Theory of Agreements

Business partners often start their cooperation with a loose and nonbinding agreement, and subsequently replace it by a strict and binding contract. This paper is the first to analyze such agreements extensively. We identify the role of information, incentives, uncertainty and expectation errors in agreements. We show that an agreement is the most efficient solution if information is symmetric, or quality is fairly uncertain, or expectation errors are large, or the firm with an information advantage contributes more to specifications, or the firm with more bargaining power contributes more to quality. Further, incentives for quality amplify the efficiency improvement of the equilibrium agreement over the equilibrium contract, and the equilibrium agreement can offer higher product quality than the equilibrium contract under certain conditions.