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T ermination C lauses in L ong ‐T erm C ontracts
Author(s) -
Sen Arijit
Publication year - 1996
Publication title -
journal of economics and management strategy
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.672
H-Index - 68
eISSN - 1530-9134
pISSN - 1058-6407
DOI - 10.1111/j.1430-9134.1996.00473.x
Subject(s) - principal (computer security) , liability , private information retrieval , incentive , term (time) , business , computer science , microeconomics , economics , finance , computer security , physics , quantum mechanics
Many long‐term contracts incorporate a termination clause. This paper argues that when agents have hidden information, such a clause has a beneficial incentive effect—it enables a principal to screen agents' private information at a lower cost. In a two‐period model, this paper characterizes the optimal long‐term contract with a termination clause, which specifies that the principal will switch agents in the second period when the first‐period cost is high. The analysis delineates how the optimality of this clause depends on the intertemporal cost correlation structure, on the limits to agents' liability, and on the principal's degree of commitment.