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Simple contest schemes, which tend to use extreme contemporaneous peer benchmarking, are generally thought to be less efficient at motivating productive and cooperative effort than explicit bonus contracts that optimally weight observed own and peer outputs. We show, however, that contest schemes can outperform explicit bonus contracts in a two-period dynamic setting if periodic output is correlated over time, and contract terms can be renegotiated. In our model, all parties update their beliefs about ex ante unknown time-invariant noise upon observing first-period outputs, and second-period wage offers are updated accordingly. This creates first-period shirking incentives for the agents. We show that relative to bonus contracts, the extreme contemporaneous peer benchmarking in contest schemes can weaken or even eliminate the adverse incentives created by prior-period benchmarking, even though the available information and the learning process are the same under both schemes. This dynamic advantage allows contest schemes to outperform repeated bonus contracts for a wide range of parameter values, despite imposing higher static efficiency losses in each period. If competing agents are assigned to sufficiently similar tasks, a contest scheme's ability to sever the statistical link between periods can yield not only higher early productive effort compared with bonus contracts, but also less uncooperative behavior, despite putting the agents in a more contest-like situation. This paper was accepted by Brian Bushee, accounting. Supplemental Material: The online appendices are available at https://doi.org/10.1287/mnsc.2022.00035. [ABSTRACT FROM AUTHOR]

A primary concern in mergers and acquisitions is the risk the deal may be cancelled before it is completed. We document that "interim risk" varies asymmetrically with the aggregate market return. Deals tend to be renegotiated when the market rises, but cancelled when the market crashes. These effects are conditional on the method of payment and the contracting stage of the deal, consistent with a mechanism of ex post renegotiation. Variation in interim risk over time alters the method of payment in mergers and the firms that are targeted and acquired. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The e-companion and data are available at https://doi.org/10.1287/mnsc.2022.4315. [ABSTRACT FROM AUTHOR]

Motivated by challenges facing IT procurement, this paper studies a hybrid procurement model in which a reverse auction of a fixed-price IT outsourcing contract may be followed by renegotiation to extend the contract's scope. In this model, the buyer balances the needs to incentivize noncontractible vendor investment and to curb the winning vendor's information rent by choosing the initial project scope and the buyer's investment in the quality of the project. We find that a buyer may benefit from inducing ex post renegotiation to motivate vendor investment, especially when the winning vendor has high bargaining power and the quality uncertainty is low. Broadening the initial scope reduces information rent but leaves little room for ex post renegotiation and, hence, discourages vendor investment, whereas increasing the buyer's investment has opposite effects. Interestingly, the two measures can be strategic substitutes or complements depending on the likelihood of the renegotiation and the two parties' bargaining powers. The buyer may strategically set a low initial project scope and high investment to incentivize renegotiation and vendor investment, which may explain why many IT outsourcing projects start small and allow expansions. Our findings also generate several testable predictions for IT outsourcing. This paper was accepted by Kartik Hosanagar, information systems. [ABSTRACT FROM AUTHOR]

Renegotiations and last-minute contracting are prevalent in many vertical relationships. Information transmission between firms and buyers can be imperfect as well. In this paper we present a theory to explicate how early/delayed contracting over wholesale prices, and partial unraveling of private information, can sustain each other endogenously in a channel setting with bilateral monopoly. Should the wholesale price be predetermined, the downstream manufacturer would be compelled to fully disclose all private information. By contrast, the to-be-negotiated wholesale price can be potentially affected by manufacturer disclosure or concealment. This can represent a countervailing force for equilibrium revelation to be imperfect, even when disclosure is costless. Thus partial unraveling may emerge if and only if no enforceable contract has been signed (i.e., contracting is delayed). Conversely, partial unraveling can endogenously influence ex ante preferences for contract timing. Therefore, contracting may be deliberately delayed even without learning/cost considerations. Moreover, equilibrium contract timing can be socially too early to alleviate channel distortions, and bilateral bargaining can align private and social preferences for delayed contracting. This paper was accepted by Dmitri Kuksov, marketing. [ABSTRACT FROM AUTHOR]

We study relationships between parties who have different preferences about how to tailor decisions to changing circumstances. Our model suggests that relational contracts supported by formal contracts may achieve relational adaptation that improves on adaptation decisions achieved by formal or relational contracts alone. Our empirics consider revenue-sharing contracts between movie distributors and an exhibitor. The exhibitor has discretion about whether and when to show a movie, and the parties frequently renegotiate formal contracts after a movie has finished its run. We document that such ex post renegotiation is consistent with the distributor rewarding the exhibitor for adaptation decisions that improve their joint payoffs. This paper was accepted by Joshua Gans, business strategy. [ABSTRACT FROM AUTHOR]

A buyer who wants to procure a complex good is often aware that there may be flaws in her initial design, but she does not know what they look like. Potential sellers who discover flaws have no incentive to reveal them early if the buyer uses a price-only auction. We derive an efficient mechanism that induces all sellers to report flaws early and that allocates the project to the seller with the lowest cost. We show that this can be implemented with a simple two-stage auction that does not require any prior knowledge of the set of possible flaws. This paper was accepted by Yan Chen, decision analysis. [ABSTRACT FROM AUTHOR]

