Contracts as Reference Points
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
University of Edinburgh - Economics; London School of Economics
We argue that a contract provides a reference point for a trading relationship: more precisely, for parties' feelings of entitlement. A party's ex post performance depends on whether he gets what he is entitled to relative to outcomes permitted by the contract. A party who is shortchanged shades on performance. A flexible contract allows parties to adjust their outcome to uncertainty, but causes inefficient shading. Our analysis provides a basis for long-term contracts in the absence of non-contractible investments, and elucidates why "employment" contracts, which fix wage in advance and allow the employer to choose the task, can be optimal.
Number of Pages in PDF File: 66
Keywords: contracts, reference points, entitlements, aggrievement
JEL Classification: D23, D86, K12
Date posted: November 14, 2006