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Communication and Renegotiation
Birger Wernerfelt*
August 24, 2004
*J. C. Penney Professor of Management Science, MIT Sloan School of Management,
Cambridge, MA 02142, 617-253-7192,[email protected]. The paper has benefitedgreatly from discussions with Bob Gibbons, Oliver Hart, Tracy Lewis, Rohan Pitchford,
Duncan Simester, Steven Tadelis, Miguel Villas-Boas, and numerous seminarparticipants. Of course, the usual disclaimer applies.
JEL Codes: D2, L2
Key Words: Contract Theory, Communication, Renegotiation.
mailto:[email protected]:[email protected] -
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Communication and Renegotiation
Abstract
In a bilateral monopoly, we are looking at the sellers incentives to propose an
improved widget design under two different negotiation rules. With Renegotiation, the
players negotiate a price after a design has been agreed upon, and with Commitment, they
negotiate the price beforehand. The comparison depends on two effects. (1) Bargaining
power: Since communication reveals information about his preferences, a seller with little
bargaining power may prefer to remain quiet in anticipation of ex post negotiation. (2)
Incentive transfer: If the gains from adjustment are large, ex post negotiation gives the
seller a chance to share the gains. On balance, Renegotiation is better when adjustments
are rare but large, while Commitment is better when adjustments are frequent but small.
The comparison might help explain why some contracts have more features left
incomplete and throw some light on the nature of the employment relationship.
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I. INTRODUCTION
One of the central lessons of the incomplete contracting paradigm (Grossman
and Hart, 1986) is that the possibility of renegotiation may keep players from
implementing specific investments. In the present paper we show that another cost of
expected renegotiation is that players will withhold certain types of information.On the
other hand, we also show that other types of information will be withheld if contracts can
not be renegotiated.More generally, when identification of efficient trades require one
player to communicate information to the other, should the players negotiate the price
before or after communication?
We identify three effects of renegotiation: It makes prior communication
- (1) unattractive, because senders prefer opponents with bargaining power to know as
little about their preferences as possible (the bargaining power effect),
- (2) attractive, because the ability to negotiate for a share of the gains from a trade can
give a player incentives to help implement it (the incentive transfer effect), and
- (3) attractive, because the revealed information contributes to the efficiency of the
negotiation process (the bargaining efficiency effect).
Put differently, early negotiation is good because players can communicate without
worrying about revealing their preferences, but bad because payments can not be
contingent on what is communicated. The relative magnitudes of these effects depend on
the extent to which communication reveals preferences, the gains from communication,
and the players relative bargaining power.
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The analysis compares a sellers incentives to propose an improved widget design
to a buyer in two different game forms. In the Commitment game form, the players first
negotiate price and then agree on a design, while the sequence is reversed in the
Renegotiation game form. We imagine that the new design may or may not be more
costly to produce. So if the players are committed to a fixed price, the seller will only
propose it (communicate about it) if it in fact is cheaper for him. Since the new design is
better (more valuable for the buyer), this is inefficient. However, if the seller has
bargaining power, renegotiation may help by allowing him to appropriate part of the
incremental value. This then gives him incentives to communicate even if the new design
is unattractive on a strict cost-basis. However, the argument is complicated by the fact
that the buyer can use the sellers communication-decision to make inferences about his
costs of the two designs. If he proposes the new design, it must be cheap to make, and if
he does not, the old design must be cheap. We rig the model such that the buyer, ceteris
paribus, learns more if the seller communicates than if he stays quiet. In particular, we
assume that the seller only sometimes knows about the improved design. So if he
communicates, the new design is known to be relatively cheap, but if he does not
communicate, the old design could be expensive. To the extent that the buyer has
bargaining power, this reduces the sellers incentives to communicate.
