Contract Renegotiation in Agency Problems

37 Pages Posted: 22 May 1997

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: May 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 holdup 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 problems, and modern manufacturing.

JEL Classification: D81, D82

Suggested Citation

Edlin, Aaron S. and Hermalin, Benjamin E., Contract Renegotiation in Agency Problems (May 1997). Available at SSRN: https://ssrn.com/abstract=91 or http://dx.doi.org/10.2139/ssrn.91

Aaron S. Edlin

University of California at Berkeley ( email )

Dept of Economics 549 Evans Hall #3880
Berkeley, CA 94720
United States
510-642-4719 (Phone)
510-643-0413 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Benjamin E. Hermalin (Contact Author)

University of California, Berkeley ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-642-7575 (Phone)
510-643-1420 (Fax)

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