Contract Renegotiation in Agency Problems

35 Pages Posted: 4 Aug 2000 Last revised: 6 Oct 2010

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

Multiple version iconThere are 2 versions of this paper

Date Written: July 1997

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 hold up 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. In such cases, we show that if parties have an appropriate signal available, then the first best is still attainable for a wide class of bargaining procedures. A noisy signal, however, means that the optimal contract will involve terms that courts might view as punitive and so refuse to enforce.

Suggested Citation

Edlin, Aaron S. and Hermalin, Benjamin E., Contract Renegotiation in Agency Problems (July 1997). NBER Working Paper No. w6086. Available at SSRN: https://ssrn.com/abstract=226491

Aaron S. Edlin (Contact Author)

University of California at Berkeley ( email )

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Benjamin E. Hermalin

University of California, Berkeley ( email )

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Berkeley, CA 94720
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510-643-1420 (Fax)

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