After discussing some related literature in Section II, we present the core
argument in Section III, looking at a model in which the buyer has bargaining power. The
analysis shows that Renegotiation is better when adjustments are rare but large, while
Commitment is better when adjustments are frequent but small. We show in Section IV
that more communication also can be implemented by reallocation of bargaining power
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to the buyer. However, we argue that this alternative instrument is likely to be quite blunt.
More sophisticated contracts, an application to the theory of the firm, and empirical
evidence is discussed in Section V. We end with a brief conclusion in Section VI.
II. RELATED LITERATURE
Our effects are known from other contexts, but we here interpret them differently
and in many cases reverse the direction of the argument. The bargaining power effect is a
cost of renegotiation and as such fits into a large literature on the appropriate allocation
of bargaining power. Most work in the area is concerned with hold up problems, but
Farrell and Gibbons (1995) look at the incentives to communicate. They invoke intuition
similar to ours and show that intermediate allocations of bargaining power are necessary
to give both parties incentives. The present analysis is different because we are varying
the game form - comparing ex ante and ex post bargaining while holding bargaining
power fixed. (In fact, our version of the bargaining power effect is more closely related to
the idea that offering a contract reveals information about the offerer as in Aghion and
Bolton (1987) and Hermalin and Katz (1993)). Another way to limit the harm done by
renegotiation is to commit against doing it and a number of other papers have shown how
such a commitment can be sustained by a commitment not to acquire certain pieces of
information (Cremer, 1995, Dewatripont and Maskin, 1995; Spier, 1992). The bargaining
power effect studied in this paper makes the causality go the other way: A commitment
not to renegotiate influences the amount of information revealed.
The incentive transfer effect plays a role in models in which incentive systems
may cause agents not to reveal information that is of value to their principals
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(Dewatripont and Tirole, 1999; Rotemberg and Saloner, 1993). The arguments are
variants of the hold-up problem. If only one player has search costs, renegotiation can be
bad, because it may prevent a player from getting enough expected surplus to warrant the
specific investment. In the present paper we highlight the opposite case in which it may
be efficient to spread the surplus in ex post negotiation, rather than concentrate it in ex
ante negotiation. This then provides a possible rationale for contractual incompleteness.
Finally, the bargaining efficiency effect is exploited in a lot of signaling and screening
games in which revelation of a players type allows implementation of previously
impossible trades (Akerlof, 1970; Rothschild and Stiglitz, 1976; Spence, 1973).
The most closely related paper is by Gertner (1999), who also is concerned with
withholding of information. He compares a game form with a neutral arbitrator (a firm)
and an asymmetric game form in which one party has control (a market). So
information is sent to a neutral party in one, but an adversary in the other. Ergo, less
information is sent in the latter case. In the present paper, information is always sent to an
adversary, but either after or before negotiation. Depending on parameter values, we find
that there may be more communication with or without renegotiation. On the other hand
both papers predict that concerns about bargaining power ceteris paribus will hamper
communication.
III. BASIC MODEL
A seller and a buyer may trade a widget. The initial plan is to trade the old
design, but with probability < 1, the seller can also produce a new and improved
design. It is common knowledge that the buyer values the old design at 1 and the new
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design at rn > 1. The seller incurs costs co for the old design and cn for the new design.
These costs are privately known, but i.i.d. draws from a uniform distribution over [0,1].
Only the seller knows if he can produce the new design and if he can, he may propose it
to the buyer who then may select either of the two designs. Because she can invert the
sellers equilibrium strategy, the buyer may get information about the relative magnitudes
ofcoand cn from the sellers decision to propose the new design or not. However, since it
is possible that the seller can not produce the new design (< 1), a failure to propose is
generally less informative than a proposal because it leaves open the possibility that co is
high. These inferences will be important because we do not allow contracts to depend
on whether a design is old or new, nor on whether a proposal was made. (We imagine
that outsiders understand very little about the products and that neither the truthfulness,
nor the occurrence, of communication is verifiable.)
