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Renegotiation and the Efficiency of Investments
The RAND Journal of Economics
Vol. 30, No. 1 (Spring, 1999), pp. 106-119
Stable URL: http://www.jstor.org/stable/2556048
Page Count: 14
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In a long-term relationship between two parties, one party's threat of a unilateral violation of an initial contract may induce a renegotiation of the contract. As a renegotiation may result in one party capturing some of the return from the other's investments, this possibility may lead to underinvestment. I show that if there is uncertainty associated with the outcome of a renegotiation, and if players are risk averse, there will be an interval for the initial contract so that it is not renegotiated. By an appropriate choice of the initial contract, underinvestment can thus be avoided.
The RAND Journal of Economics © 1999 RAND Corporation