TERMINATION CLAUSES IN LONG-TERM-CONTRACTS

Many long-term contracts incorporate a termination clause. This paper argues that when agents have hidden information, such a clause has a b eneficial incentive effect-it enables a principal to screen agents' pr ivate information at a lower cost. In a two-period model, this paper c haracterizes the optimal long-term contract with a termination clause, which specifies that the principal will switch agents in the second p eriod when the first-period cost is high. The analysis delineates how the optimality of this clause depends on the intertemporal cost correl ation structure, on the limits to agents' liability, and on the princi pal's degree of commitment.