Loss aversion and ex post inefficient renegotiation

Arbeitspapier

We propose a theory of ex post inefficient renegotiation that is based on loss aversion. When two parties write a long-term contract that has to be renegotiated after the realization of the state of the world, they take the initial contract as a reference point to which they compare gains and losses of the renegotiated transaction. We show that loss aversion makes the renegotiated outcome sticky and materially inefficient. The theory has important implications for the optimal design of long-term contracts. First, it explains why parties often abstain from writing a beneficial long-term contract or why some contracts specify transactions that are never ex post efficient. Second, it shows under what conditions parties should rely on the allocation of ownership rights to protect relationship-specific investments rather than writing a specific performance contract. Third, it shows that employment contracts can be strictly optimal even if parties are free to renegotiate.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: CESifo Working Paper ; No. 4031

Classification and Topics

• Classification: Wirtschaft ; Bargaining Theory; Matching Theory ; Economics of Contract: Theory
• Subject: renegotiation ; incomplete contracts ; reference points ; employment contracts ; behavioral contract theory ; Unvollständiger Vertrag ; Verhandlungstheorie ; Prospect Theory ; Theorie

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Herweg, Fabian ; Schmidt, Klaus M.
• Event: Veröffentlichung
• (who): Center for Economic Studies and ifo Institute (CESifo)
• (where): Munich
• (when): 2012

Further information

• Handle: http://hdl.handle.net/10419/69573
• Last update: 10.03.2025, 11:44 AM CET