Inefficient Agreements: The Role of Second-Order Optimism

This paper provides a novel understanding of delays in reaching agreements: second-order optimism. Under second-order optimism, it is “common knowledge” that there will be delays in reaching agreement. Nonetheless, negotiators do not put forward offers that both parties objectively prefer, because they fear that, by doing so, the other party will become more optimistic about her future prospects. The paper shows that rational, strategically sophisticated bargainers may well face such second-order optimism and that this can give rise to inefficient delays in reaching agreements. Moreover, delay must be an artifact of second-order optimism. The paper goes on to characterize the behavioral implications of delayed agreements that arise from second-order optimism. The results provides a rationale for why directive forms of mediation may be effective.