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Article
Contract Renegotiation and Options in Agency Problems
Journal of Law, Economics and Organization (2000)
  • Aaron S. Edlin
  • Benjamin E. Hermalin
Abstract

This article discusses the ability of an agent and a principal to achieve the first-best outcome when the agent invests in an asset that has greater value if owned by the principal than by the agent. When contracts can be renegotiated, a well-known danger is that the principal can hold up the agent, undermining the agent's investment incentives. We begin by identifying a countervailing effect: Investment by the agent can increase his value for the asset, thus improving his bargaining position in renegotiation. We show that option contracts will achieve the first best whenever his threat-point effect dominates the holdup effect. Otherwise, achieving the first best is difficult and, in many cases, impossible.

Disciplines
Publication Date
October, 2000
Citation Information
Aaron S. Edlin and Benjamin E. Hermalin. "Contract Renegotiation and Options in Agency Problems" Journal of Law, Economics and Organization (2000)
Available at: http://works.bepress.com/hermalin/2/