Renegotiation of Long-Term Contracts as Part of an Implicit Agreement
36 Pages Posted: 28 Sep 2017 Last revised: 21 Dec 2018
Date Written: June 26, 2018
Long-term relationships are often governed by a combination of contracts and implicit agreements. I show that there are welfare gains to writing long-term contracts with the intention of rewriting their terms at a later stage, despite lack of change in the underlying environment. This form of renegotiation is perfectly anticipated as part of an implicit agreement. The benefits of renegotiation are demonstrated in a principal-agent model with observable but noncontractible effort where the players sign long-term output-contingent contracts. Continuation contracts form a basis for punishing deviations from the implicit agreement, but their terms are renegotiated away on the equilibrium path. In the baseline model continuation contracts are designed to lead to unbounded punishments to the principal who is not protected by limited liability. This facilitates the implementation of first best outcomes regardless of the patience of the players and the output technology. In contrast, the first best is not attainable in equilibria without on-path renegotiation when the players are impatient. When the principal is protected by limited liability, continuation contracts can hold either player down to their outside option in equilibrium.
Keywords: Long-term contracts, Renegotiation, Relational contracts
JEL Classification: C73, D86
Suggested Citation: Suggested Citation