Building on incomplete contract theory, I investigate whether the likelihood of renegotiating financial covenants is affected by the debt-contracting value of borrowers' accounting numbers. The debt-contracting value captures the inherent ability of accounting numbers to predict credit quality. Using a large sample of private credit agreements, I hypothesize and find that a higher debt-contracting value gives rise to smaller ex post measurement errors in accounting numbers used in covenants, and thus borrowers and lenders are less likely to renegotiate financial covenants. This effect is stronger when the financial covenant intensity is higher. Consistent with the notion that renegotiation improves contracting efficiency by eliminating errors in financial covenants, I show that the distance of the covenant variable to its new contractual threshold better predicts a borrower's creditworthiness than does the distance to the original threshold absent the renegotiation. This paper was accepted by Shiva Rajgopal, accounting. [ABSTRACT FROM AUTHOR]

In a stylized model of biopharmaceutical contract manufacturing, this paper shows how the potential for renegotiation influences the optimal structure of supply contracts, investments in innovation and capacity, the way scarce capacity is allocated, and firms' resulting profits. Two buyers contract for capacity with a common manufacturer. Then, the buyers invest in innovation (product development and marketing) and the manufacturer builds capacity. Finally, the firms may renegotiate to allow a buyer facing poor market conditions to purchase less than the contractual commitment and a buyer facing favorable conditions to purchase more. We show that renegotiation can greatly increase the firms' investments and profits, provided that the contracts are designed correctly. Failing to anticipate renegotiation leads to contracts that allow too much flexibility in the buyer's order quantity, and perform poorly relative to contracts designed to anticipate renegotiation. We provide clear conditions under which quantity flexibility contracts with renegotiation coordinate the system. Where quantity flexibility contracts fail, employing tradable options improves performance. © 2007 INFORMS.

A manufacturer writes supply contracts with N buyers. Then, the buyers invest in innovation, and the manufacturer builds capacity. Finally, demand is realized, and the firms renegotiate the supply contracts to achieve an efficient allocation of capacity among the buyers. The court remedy for breach of contract (specific performance versus expectation damages) affects how the firms share the gain from renegotiation, and hence how the firms make investments ex ante. The firms may also engage in renegotiation design, inserting simple clauses into the supply contract to shape the outcome of renegotiation. For example, when a buyer grants a financial "hostage" to the manufacturer or is charged a per diem penalty for delay in bargaining, the manufacturer captures the gain from renegotiation. "Tradable options," which grant buyers the right to trade capacity without intervention from the manufacturer, return the gain from renegotiation to the buyers. This paper proves that, under surprisingly general conditions, the firms can coordinate their investments with the simplest of supply contracts (fixed-quantity contracts). This may require renegotiation design, and certainly requires that the firms understand the breach remedy and set their contract parameters accordingly. © 2007 INFORMS.

After a contract is signed, contracting partners may engage in opportunistic behavior aimed at circumventing the original intention of the agreement governing their business relationship, complying with the letter but not the spirit of the contract. We use an incomplete contracts approach to show that the anticipation and observability of such behavior are typically not enough to prevent it when parties can renegotiate contractual outcomes. This is because contractually specified incentives inevitably have conflicting effects: they simultaneously increase the likelihood of welfare-improving investments and welfare-reducing opportunistic behavior. The possibility of such opportunism thus limits the effectiveness of contractual incentives. We also discuss how our results relate to contracting practices observed in industries characterized by rapid innovation, such as information technology. This paper was accepted by Suraj Srinivasan, accounting. [ABSTRACT FROM AUTHOR]

We study a buyer's sourcing strategy along two dimensions: the supply base design and the pricing mechanism, considering supplier competition and cost-reduction effort. The supply base design concerns the number of suppliers (one or two) included in the supply base and the capacity to be invested in each supplier. The pricing mechanism determines the timing of the price decisions, with the buyer making price commitments before suppliers exert cost-reduction efforts that may be renegotiated afterward. We find that symmetric capacity investment in suppliers and low price commitments (more likely to be renegotiated) are effective at fostering supplier competition, whereas asymmetric investment and high price commitments (less likely to be renegotiated) are better at motivating supplier effort. A complementary relationship exists between the supply base design and pricing mechanism: A more symmetric supply base should be combined with lower price commitments, leading to more renegotiation opportunities. This results in three possible sourcing structures: sole sourcing (investing capacity in a single supplier and forming price with ex ante commitments), symmetric dual sourcing (investing equal capacity in both suppliers and forming price with ex post negotiations), and asymmetric dual sourcing (investing positive but unequal capacities in two (ex ante identical) suppliers and forming price using both ex ante commitments and ex post (re)negotiations). We characterize the conditions for each structure and identify a strategic role of capacity investment. [ABSTRACT FROM AUTHOR]