We model the bargaining game by assuming that one of the players has all the
bargaining power and makes a take-it-or-leave-it (TIOLI) offer. In this Section, we
assume that the buyer makes the offer. This negotiation mechanism is clearly arbitrary
and in general less than second best. However, it is very simple to work with, and it has
the property that bargaining is more efficient when players have better information, such
that we can isolate the bargaining efficiency effect.
Given the situation described above, we will compare two game forms. In the
Commitment game form, the players make decisions about the design in light of an ex
ante negotiated price, while the price in the Renegotiation game form is negotiated ex
post, once the design is known. It is clearly possible to look at a number of other game
forms. In particular, one could imagine a game form with some intermediate degree of
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commitment (Aghion and Tirole, 1997; Rogoff, 1985) to an ex ante negotiated contract.
However, as a first cut, we will focus on a comparative analysis of the two extreme cases
with full and no commitment.
The Commitmentgame form is defined by the following six stages:
1. The players write a contract, which says that the sellerwill deliver an unspecified
design as chosen by the buyer. In return, hegets w if a trade is made. The players
negotiate w according to the bargaining mechanism described above. If negotiations
fail, the game ends with (seller, buyer) payoffs (0, 0).
2. The seller learns whether or not he can produce the new design.
3. The seller learns his costs for the old design, and if he can produce it, those for the
new design as well.
4. The sellermay propose the new design to the buyer.
5. The buyermay ask the seller to deliver a specific design. If she does not, the game
ends with total (seller, buyer) payoffs (0, 0).
6. The seller may deliver the design in question, and if he does, the (seller, buyer)
payoffs are (w - cn, w + rn) when the new design is delivered, and ( w - co, w + 1)
when the old design is delivered. If the seller does not deliver, or delivers the
wrong design, the game ends with total (seller, buyer) payoffs (0, 0).
TheRenegotiation game form is identical except that negotiation takes place after the
players have agreed on a design. It is formally defined as follows:
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1. The seller learns whether or not he can produce the new design.
2. The seller learns his costs for the old design, and if he can produce it, those for the
new design as well.
3. The sellermay propose the new design to the buyer.
4. The buyermay ask the seller to deliver a specific design. If she does not, the game
ends with total (seller, buyer) payoffs (0, 0).
5. The players negotiate w according to the bargaining mechanism described above. If
they succeed, they write a contract specifying that the seller will get w in return for
delivering the chosen design. If negotiations fail, there are no further payoffs and the
game ends with total (seller, buyer) payoffs (0, 0).
6. The seller may deliver the design in question, and if he does, (seller, buyer) payoffs
are (w - cn, -w + rn) when the new design is delivered, and (w - co, -w + 1) when the
old design is delivered. If the seller does not deliver, or delivers the wrong design,
the game ends with total (seller, buyer) payoffs (0, 0).
The first best calls for the new design to be chosen when rn - cn> 1 - coand forall
bargains to succeed. However, both game forms will have trouble inducing the seller to
propose the new design in sufficiently many cases, and both will suffer some failed
bargains. Since the Commitment game form is easier to analyze, we look at that first.
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The Commitment Game Form.
With ex ante negotiation, communication and choice can not influence
bargaining, so the equilibrium is relatively simple. Analyzing from the back, we first
assume that the price is less than 1. In this case, the buyer will always want the new
design because she values it more than the old design or the price. The sellerwill propose
the new design wheneverco > cnand he will want to deliver if the price is larger than the
smaller of the two costs. The buyers best TIOLI offer below 1, call wb, will be
wb= Argmax[(rn/2 + - w)Prob(w > Min{co, cn}) + (1 - )(1 w)Prob(w > co)]
= Argmax[(rn /2 + - w)(2w w2
) + (1 - )(1 w)w] =
= [rn + 3 + 2/- ( rn2
+ 9 + 4/2 - 6rn + 4rn/)1/2
]/6. (1)
Since this is independent of the realized costs, the seller communicates iff he can produce
the new design and cn < co. The probability of this is /2.
