DP2680 Promises, Promises…

Author(s): Juan D Carrillo , Mathias Dewatripont

Publication Date: January 2001

Keyword(s): Time-Inconsistency , Hyperbolic Discounting , Promises , Limits To Contracts

JEL(s): A12 , D84

Programme Areas: Industrial Organization , Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP2680.asp

This Paper considers a time-inconsistent individual who has the ability to make promises that lead to a financial or reputation loss if broken. We first identify conditions under which promises made are kept, and conditions under which they are (partially) broken. Second, we endogenize the financial loss from breaking promises by considering interpersonal monitoring and explicit contracting. We describe optimal contracting under the assumptions that monitoring requires meeting and that meeting also opens the door to renegotiation of earlier promises. Third, we show how the loss from breaking promises can be reinterpreted in terms of reputation loss in the presence of incomplete information. Finally, we argue that the above results remain valid when we replace time-inconsistent preferences with limits to contracting as the source of the commitment problem of the individual. This significantly enhances the generality of these results.