Loss Aversion and Ex Post Inefficient Renegotiation

48 Pages Posted: 3 Jan 2013

See all articles by Fabian Herweg

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics

Klaus M. Schmidt

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Date Written: December 28, 2012

Abstract

We propose a theory of ex post inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegotiated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to renegotiate.

Keywords: renegotiation, incomplete contracts, reference points, employment contracts, behavioral contract theory

JEL Classification: C780, D030, D860

Suggested Citation

Herweg, Fabian and Schmidt, Klaus M., Loss Aversion and Ex Post Inefficient Renegotiation (December 28, 2012). CESifo Working Paper Series No. 4031, Available at SSRN: https://ssrn.com/abstract=2195473

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics ( email )

Universitätsstraße 30
Bayreuth, 95447
Germany

Klaus M. Schmidt (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics ( email )

Ludwigstrasse 28
Munich, D-80539
Germany
+49 89 2180 3405 (Phone)
+49 89 2180 3510 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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