Dynamic contracting under adverse selection and renegotiation

We study an in…nitely repeated principal-agent model with adverse selection and renegotiation. The model is suitable for studying procurement, labor market relationships, and monopoly pricing, which is our main interpretation. A monopolist faces a consumer who has private information regarding his preferences for quality. The monopolist can o¤er long-term contracts, promising to deliver a certain quality in each future period. The terms of the contract must be honored unless both parties agree to renegotiate. The monopolist chooses to gradually screen consumers who have high taste. During the screening process, these consumers balance the desire to immediately start consuming the high-quality good against the wish to pool themselves with consumers who have low taste and purchasing the high-quality good at a lower cost later. The model predicts an expected wedge between the marginal bene…t for each kind of consumer and the marginal cost for the monopolist. As the parties renegotiate, this wedge gradually decreases and eventually disappears. We show that a version of the Coase conjecture holds for the monopoly model even in the case of a nondurable good. The possibility of renegotiation decreases the monopolist’s ability to extract rents from consumers. This e¤ect becomes more severe when the time periods shrink and, as a result, the allocation converges to an e¢ cient allocation. I am very indebted to Larry Samuelson for his encouragement, support and guidance. I am also very grateful to Dino Gerardi and Johannes Hörner for their valuable advice. I thank Dirk Bergemann, Mehmet Ekmekci, Eduardo Faingold, Daniel Gottlieb, Vitor Luz, Rick Mans…eld, Giuseppe Moscarini, Philip Reny, Eduardo Rodrigues, Priscila Souza, Joel Watson and all the seminar participants at Yale and at the Midwest Economic Theory Conference for comments and suggestions. Any remaining error is mine.