DP5292 Should Contractual Clauses that Forbid Renegotiation Always be Enforced?

Author(s): Patrick W. Schmitz
Publication Date: October 2005
Keyword(s): contract modification, moral hazard, renegotiation
JEL(s): K12
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5292

Recent work in the field of mechanism design has led some researchers to propose institutional changes that would permit parties to enter into non-modifiable contracts, which is not possible under current contract law. This paper demonstrates that it may well be socially desirable not to enforce contractual terms that explicitly prevent renegotiation, even if rational and symmetrically informed parties have deliberately signed such a contract. The impossibility to prevent renegotiation can constrain the principal's abilities to introduce distortions in order to reduce the agent's rent, so that the first-best benchmark solution will more often be attained.