Contracts as Reference Points

We argue that a contract provides a reference point for a trading relationship: more precisely, for parties' feelings of entitlement. A party's ex post performance depends on whether he gets what he is entitled to relative to outcomes permitted by the contract. A party who is shortchanged shades on performance. A flexible contract allows parties to adjust their outcomes to uncertainty but causes inefficient shading. Our analysis provides a basis for long-term contracts in the absence of noncontractible investments and elucidates why "employment" contracts, which fix wages in advance and allow the employer to choose the task, can be optimal. (c) 2008 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology..