Commitment Through Renegotiation-Proof Contracts with Third Parties

The paper analyzes contracts as means of strategic commitment, that is, commitment against outside parties to the agreement. It considers the example of an incumbent firm which enters a contractual relationship with its workers in order to deter entry. It assumes away the possibility for the parties to precommit not to make Pareto-improving renegotiations of the agreement once entry has taken place. Under symmetric information, the contract is thus found to be useless for entry deterrence. If the incumbent firm or workers possess some private information, excessive post-entry production levels can however be sustained ex post, since output reductions may not be incentive compatible. While information asymmetries are usually welfare-decreasing when the goal is optimal risk sharing, they can thus be welfare-improving for the contracting parties when commitment against outsiders is the goal of the contract. The role of the renegotiation process as a constraint on sustainable agreements is stressed in the paper, and the general relevance of strategic contractual commitment is discussed.