Investment and liquidation in renegotiation-proof contracts
with moral hazard
In a long-term contract with moral hazard, the liquidation of the firm
can arise as the outcome of the optimal contract. However, if the
future production capability or market opportunities remain unchanged,
liquidation may not be free from renegotiation. Will the firm ever be
liquidated if we allow for renegotiation? This paper shows that the
firm can still be liquidated even though liquidation is not free from
renegotiation in the long-term contract. In addition to liquidation,
the renegotiation-proof contract generates important features of the
investment behavior and dynamics of firms observed in the data.