Contracts as Reference Points

In this NBER report, Oliver Hart and John Moore argue that a contract provides a reference point for a trading relationship:  more precisely, for parties' feelings of entitlement. A party's ex post performance depends on whether he gets what he is entitled to relative to outcomes permitted by the contract.  A party who is shortchanged shades on performance.  A flexible contract allows parties to adjust their outcome to uncertainty, but causes inefficient shading.  The authors' analysis provides a basis for long-term contracts in the absence of noncontractible investments, and elucidates why "employment" contracts, which fix wage in advance and allow the employer to choose the task, can be optimal. See Contracts as Reference Points. [JH]