A Theory of Ex Post Inefficient Renegotiation

We propose a theory of ex post inefficient renegotiation that is
based on loss aversion. When two parties write a long-term contract
that has to be renegotiated after the realization of the state of
the world, they take the initial contract as a reference point to
which they compare gains and losses of the renegotiated
transaction. We show that loss aversion makes the renegotiated
outcome sticky and materially inefficient. The theory has important
implications for the optimal design of long-term contracts. First,
it explains why parties often abstain from writing a beneficial
long-term contract or why some contracts specify transactions that
are never ex post efficient. Second, it shows under what conditions
parties should rely on the allocation of ownership rights to
protect relationship-specific investments rather than writing a
specific performance contract. Third, it shows that employment
contracts can be strictly optimal even if parties are free to
renegotiate.