Department of Economics, UCSD

This paper explores how the opportunity to recontract affects investment and trade in contractual relationships when it is assumed that renegotiation is costly. In this world, recontracting retains much of the benefit that has been ascribed to it, including the realization of any surplus that is available ex post. Costly recontracting also mitigates the well-known drawback, that parties who expect to renegotiate sometimes cannot credibly commit to invest efficiently. This is because the attractiveness of renegotiation decreases in recontracting costs. We show that the optimal contracting environment often involves moderate recontracting costs, which balance the beneficial and detrimental effects of renegotiation. Our result stands in contrast to those derived in common models that assume unrealistically either that recontracting costs are zero or that they are infinite. We discuss implications for the design of legal institutions, governance systems, and contractual form.