Contract Adjustment Under Uncertainty

36 Pages Posted: 11 Jun 2005

See all articles by Lars Holden

Lars Holden

Norwegian Computing Center

Helge Holden

Norwegian University of Science and Technology (NTNU)

Steinar Holden

University of Oslo - Department of Economics; Norges Bank; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: May 2005

Abstract

Consider a contract over trade in continuous time between two players, according to which one player makes a payment to the other in exchange for an exogenous service. At each point in time, either player may unilaterally require an adjustment to the contract payment, involving adjustment costs for both players. Players' payoffs from trade under the contract, as well as from trade under an adjusted contract, are exogenous and stochastic. We consider players' choice of whether and when to adjust the contract payment. It is argued that the optimal strategy for each player is to adjust the contract whenever the contract payment relative to the outcome of an adjustment passes a certain threshold, depending among other things on the adjustment costs. There is strategic substitutability in the choice of thresholds, so that if one player becomes more aggressive by choosing a threshold closer to unity, the other player becomes more passive. If players may invest in order to reduce the adjustment costs, there will be over-investment compared to the welfare-maximizing levels.

JEL Classification: C72, C73, C78, E31

Suggested Citation

Holden, Lars and Holden, Helge and Holden, Steinar, Contract Adjustment Under Uncertainty (May 2005). Available at SSRN: https://ssrn.com/abstract=741064 or http://dx.doi.org/10.2139/ssrn.741064

Lars Holden

Norwegian Computing Center ( email )

P. O. Box 114 Blindern
0314 Oslo
Norway

Helge Holden

Norwegian University of Science and Technology (NTNU) ( email )

Høgskoleringen
Trondheim NO-7491, 7491
Norway

Steinar Holden (Contact Author)

University of Oslo - Department of Economics ( email )

P.O. Box 1095 Blindern
N-0317 Oslo
Norway
+47 22 85 51 56 (Phone)
+47 22 85 50 35 (Fax)

HOME PAGE: http://folk.uio.no/~sholden/

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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

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