Renegotiation and the Form of Efficient Contracts

Abstract

Two parties may agree to a mutually binding contract that will govern their behavior after an uncertain event becomes known. As there is no agent who can both observe this uncertain outcome and enforce the contract, contingent agreements are precluded. However, the parties recognize that the uncertain event will be common knowledge for them, and that they will be able to renegotiate the contract voluntarily, provided that they both gain in doing so. When structuring the original contract they can foresee this renegotiation phase. Efficient contracts are those that perform best, when taking this into account. This paper studies the form of such efficient contracts. It is shown that it is always better to have a contract than it is to have none, no matter which party has the preponderence of bargaining strength in the renegotiation phase. We also study whether renegotiation can substitute completely for the absence of contingent contracts. We characterize a family of cases where it can. And we present some "second-best" results in others, where it cannot.