Contracting with Externalities and Outside Options

Abstract

This paper proposes a model of multilateral contracting where players are engaged in two parallel interactions: they dynamically form coalitions and play a repeated normal form game with temporary and permanent decisions. We show that when outside options are independent of the actions of other players all Markov Perfect equilibrium without co-ordination failures are efficient, regardless of externalities created by interim actions. Otherwise, in the presence of externalities on outside options, all Markov perfect equilibrium may be inefficient. This formulation encompasses many economic models, and we analyse the distribution of coalitional gains and the dynamics of coalition formation in four illustrative applications.

Keywords: Outside options, Externalities, Coalitional bargaining

JEL Classification: C71, C72, C78, D62