Contract, Renegotiation, and Holdup: An Optimal Contract when Interim Renegotiation Is Possible

Abstract

I consider a canonical bilateral trade setting in which the agents can exert non-verifiable investments, before they play a revelation mechanism and subsequently advance to the trading stage, where they take nondurable actions. Watson (2007) has demonstrated in a similar setting that the set of implementable outcomes is largest (i) when renegotiation can be ruled out, (ii) decreases when renegotiation takes place before the mechanism is played, and (iii) is the smallest when renegotiation takes place after the play of the mechanism. The present paper seeks to clarify the meaning of the second statement. More precisely, I show that the agents can often attain the first best in case (ii), which implies that the fact that the set of implementable outcomes in situation (ii) is smaller compared to situation (i) may not matter much from an efficiency perspective.