Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion

54 Pages Posted: 3 Apr 2014

See all articles by Fabian Herweg

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics

Heiko Karle

Frankfurt School of Finance and Management

Daniel Müller

University of Bonn

Multiple version iconThere are 3 versions of this paper

Date Written: March 10, 2014

Abstract

We consider a simple trading relationship between an expectation-based loss-averse buyer and profit-maximizing sellers. When writing a long-term contract the parties have to rely on renegotiations in order to ensure materially efficient trade ex post. The type of the concluded long-term contract affects the buyer’s expectations regarding the outcome of renegotiation. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. It can be optimal for the buyer, however, to expect that renegotiation does not take place. In this case, a good of too high quality or too low quality is traded ex post. Based on the buyer’s expectation management, our theory provides a rationale for “employment contracts” in the absence of non-contractible investments. Moreover, in an extension with non-contractible investments, we show that loss aversion can reduce the hold-up problem.

Keywords: behavioral contract theory, expectation-based loss aversion, incomplete contracts, renegotiation

JEL Classification: C780, D030, D860

Suggested Citation

Herweg, Fabian and Karle, Heiko and Müller, Daniel, Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion (March 10, 2014). CESifo Working Paper Series No. 4687, Available at SSRN: https://ssrn.com/abstract=2419894 or http://dx.doi.org/10.2139/ssrn.2419894

Fabian Herweg (Contact Author)

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

Universitätsstraße 30
Bayreuth, 95447
Germany

Heiko Karle

Frankfurt School of Finance and Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Daniel Müller

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

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