Scandinavian Working Papers in Economics

Working Paper Series,
Research Institute of Industrial Economics

No 1390: Contracting with Endogenously Incomplete Commitment: Escape Clauses

Thomas Tangerås () and Wolfgang Gick ()
Additional contact information
Thomas Tangerås: Research Institute of Industrial Economics (IFN), Postal: Research Institute of Industrial Economics, Box 55665, SE-102 15 Stockholm, Sweden
Wolfgang Gick: Free University of Bozen/Bolzano, Italy, Postal: and Research Institute of Industrial Economics (IFN), Stockholm, Sweden,

Abstract: We study mechanism design under endogenously incomplete commitment as it arises in contracting with escape clauses. An escape clause permits the agent to end a contractual relationship under specified circumstances, after which the principal can offer an ex-post contract. Escape clauses are valuable when the maximal number of initial contracts is smaller than the number of agent types. We identify a sufficient condition for incentive optimality of ex-post contracting. Escape clauses are always incentive optimal under severely constrained contracting. On the margin, the optimal escape clause balances the benefit of a better-adapted contract against an increase in dynamic inefficiency.

Keywords: Constrained contracting; Escape clauses; Endogenously incomplete commitment; Ratchet effect; Revelation principle

JEL-codes: D82; D84; D86

55 pages, May 28, 2021

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