If the price exceeds 1, the buyer will only want to trade for the new design, the
seller will always want to deliver, and the seller will propose it if possible. So by setting
the price slightly above 1, the buyer can commit herself to refusing any trade for the old
design and thus induce the seller to communicate with probability . Since this
guarantees her close to (rn 1) in expected payoff, she will prefer it if
(rn 1) > (rn /2 + - wb)(2wb wb2) + (1 - )(1 wb)wb, (2)
where wb is defined by (1). After using the envelope theorem and doing a bit of algebra,
we can see that (2) is more likely to hold for larger values ofrnand. This makes
intuitive sense. When rnandare large, the new design promises large expected payoffs
and the buyer is willing to pay extra and forego the old design for the chance to cash in
on the new. We can summarize this in
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Result C:The Commitment game form has a unique equilibrium and the seller
communicates with probability or/2 depending on whether or not (2) is satisfied.
The Renegotiation Game Form.
The game form with renegotiation is in general much more complicated. The sellers
decision about whether or not to communicate to depends on (co, cn) [0, 1]2, and the
buyers TIOLI offers in turn depends on the posterior cost distibutions induced by the
equilibrium communication strategy. Fortunately, the following Lemma greatly simplify
the analysis.
Lemma: There exists a [-1, 1],such that it is a dominant strategy for the seller to
communicate iffcn co.
Proof: Let wn and wo be the buyers TIOLI offers for the new and old design,
respectively. When the buyer makes her choice between the new and the old design, she
only has the sellers communication decision to condition on. Suppose first that the buyer
selects the new design whenever possible.If the seller communicates, his expected
payoffs are Max{wn- cn, 0}, while they are Max{wo- co, 0} if he does not communicate.
Since the buyers offers reflect only her beliefs about the sellers communication strategy
and do not change with the actual strategy, it is a dominant strategy for the seller to
communicate iff he can produce the new design and cn co < wn
wo. If the buyer does
not select the new design, the seller can avoid revealing any information by setting = 1
and pooling. QED
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We can solve the game backwards under the assumption that the sellers
communication strategy is completely characterized by the parameter[-1, 1]. To find
the buyers TIOLI offers in stage 5, we look for the posterior cost distributions as
functions of. There are three possible histories up to stage 5.
History 1: The seller did not propose the new design. This leaves open two cases. One is
that the seller is not able to produce the new design, and the other is that he can produce it
but has chosen not to propose it. To construct the posterior distribution ofco, we start by
finding the posteriors conditional on each of the cases - first assuming that = 0 and then
that = 1. The case where = 0 is easy: If the seller did not communicate because he
can not produce the new design, the probability that w > co is just w. The case where =
1 forces us to look at two different regions. (i) If> 0 the conditional posterior density is
triangular and decreasing, such that the probability that w > cois [2w(1 - ) - w2]/(1 - )2
for 0 < w < 1- . (ii) If< 0 the conditional posterior density is shaped like a square less
a triangle in the upper right corner and the probability that w > cois w/[1/2 -2/2 - ] for
w < - and [w (w +)2/2]/[1/2 -2/2 - ] forw > - . Since the buyer can not tell the
two cases apart, she will make her TIOLI offer based on the unconditional posterior. We
can find the posterior probabilities that the seller can not produce the new design as
() (1 - )/[1 - (1/2 + + 2/2)] for > 0, and
(1 - )/[1 - (1/2 + - 2/2)] for < 0.
Given this, the posterior distribution ofco is
F1(w|) ()w + [1 - ()][2w(1 - ) - w2]/(1 - )2 for > 0 and w < 1 - ,
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()w + [1 - ()]w/[1/2 - 2/2 - ] for< 0 and w < - , and
()w + [1 - ()][w (w +)2/2]/[1/2 -2/2 - ] for< 0 and w > - .
