CeDEx
Centre for Decision Research and Experimental Economics

CeDEx workshop - Klaus Schmidt (University of Munich)

Date(s)
Wednesday 19th February 2014 (15:00-16:30)
Contact

 


 

Description

 joint with Senior Academic Seminar Series

Loss Aversion and Inefficient Renegotiation

Abstract:

We propose a theory of 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 relations hip-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.


Centre for Decision Research and Experimental Economics

Sir Clive Granger Building
University of Nottingham
University Park
Nottingham, NG7 2RD

telephone: +44 (0)115 951 5458
Enquiries: jose.guinotsaporta@nottingham.ac.uk
Experiments: cedex@nottingham.ac.uk