SIGNALING AND RENEGOTIATION IN CONTRACTUAL RELATIONSHIPS

This paper examines how the possibility of renegotiation affects contractual outcomes in environments in which adverse selection is a problem. The game setup is an extension of the one-shot signalling game in which an infinite number of rounds of renegotiation are permitted before contracted actions are in fact executed. The main results of the paper are (1) executed contracts may still contain distortions although players can never commit not to renegotiate, (2) the popular ''efficient'' separating-equilibrium outcome of one-shot signalling games is never an equilibrium outcome when an infinite number of rounds of renegotiation are permitted, (3) standard incentive-compatibility constraints can be easily generalized to incorporate situations that allow for an infinite number of rounds of renegotiation, (4) equilibrium outcomes can be separating and nevertheless depend on the uninformed player's priors as informed types pool in the first stage and use the renegotiation stages to separate, (5) renegotiation in signalling games may lead to outcomes similar to equilibrium outcomes of screening games in which multiple contract purchases are allowed.