So we can find the buyers TIOLI offer after History 1 as
wo()Argmax(1 w)F1(w|). (3)
We can use standard tools to derive several properties of the buyers expected
payoff and his offer. Note first that are both continuous functions of, that is
decreasing in , andthat the distributions [2w(1 - ) - w2]/(1 - )2, w/[1/2 - 2/2 - ], and
[w (w +)2/2]/[1/2 -2/2 - ], all dominate w on [0, 1]. Sowe can appeal to the
envelope theorem to conclude that the buyers expected payoff is an increasing function
of, and we can use the implicit function theorem to see (after some algebra) that wo is
weakly decreasing in . Neither result is surprising, because larger values ofincreases
the likelihood that the buyer is facing a more favorable cost-distribution.
The effects ofare more complicated. The buyers expected payoff and his offer
are both continuous functions of, but it affects (3) in two different ways. Reflecting the
fact that() is increasing, higher values ofincrease the posterior probability that the
seller had no choice, implying that the buyer more likely faces relatively unattractive
(uniform) cost distribution. However, if the seller had a choice and decided against
communicating, the distribution faced by the buyer is more attractive for higher values of
. The former force, which we will call the bargaining power effect, dominates for small
and the latter for large . So when is close to zero, the buyers expected payoff are
decreasing in , while wo is increasing in . Conversely, the buyers expected payoff are
increasing in , while wo is decreasing in when is close to one.
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History 2: The seller proposed the new design but the buyer chose the old. In this case the
posterior density ofcois less attractive than the uniform. If< 0, the density is shaped
like an increasing triangle and the probability that w > co is (w 1 - )2/2 forw > 1 + .
If> 0, the density is shaped like a square less a triangle in the upper left corner. In this
region the probability that w > cois [w + w2/2]/[1/2 -2/2 + ] for 0 < w < 1- , and [1/2
-2/2 + w (1 - )]/[1/2 -2/2 + ] for 1 - < w < 1. If we denote this distribution byF2,
the offer that maximizes expected payoffs for the buyer, call wo, is
wo() = Argmax(1 w)F2(w|). (4)
The expected payoffs are again a continuous function ofand sinceF2 becomes more
attractive as increases, we can use the envelope theorem on (4) to conclude that the
buyers expected payoffs are increasing in .
History 3: The seller proposed the new design and the buyer chose it. If< 0, the
posterior density ofcnis shaped like a decreasing triangle and the probability that w > cn
is 1 (1 + - w)2
/(1 - )2
forw 0, the posterior density ofcnis shaped like
a square less a triangle in the upper right corner. We can find the probability that w > cn
as w/[1/2 -2/2 + ] for 0 < w < , and [w (w - )2/2]/[1/2 -2/2 + ] for < w < 1. If we
denote this distribution byF3, the buyers TIOLI offer will be
wn() = Argmax(rn w)F3(w|). (5)
The expected payoffs are once again a continuous function of. As increases,
the density becomes less favorable implying that the buyers expected payoffsare
decreasing in , while wnis increasing in .
Going now to stage 4, the buyer will choose the new design iff
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[rn wn()]F3(wn()|) >[1 wo()]F2(wo()|), (6)
where wn() and wo() are given by (3) and (2), respectively. We have seen that the left
side is decreasing in , while the right side is increasing. So (6) defines a critical value,
call (rn), such thatthe buyer always chooses the new design ifis smaller than (rn),
and never chooses it if> (rn). As the problem has limited interest if the buyer never
chooses the new design, it would be convenient if> 1, such that (6) holds for all values
of. A sufficient condition for this is [rn wn(1)]F3(wn(1)|1) >[1 wo(-1)]F2(wo(-1)|-1),
which reduces to rn2/4 > 4/27. So it follows from rn > 1 that the buyer always chooses the
new design.
