To solve our incentive problem, we have implicitly assumed that the principal has a strong ability to commit himself not only to a distribution of rents that will induce information revelation but also to some allocative inefficiency designed to reduce the cost of this revelation. Alternatively, this assumption also means that the court of law can perfectly enforce the contract and that neither renegotiating nor reneging on the contract is a feasible alternative for the agent and (or) the principal. What can happen when either of those two assumptions is relaxed?

1. Renegotiating a Contract

A first source of limited commitment occurs when the principal can renegotiate the contract offered to the agent along the course of actions. Renegotiation is a voluntary act that should benefit both the principal and the agent. It should be contrasted with a breach of contract, which can hurt one of the contracting parties. One should view a renegotiation procedure as the ability of the contracting partners to achieve a Pareto improving trade if any becomes incentive feasible along the course of actions.

Once the different types have revealed themselves to the principal by selecting the  contracts  (tSB, qSB) for  the  efficient  type  and  (t¯SB, q¯SB) for  the  inefficient  type, the principal may propose a renegotiation to get around the allocative inefficiency he has imposed on the inefficient agent’s output. The gain from this renegotia-tion comes from raising allocative efficiency for the inefficient type and moving output  from  q¯SB   to  q¯*.  To  share  these  new  gains  from  trade  with  the  inefficient agent, the principal must at least offer him the same utility level as before rene- gotiation. The participation constraint of the inefficient agent can still be kept at zero  when  the  transfer  of  this  type  is  raised  from .  How-ever, raising this transfer also hardens the ex ante incentive compatibility constraint of the efficient type. Indeed, it becomes more valuable for an efficient type to hide his type so that he can obtain this larger transfer, and truthful revelation by the efficient type is no longer obtained in equilibrium. There is a fundamental trade-off between raising efficiency ex post and hardening ex ante incentives when renegotiation is an issue.

The ability to commit to a menu of contracts may not be too problematic in some instances. Producing a quantity q may require building capacity up to that level. Raising production as requested by the renegotiation procedure asks for increasing the productive capacity and this can be excessively costly com- pared to the allocative gains coming from a larger volume of trade. Moreover, this commitment issue seems highly dependent on the use of a direct revela- tion mechanism since renegotiation takes place after the agent has revealed his type but before the principal imposes an output target.28 Therefore let us con- sider the simple and equivalent indirect mechanism where the principal offers the same menu to the agent but lets the agent choose the output himself (as we did in section 2.9). This alternative mechanism does not require any communication from the agent to the principal before production takes place. The agent makes the choice of an output and, if this choice is irreversible, there is no scope for renegoti- ation since the one-shot relationship ends. The commitment issue becomes much more problematic in truly dynamic contexts where different actions take place at various dates.

2. Reneging on a Contract 

A second source of imperfection arises when either the principal or the agent causes a breach in the contract and thus reneges on their previous contractual obligation. Let us take the case of the principal reneging on the contract. Indeed, once the agent has revealed himself to the principal by selecting the contract within the menu offered by the principal, the latter, having learned the agent’s type, might propose the complete information contract which extracts all rents without inducing any allocative inefficiency. Of course, this breach of contract should be anticipated by the agent and the agent’s anticipation of the breach will interfere with his truthful revelation in the first place. Additionally, the agent may want to renege on a contract which gives him a negative ex post utility level as we mentioned in section 2.11.1. In this case, the threat of the agent reneging a contract signed at the ex ante stage forces the agent’s participation constraints to be written in interim terms. Such a setting justifies the focus of this chapter on the case of interim contracting.

Source: Laffont Jean-Jacques, Martimort David (2002), The Theory of Incentives: The Principal-Agent Model, Princeton University Press.

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