Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion

We consider a simple trading relationship between an expectation-based loss-averse buyer and a profit-maximizing seller. When writing a long-term contract the parties have to rely on renegotiation in order to ensure materially efficient trade ex post. If the buyer expects renegotiation always to take place, the parties are always able to implement the materially efficient good ex post. Expecting materially efficient trade, however, is often not in the buyer's interest, because ex post the seller can opportunistically exploit the buyer's attachment to the expected outcome of renegotiation. In other words, incomplete contracts create a new type of hold-up problem if the buyer is expectation-based loss averse. If credible, the buyer prefers to expect not to renegotiate, which gives rise to ex post inefficiencies. The optimal contract trades off maximizing standard efficiency and minimizing variations in the default outcome and thereby also minimizing the ex ante expected losses