These studies show that tight covenants can serve as an effective means to enlarge the self-enforcing range of the relational contract (e.g., Watson et al 2020;Kostadinov 2021). This latter theoretical approach replaces an earlier stylized representation where all decision rights are assigned to only one contracting party with a more nuanced setting where the relational agreement requires ongoing inputs from both contracting parties.…”

“…Strict debt covenants, which constitute a part of the formal contract, compel the parties to renegotiate their relational-i.e., informal-contract based on relevant new information. When each of the parties performs in a mutually agreeable manner, covenant violations are waived and the relationship continues (Watson et al 2020;Kostadinov 2021). In other words, covenants play a unique role in debt contracting because they increase the self-enforcing range of the relational contract and thereby improve the efficiency of a contractual relationship.…”

Past and Future Developments in the Economics of Relational Contracts

“…Pearce and Stacchetti also discuss a more general approach (which has been carried out by Kostadinov, 2021) where long-term formal contracts are possible. Then, the formal contract still determines payoffs after breach and thus constitutes the optimal punishment.…”