Strategic Determination of Renegotiation Costs

Recently, some literature on incomplete contracts studies the cases where renegotiations take place inefficiently. We extend the incomplete contract model in Hart (2009) by assuming that one party chooses an action which affects renegotiation costs. In our model, renegotiation costs are determined endogenously. We characterize the condition that she can get higher payoff by manipulating renegotiation costs than when she cannot manipulate renegotiation costs and renegotiations take place efficiently. Whereas she chooses positive renegotiation costs, renegotiations never occur on the equilibrium paths. They work just as "credible threat". Her equilibrium share ratio of the ex ante bargaining surplus is higher than her bargaining power. As an application, we discuss an investment problem by using a variant of our basic model. We show that the agents mitigate the investment problem by setting some positive renegotiation costs and increasing a high skilled agent's share ratio of the ex ante bargaining surplus to give her larger incentive of investment.