Contracts as Reference Points
66 Pages Posted: 12 Jan 2007
Date Written: November 2006
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 noncontractible investments, and elucidates why employment contracts, which fix wage in advance and allow the employer to choose the task, can be optimal.
JEL Classification: D23, D86, K12
Suggested Citation: Suggested Citation