Contract Renegotiation and Options in Agency Problems

35 Pages Posted: 26 Dec 1998

See all articles by Aaron S. Edlin

Aaron S. Edlin

University of California at Berkeley; National Bureau of Economic Research (NBER)

Benjamin E. Hermalin

University of California, Berkeley

Date Written: October 1998

Abstract

This paper studies the ability of an agent and a principal to achieve the first-best outcome when the agent invests in an asset that has greater value if owned by the principal than by the agent. When contracts can be renegotiated, a well-known danger is that the principal can holdup the agent, undermining the agent's investment incentives. We begin by identifying a countervailing effect: Investment by the agent can increase his value for the asset, thus improving his bargaining position in renegotiation. We show that option contracts will achieve the first best whenever this threat-point effect dominates the holdup effect. Otherwise, achieving the first best is difficult and, in many cases, impossible.

JEL Classification: D29, D82, L14, L29

Suggested Citation

Edlin, Aaron S. and Hermalin, Benjamin E., Contract Renegotiation and Options in Agency Problems (October 1998). Available at SSRN: https://ssrn.com/abstract=142788 or http://dx.doi.org/10.2139/ssrn.142788

Aaron S. Edlin

University of California at Berkeley ( email )

Dept of Economics 549 Evans Hall #3880
Berkeley, CA 94720
United States
510-642-4719 (Phone)
510-643-0413 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Benjamin E. Hermalin (Contact Author)

University of California, Berkeley ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-642-7575 (Phone)
510-643-1420 (Fax)

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