Memorandum
No 20/2004:
Contract Renewal
Helge Holden ()
, Lars Holden ()
and Steinar Holden ()
Abstract: Consider a contract between two players, describing the
payment an agent obtains from the principal, in exchange for a good or
service supplied. At each point in time, either player may unilaterally
demand a renegotiation of the contract, involving renegotiation costs for
both players. Players’ payoffs from trade under the contract, as well as
from a renegotiated contract, are stochastic, following the exponential of
a L´evy process. It is argued that the optimal strategy for each player is
to require a renegotiation when the contract payment relative to the
outcome of a renegotiation passes a certain threshold, depending on the
stochastic processes, the discount rate, and the renegotiation costs. There
is strategic substitutability in the choice of thresholds, so that if one
player becomes more aggressive by choosing a threshold closer to unity, the
other player becomes more passive. If players may invest in order to reduce
the renegotiation costs, there will be over-investment compared to the
welfare maximizing levels.
Keywords: contract; stochastic; Levy process; renegotiation; (follow links to similar papers)
JEL-Codes: C73; D61; (follow links to similar papers)
44 pages, October 28, 2004
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