Given the above, we can disregard History 2 and conclude that the seller will
communicate in stage 3 iffwn() cn > wo()co, such he prefers History 3 over History
1. According to the Lemma, an equilibrium is defined by a * satisfying
* { wn(*)wo(*), 1}. (7)
The existence of at least one * follows from the facts that wn()
- wo() is continuous,
wn(-1)wo(-1)= 0 > -1,and wn(1)
wo(1)= rn/2 > 0. So there is a * < 1 ifrn< 3.
Furthermore, since wn(0)wo(0)= 1 (1/3)
1/2- < 0, there is a * < 0 if 0 and rn = 1.
We can summarize the above analysis in:
Result R:The Renegotiation game form has at least one equilibrium. Any equilibrium is
characterized by a * [-1, 1] and the seller communicates iff cnco
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The result combines at least two interesting effects. First, there is more
communication for large values ofrn due to the incentive transfer effect. Because the
buyer wants to be sure that her offer is accepted, she will bid more and thus transfer some
of the incentives to the seller. Secondly, ifis small, the bargaining power effect may
cause the seller to remain silent even ifcn< co. Not communicating allows him to extract
a better offer by hiding behind the 1 - probability that he could not produce the new
design. We get * >0 and more communication when the incentive transfer effect
overwhelms the bargaining power effect.
It is difficult to make a global comparison with the Commitment game form, but
we can characterize the relative intensity of communication in several different regions of
the parameter space. (i) Ifrnandare very large, the probability of communication is
in both game forms. (ii) Ifrn is large and is small, the probability is with
Renegotiation and /2 with Commitment. (iii) Ifrn is small and is large, the probability
is less than /2with Renegotiation and /2 with Commitment. (iv) For intermediate
values ofrnand, Renegotiation implements communication with probability between
and /2, while the probability is /2 in the Commitment game form. (v) For very small
values ofrnand, Renegotiation implements less communication than Commitment.1
The comparison between regions (ii) and (iii) shows that Renegotiation is better when
adjustments are rare but large, while Commitment is better when adjustments are
frequent but small. We can intuitively understand this as a result of the tradeoff between
the incentive transfer effect and the bargaining power effect.
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IV. THE SELLER HAS POWER
To see how the effects are driven by the allocation of bargaining power, we now
look at the case in which the communicating party makes the TIOLI offer. We start with
the Commitment game form.
The Commitment Game Form
Again analyzing from the back, we first assume that the price is less than or equal
to1. In this case, the buyer will always want the new design, the sellerwill propose it
wheneverco > cn,and he will want to deliver if the price is larger than the smaller of the
two costs. If the price exceeds 1, the buyer will only want to trade for the new design, the
seller will always want to deliver, and the seller will propose it if possible. When the
seller makes the TIOLI offer, call ws, she will want to set it equal to 1 if
1 (1 - )/2 - EMin{co, cn} > (rn - ), (6)
and otherwise equal to rn. So ws = 1 for small values ofrnand . In such cases, the seller
communicates iff he can produce the new design and cn < co. For larger values ofrnand
, the seller sets ws = rn and then communicates whenever he can make the new design.
Simplifying (6) and summarizing, the probability of communication is /2 or
depending on whether or not rn< 1/3 + 1/(2).
Compared to the case in which the buyer makes the TIOLI offer we find the same
basic effect. When rnand are large, the new design promises a lot of expected surplus
1Renegotiation may be more efficient in some cases when * < 0 because the buyer makes her TIOLI offer
with better information. However, the Commitment game form will be more efficient for sufficiently small
values ofrnand.
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and the price is set to ensure that the probability of communication is maximal at . For
smaller values of one or both of the parameters, the probability of communication is
again /2.
The Renegotiation Game Form
Since the seller makes his TIOLI offer with complete information, it is obvious
that the will charge 1 for the old design and rn for the new. This makes the analysis of the
Renegotiation game form much easier. Note first that the Lemma continues to hold.
Assuming that the buyer selects the new design whenever possible, the sellers expected
payoffs from communication are rn - cn, while they are 1 - co if he does not communicate.
