Adverse Selection and Renegotiation in Procurement

As was shown by Dewatripont, optimal long-term contracts are generally not sequentially optimal. The parties ex-post renegotiate them to their mutual advantage. This paper fully characterizes the equilibrium of a simple two-period procurement situation and studies the extent to which renegotiation reduces ex-ante welfare: i) A central result is that, like in the non-commitment case, the second period allocation is optimal for the principal conditionally on his posterior beliefs about the agent. ii) The first period allocation exhibits an increasing amount of pooling when the discount factor grows. iii) With a continuum of types, it is never optimal to induce full separation. The paper also analyzes whether renegotiated long-term contracts yield outcomes resembling those under either unnegotiated long-term contracts or a sequence of short-term contracts and it links the analysis with the multiple unit durable good monopoly problem.