Contracts as Reference Points

Abstract

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.

Keywords: contracts, reference points, entitlements, aggrievement

JEL Classification: D23, D86, K12