The renegotiation-proofness principle and costly renegotiation

We study contracting and costly renegotiation in settings of complete, but unverifiable information, using the mechanism-design approach. We show how renegotiation activity is best modeled in the fundamentals of the mechanism-design framework, so that noncontractibility of renegotiation amounts to a constraint on the problem. We formalize and clarify the Renegotiation-Proofness Principle (RPP), which states that any state-contingent payoff vector that is implementable in an environment with renegotiation can also be implemented by a mechanism in which renegotiation does not occur in equilibrium. We observe that the RPP is not valid in some settings. However, we prove a general monotonicity result that confirms the RPP’s message about renegotiation opportunities having negative consequences. Our monotonicity theorem states that, as the costs of renegotiation increase, the set of implementable state-contingent payoffs becomes larger.