(DP 2016-06) Why Fixed Rent Contracts are Less Prevalent: Weak Third Party Enforcement and Endogenous Principal Type
We revisit the question of why fixed rent contracts are less prevalent than crop share contracts despite Marshallian inefficiency. We consider the case where the type of the principal is endogenous to contract provisions and reneging by the principal may pay due to weak third party enforcement (TPE). We imbed the quality of TPE into the participation constraint of the agent in an effort-in-advance P-A model. The governance regime explicitly involves interplay of three categories of the Northian enforcement, viz., first, second and third party enforcement. Weak and strong TPE are formally defined. We show that the general contract derived nests the usual textbook contract when TPE is strong; weak TPE on the other hand results in a strictly positive induced risk aversion which always exceeds the inherent risk aversion of the agent. This prevents the power of the contract to equal one even when the agent is risk-neutral, thus, rendering a fixed-rent contract sub-optimal.
JEL Classification: D23, D82, D86
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