It is a dominant strategy for him to communicate iff he can produce the new design and
cn - co< rn -1. So * = Min{rn 1, 1}, and the probability of communication is ifrn > 2,
and (2rn - rn2/2 1) forrn [1, 2].
2
Comparing with the case in which the buyer makes the TIOLI offer we here see a
somewhat different picture. The communication and offer strategies implement the first
best and neither the bargaining power effect nor the incentive transfer effect plays any
role. This is once again intuitively appealing, since all the bargaining power and therefore
all surplus is given to the player who communicates. The distortions discussed in Section
III appear because communication and power are misaligned.
The finding that communication can be induced by an appropriate allocation of
bargaining power is consistent with Farrell and Gibbons (1995). There are, however,
many reasons to doubt the feasibility of this solution: (i) Bargaining power may not be a
control variable, for example if it is tied to market position. (ii) Other forces, such as a
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desire to minimize hold up problems, may influence the optimal allocation of bargaining
power. (iii) The parties may be communicating about several issues, suggesting different
allocations of power. (iv) There may be uncertainty on both sides. For example, suppose
that rn equals Rn with probability and otherwise is one. In this case the sellers TIOLI
offer will beRn or 1, depending on the relative magnitudes of(Rn -cn) and 1 cn. If the
latter is larger, he will offer 1 and communicate with probability (iffcn < co). So in this
case nothing is accomplished by reallocating bargaining power.
There is no question that some communication problems can be solved by
reallocation of bargaining power, but a change in game form is an alternative instrument.
A significant advantage of solution-by-game-form is that it can be done on a feature by
feature basis as a contract is designed. A disadvantage is that the solutions are likely to be
imperfect.
V. DISCUSSION
In this Section, we generalize the Commitment game form, argue that it has
several properties in common with an employment contract, and review some empirical
evidence with this in mind.
Aligning Incentives in the Commitment Game Form
One way of thinking about the inefficiencies in the Commitment game form is that
the players gains from adjustment are uncorrelated. The players could reduce the
problems caused by the incentive transfer effect by increasing the correlation, thereby
raising the efficiency of the commitment game form. As we saw in the Result C, if the
2 Compared to the Commitment game form, we see that Renegotiation is better because the price can be
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seller has an idea that will increase the buyers revenues, he will still not communicate it
unless it reduces his own costs. However, he will be more cooperative if the contract
gives him a different payment when the buyer has large gains. (This is of course just an
example of the principle that an ex ante contract is more efficient if it is closer to being
complete.)
Even if we maintain the assumption that it is impossible for the players to contract
directly on the nature of the design itself, there are many other ways of inducing
correlation. To illustrate the general idea, we will look at a single example: the widgets
come in units,the contract species a unit price, and the buyer may choose to use more
units of the new design than of the old. Suppose that the buyers unit revenues are o and
nfor the old and new designs, respectively. If she buys the quantity Q() and v is the
unit input price, then w = vQ may let the seller share some of the gains from adjustment
without ex post renegotiation. Specifically, the buyers gains from adjustment are
Q(n)(n- v) - Q(o)(o - v),while the sellers gains are Q(n)(v - cn) - Q(o)(v - co). The
ability to use such contracts allows the Commitment game form to induce more
communication.
Interpretation of the Commtment Game Form as an Employment Contract
Like the seller in the Commitment game form, employees take orders and only
rarely ask to renegotiate their compensation as a direct consequence of a new order. In
contrast, and like the seller in the Renegotiation game form, independent contractors
typically renegotiate prices as a result of change orders.
adjusted to reflect the identity of the traded design.
