Multilateral Contracting with Externalities

Abstract

This paper proposes a model for multilateral contracting, where contracts are written and renegotiated over time, and where contracts may impose externalities on other agents. The paper derives several properties of the Markov perfect equilibria of the infinite state-space contracting model. Equilibria always exist and the equilibrium value function is linear and monotonic on the contracts. If the grand coalition is not efficient we show that bargaining delays arise in positive-externality games. Otherwise, if the grand coalition is efficient, there are no bargaining delays and convergence to the grand coalition occurs in a finite number of contracting rounds. Thus, if bargaining frictions are insignificant, the outcome is Pareto efficient. However, if bargaining frictions are not small, we show that inefficiencies arise in negative-externality games because contracting takes place in multiple steps, while in positive-externality games contracting occurs in one step and is Pareto efficient.

Keywords: Coalitional bargaining, contracts, externalities, renegotiation

JEL Classification: C71, C72, C78, D62