This paper investigates the impact of royalty revision on incentives and profits in a two-stage (research and development (R&D) stage and marketing stage) alliance with a marketer and an innovator. The marketer offers royalty contracts to the innovator. We find that the potential for royalty revision leads to more severe distortions in the optimal initial royalty contracts offered by the marketer. We show that if the innovator plays a significant role in the marketing stage, the marketer should offer a low royalty rate initially and then revise the royalty rate up later. Otherwise, she should do the opposite. We identify two major effects of royalty revision. First, royalty revision provides the marketer with a flexibility to dynamically adjust royalty rates across the two stages of the alliance to better align the innovator's incentives. This incentive-realigning effect improves the marketer's profit. Second, royalty revision makes it harder for the marketer to obtain private information from the innovator, because the innovator worries that the marketer will take advantage of the information to revise the initial contract to a more favorable one to herself later. This information-revealing effect hurts the marketer's profit. We characterize in what kind of alliances marketers would benefit the most from royalty revision so that managers should clearly establish the expectation for royalty revision, and in what kind of alliances markerters would not benefit from royalty revision so that managers should commit not to revise the initial royalty contract. With royalty contracts that are contingent on the R&D outcome of the R&D stage, we find that contingent contract structure could be either substitutable (by fully capturing the incentive re-aligning effect) or complementary (by weakening the information revealing effect) to royalty revision, depending on whether the innovator plays a significant role in the marketing stage. Managers may need to use a contingent contract (if possible) either to replace or with royalty revision accordingly to improve profits. [ABSTRACT FROM AUTHOR]

This paper examines renegotiation design in contracts for outsourced information technology (IT) services. Whereas prior literature in information systems has highlighted the likelihood of ex post rent seeking engendered by renegotiation, we build upon literature on incomplete contracts to posit that renegotiation can be Pareto improving by incorporating contingencies revealed ex post. Research on contract renegotiation has been hampered by two sets of challenges: the lack of appropriate data and empirical challenges in identification. We circumvent this problem both by appropriate data collection and by employing an identification strategy to address alternate causal explanations. We propose a measure, Pareto improving amendments, to assess renegotiation outcomes that enhance the value from outsourcing by hazard equilibration and by incorporating learning. Using a unique sample of 141 IT outsourcing contracts, we examine the role of decision rights delineated ex ante in enabling Pareto improving amendments and in resolving the trade-off between adaptation and rent seeking. We find that flexibility provisions, termination for convenience rights, and contractual rights whereby vendors are granted rights to reuse know-how are associated with Pareto improving amendments. The results are robust to potential endogeneity of contractual provisions when parties have feasible foresight and to the possibility of adverse selection in the sample. We also examine alternate explanations from the literature on contractual breach. Implications for practitioners and researchers are discussed. [ABSTRACT FROM AUTHOR]

This paper proves the renegotiation-proofness principle for a dynamic LEN (linear contracts, exponential utility, normal distributions) model and examines the impact of repeated renegotiation on incentives and managerial tenure when performance information is serially correlated. In addition to providing a general solution to a multiperiod agency problem with serially correlated performance measures, this paper characterizes optimal managerial tenure/turnover policies as a function of the time-series properties of performance measures. With negatively correlated performance measures, the principal prefers longer managerial tenure, and no turnover is optimal. With positively correlated performance measures, absent a switching cost, turnover every period is optimal. In the presence of a fixed switching cost, interior optimal turnover policies exist if the performance measures are positively correlated. Switching costs are necessary, but not sufficient for interior optimal tenure. The optimal turnover policies present an alternative to theories of performance-driven managerial turnover and are consistent with evidence that a majority of managerial turnovers are (age-related) normal retirements. [ABSTRACT FROM AUTHOR]

This paper studies a queuing model in which a buyer sources a good or service from a single supplier chosen from a pool of suppliers. The buyer seeks to minimize the sum of her procurement and operating costs, the latter of which depends on the supplier's lead time. The selected supplier can regulate his lead time, but faster lead times are costly. Although the buyer selects the supplier to source from (possibly via an auction) and dictates the contractual terms, the buyer's bargaining power is limited by asymmetric information: The buyer only has an estimate of the suppliers' costs, while the suppliers know their costs precisely. We identify a procurement mechanism that minimizes the buyer's total cost (procurement plus operating). This mechanism is not simple: It is a numerically derived nonlinear menu of contracts. Therefore, we study several simpler mechanisms: e.g., one that charges a late fee and one that specifies a fixed lead-time requirement (no menus, no nonlinear functions). We find that simple mechanisms are nearly optimal (generally within 1% of optimal) because asymmetric information conveys significant protection to the supplier, i.e., the supplier is able to retain most of the benefit of having a lower cost. Renegotiation is another concern with the optimal mechanism: Because it does not minimize the supply chain's cost, the firms can be both better off if they throw away the contract and start over. Interestingly, we find that the potential gain from renegotiation is relatively small with either the optimal or our simple mechanisms. We conclude that our simple mechanisms are quite attractive along all relevant dimensions: buyer's performance, supply chain performance, simplicity, and robustness to renegotiation. [ABSTRACT FROM AUTHOR]