Moral hazard, renegotiation, and forgetfulness

When a principal and an agent operate with simple contracts, in equilibrium, renegotiation will occur after the agent takes her action. Since renegotiation makes incentive contracts non-credible, the principal may prefer non-renegotiable monitoring options. The current literature does not fully reconcile these predictions with the observation of simple, non-renegotiated incentive contracts. We model a principal-agent interaction in a social learning framework, and assume that when renegotiation is not observed, agents may forget its feasibility with infinitesimal probability. In the unique stable state of our model, renegotiation occurs with infinitesimal frequency, and second-best simple incentive contracts appear with non-negligible frequency. (C) 2003 Elsevier Science (USA). All rights reserved.