Econometrica: Nov, 1991, Volume 59, Issue 6

Moral Hazard and Verifiability: The Effects of Renegotiation in Agency

https://doi.org/0012-9682(199111)59:6<1735:MHAVTE>2.0.CO;2-N
p. 1735-1753

Benjamin E. Hermalin, Michael L. Katz

We examine the effects of renegotiation in an agency relationship. We show how renegotiation affects: (i) the set of actions the principal can induce the agent to take; and (ii) the cost of implementing a given action. We show that, when the principal receives an unverifiable signal of the agent's action, renegotiation can improve welfare. This result stands in contrast to Fudenberg and Tirole's (1990) finding that renegotiation lowers welfare when the principal receives no signal about the agent's action prior to renegotiation.