Contract Renewal Under Uncertainty

Abstract:     
The incentive to call for contract renewal to adjust prices is considered from a bilateral perspective in a setting where changes in outside opportunities drive the incentive to renew contracts and costs preclude continuous renewal. A model encompassing several contract forms is formulated, and the existence of an equilibrium to the bilateral renewal game is established. Prices display inertia, and the incumbent contract is found to be more resistant to changes in outside opportunities, the larger the costs of contract renewal, the variability of outside opportunities and the lower the discount rate. The model is shown to match a number of empirical observations on contracts, and in a macroeconomic application of the model it is shown how nominal inertia may arise and why the rate of inflation and monetary uncertainty have real effects.

Number of Pages in PDF File: 34

JEL Classification: C72, D81, E31

working papers series