Unforeseen Contingencies, Incentives and Economic Power

This paper focuses on the issue of unforeseen or indescribable contingencies, wherein people are unable to foresee, or describe ex-ante some future possibilities that are relevant for them. I build a principal-agent model wherein the agent expends nonmonitorable effort and incurs fixed (hold-up) costs. Within the context of this model, I examine unforeseen contingencies that: (i) increase the fixed costs of the agent, or (ii) adversely affect the returns on the project. In (i), I show that a contract can exist with unforeseen contingencies, even when no contract exists with these contingencies being foreseen. As a result, the agent’s (principal’s) welfare is lower (higher) with unforeseen contingencies, as compared to when these contingencies are foreseen. In (ii), I show that comparing the welfare of parties when contingencies are foreseen and when they are not, leads to ambiguous results. I provide an interpretation based upon rents accruing to the parties if they had private information regarding the unforeseen contingency. In both (i) and (ii), if the unforeseen contingency occurs, renegotiation does not arise endogenously. I show that the timing of the unforeseen contingency is crucial for endogenous renegotiation. I discuss the relevance of these results for the exercise of economic power.