Non Verifiability, Costly Renegotiation and Efficiency

Abstract

We study the implications of the non verifiability of information for the allocation of resources and the bearing of risk in a two party relationship. We consider a two step approach. In step one the two parties define a non contingent contract which will be executed when the non verifiable information will become common knowledge of the two parties. In step two a costly exogenous bargaining process takes place. The main result is that with risk neutrality it is possible to induce the first best as a Nash equilibrium of the contract without having to renegotiate. A counter-example shows that the result does not extend to risk averse parties for which non verifiability of information will impede in general risk sharing.