Contracting on Time
25 Pages Posted: 2 Jan 2004
Date Written: November 2003
The paper shows how the time considerations - especially concerning contract duration - affect incomplete contract theory. We consider a bilateral trade setting where contracting, investment, trade, and renegotiation take place in continuous time. Time is not only a dimension along which the relationship unfolds but also a continuous verifiable variable that can be included in contracts. We show that incentives for efficient investment can be provided either through a chain of constantly renegotiated fixed-term contracts; or through a renegotiation-proof 'evergreen' contract - a contract of indefinite duration that includes an option of unilateral termination with advance notice. We provide a detailed analysis of properties of optimal contracts.
Keywords: incomplete contracts, renegotiation, optimal duration, evergreen contracts
JEL Classification: D23, K12, L14
Suggested Citation: Suggested Citation