Chapter 5 Dynamic Contracting 5.1 Incomplete contracts In our earlier treatment of contracting problems, we assumed that the in- centive problem was generated by asymmetric information, either a problem of moral hazard(hidden actions)or adverse selection(hidden information) The incomplete contracts approach eschews asymmetric information because of its intractability and instead focuses on environments in which informa- tion is observable but not verifiable. Observable "means the information is common knowledge among the contracting parties. Non-verifiable"means that the information cannot be confirmed by an outside agency such as a court and hence cannot be made an explicit part of any written contract A crucial aspect of the incomplete markets approach is that it allows for renegotiation, that is, agents can replace the pre-existing contract with a new contract at any point if it is mutually beneficial. Renegotiation under ncomplete information is analytically intractable, so this is another reason for avoiding informational asymmetries 5.1.1 The holdup problem This example comes from Hart(1995). There are two firms, MI and M2 Firm M2 produces a widget that is needed by firm Ml at a cost of C*. There is no alternative supplier or purchaser The gross return from the widget is R(i) if MI makes a prior investmentChapter 5 Dynamic Contracting 5.1 Incomplete contracts In our earlier treatment of contracting problems, we assumed that the in￾centive problem was generated by asymmetric information, either a problem of moral hazard (hidden actions) or adverse selection (hidden information). The incomplete contracts approach eschews asymmetric information because of its intractability and instead focuses on environments in which informa￾tion is observable but not verifiable. “Observable” means the information is common knowledge among the contracting parties. “Non-verifiable” means that the information cannot be confirmed by an outside agency such as a court and hence cannot be made an explicit part of any written contract. A crucial aspect of the incomplete markets approach is that it allows for renegotiation, that is, agents can replace the pre-existing contract with a new contract at any point if it is mutually beneficial. Renegotiation under incomplete information is analytically intractable, so this is another reason for avoiding informational asymmetries. 5.1.1 The holdup problem This example comes from Hart (1995). There are two firms, M1 and M2. Firm M2 produces a widget that is needed by firm M1 at a cost of C∗. There is no alternative supplier or purchaser. The gross return from the widget is R(i) if M1 makes a prior investment 1