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Working Paper No. 1390

Contracting with Endogenously Incomplete Commitment: Escape Clauses

Working Paper
Tangerås, Thomas and Wolfgang Gick (2021). “Contracting with Endogenously Incomplete Commitment: Escape Clauses”. IFN Working Paper No. 1390. Stockholm: Research Institute of Industrial Economics (IFN).

Thomas Tangerås, Wolfgang Gick

We study mechanism design under endogenously incomplete commitment as it arises in contracting with escape clauses. An escape clause permits the agent to end a contractual relationship under specified circumstances, after which the principal can offer an ex-post contract. Escape clauses are valuable when the maximal number of initial contracts is smaller than the number of agent types. We identify a sufficient condition for incentive optimality of ex-post contracting. Escape clauses are always incentive optimal under severely constrained contracting. On the margin, the optimal escape clause balances the benefit of a better-adapted contract against an increase in dynamic inefficiency.