How long-term contracts can mitigate inefficient renegotiation arising due to loss aversion

Purpose This paper revisits Herweg and Schmidt (2015, henceforth H&S), where loss aversion can render renegotiation inefficient, and studies the implications of endogenizing enforcement when renegotiation fails. The goal is to understand how the disagreement outcome − and thus reference-point comparisons − changes when contract performance is not automatic, and what this implies for the relative performance of long-term contracts versus spot contracting. Design/methodology/approach I extend the H&S framework by introducing a date-3 enforcement/exercise decision: after failed renegotiation, parties may invoke enforcement or walk away to an outside option. I analyze specific performance and option contracts, solve by backward induction, characterize enforcement conditions, renegotiation feasibility and renegotiated prices, and compare contract forms, with robustness discussed for alternative reference-point timing/salience assumptions. Findings Allowing for non-enforcement alters the disagreement outcome and creates a behavioral trade-off: accepting a renegotiated proposal can involve losses relative to the original contract, while rejecting it may trigger losses when the disagreement outcome materializes. This can make renegotiation more likely to succeed under loss aversion and can improve long-term contracting in the environments studied, especially under option contracts that allocate enforcement rights unilaterally and make the price a more effective strategic instrument. Originality This paper introduces an endogenous enforcement/non-enforcement margin into a canonical loss-averse renegotiation model and shows how contract form shapes the disagreement outcome that anchors reference points. This mechanism − absent in H&S where disagreement entails automatic contract performance − can change renegotiation incentives and helps explain when option-like structures can outperform spot and benchmark specific performance contracts.