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There are several possible explanations for these stylized facts. The property
rights theory of the firm (Grossman and Hart, 1986; Hart and Moore, 1990; Hart, 1995)
defines the boss by asset ownership and explains the stylized facts by appeal to the power
this confers to him. Employees attempts at renegotiation are bound to fail because they
are powerless, while independent contractors have power and thus the ability to extract
some rents from a change. In contrast, the adjustment-cost theory (Bajari and Tadelis,
2001; Simester and Wernerfelt, 2004; Tadelis, 2002; Wernerfelt, 1997; 2002; 2004)
defines the employment relationship as an implicit contract in which the employee has
agreed to refrain from renegotiation, retaining only the right to quit. It explains the
efficiency of this institution by claiming that frequent renegotiation is costly. On the other
hand, there are also various costs associated with an employment relationship and if these
costs are larger than those of infrequent renegotiation, a market relationship may be more
efficient. A central prediction of this theory is then that relationships needing more
frequent adjustment are more likely to be organized inside the firm. (The difference
between the work done by a secretary and that done by a homebuilder may illustrate this
contrast.) In the present paper, we have added another force to the tradeoff by showing
that the market may implement a different set of adjustments than those implemented in a
firm.3
Phrased in these terms, our central finding is that the market is better when
adjustments are rare but large, while employment is better when adjustments are frequent
but small.
No matter what the primary reasons for the existence of firms, they are clearly
subject to the informational inefficiencies of the commitment game form, while markets
3Another attractive feature of the story is that it suggests that the more informed party should have more
power, i. e. be the boss.
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suffer from the problems of the renegotiation game form. We would expect certain kinds
of information to be withheld in firms, and other kinds to be withheld in markets. Put
differently, we would expect that firms and markets implement different sets of
adjustments. So we can use firms and markets as examples of the commitment and
renegotiation game forms and thereby throw empirical light on the model.
Empirical Evidence
It is not hard to find evidence consistent with the bargaining power effect. At an
informal level, one often hears that firms keep secrets, to enhance their short-term
negotiating positions or to protect long-term market power. More systematically,
Simester and Knez (2001) study a company in which eighteen different parts are made
both by employees and by independent suppliers. Consistent with the prediction that
concerns for bargaining power lead to less communication between firms, they find that
external suppliers give the company less information about delivery and production
schedules and fewer design suggestions. They even report that the company restricts
communication between its engineers and those of outside suppliers.
It is harder to find systematic evidence consistent with the incentive transfer
effect. Most people know stories in which employees withhold information because its
release would make their job harder slipping deadlines and maintenance needs come to
mind (Rotemberg, 2001). The sociology literature documents individual cases in which
employees make certain tasks seem harder than they really are (Roy, 1955), and cases in
which information is hidden from management (Crozier, 1964). However, I have not
been able to identify a large sample study of this phenomenon.
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We may be able to get some sense of the balance between the two effects by
comparing incremental and radical new product development. When improvements are
incremental, the new products revenues will be only marginally higher than those of the
old product, and one could argue that commitment (a.k.a. integration) should be best. For
more radical changes, the new product may command much higher revenues, and
renegotiation (a.k.a. the market) will be more efficient. This general prediction, that more
radical innovations tend to occur between, rather than within firms, is in fact supported
by literature in the area of innovation management (Freeman, 1991; Hagedoorn, 1995;
Powell et al.,1996).
VI. CONCLUSION
The paper has contributed to contract theory by showing that different types of
information is communicated and withheld under ex ante versus ex post negotiation. In
particular, when gains from trade are private information, concerns for bargaining power
in ex post negotiation may cause players to withhold information. On the other hand, ex
post negotiation may provide incentives for communication because it allows the players
to share the resulting gains. On balance, we find that ex post negotiation is better when
adjustments are rare but large, while ex ante negotiation is better when adjustments are
frequent but small.
On a more applied level, we have contributed to the literature on incomplete
contracts by showing how the possibility of renegotiation influences information transfer
between traders. This may help explain why some contracts have more features left up to
renegotiation than others. Finally, because adjustments do not lead to renegotiation in
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employment contracts, the results also allow us to suggest that the information
communicated in firms differ from that communicated in markets.
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