Rights of first refusal are contract clauses common in such industries as entertainment. In 2001, Paramount Studios and the National Broadcasting Company negotiated the broadcasting rights for the hit show "Frasier." NBC held a right of first refusal that seemingly would give it an incumbent advantage.

But did it really? As Harvard Business School professor Alvin E. Roth and Texas A&M professor Brit Grosskopf demonstrate in recent research, the devil is in the details. And the devil gave Paramount, not NBC, the true upper hand.

Likewise the Landlord and Tenant Act of 1987 was written to protect renters in Britain when their landlord put their flat up for sale. Renters had a right of first refusal to purchase the property. In the end, however, the right worked against the renters.

The issue in both contracts, says Roth, who specializes in game theory, experimental economics, and market design, was that the right was structured as what he terms a Before and After Right of First Refusal (BA-ROFR). The right holder is offered an initial deal by the asset owner—the landlord offers to sell the flat to the renter for $100,000, probably a relatively high price. If the tenant rejects the deal, the landlord is free to offer the property to a third party. But the tenant is still in the game. If the owner and a third party agree on a price below the $100,000 originally offered to the tenant, the tenant has the option to acquire the property for that lower price.

Seems like a sweet opportunity for the tenant. But the timing of the deal works in favor of the landlord, who can now present an ultimatum to the third party saying that if the third party offers a price below $100,000 the renter has a right to match the offer. The BA-ROFR not only strengthens the bargaining position of the owner with the third party, but it also allows the initial offer to the tenant to be set high.

To explore the question of who actually benefits from this particular right of first refusal, the researchers conducted an experiment by designing two bargaining games that modeled a network/studio negotiation. The resulting paper "If You Are Offered the Right of First Refusal, Should You Accept?" is scheduled to be published later this year in the journal Games and Economic Behavior.

Sean Silverthorne: Rights of first refusal come in many forms, but your study focuses on BA-ROFR. Why are these agreements a fertile ground for your research?

Alvin Roth: We noticed those because they are unusual, and because they appear to be mistakes. Sometimes you get increased insight into how something—in this case a contract clause—works by studying the ones that don't work so well. (That's a line of thought that has led me and my colleagues to study many failed markets—some of which we've helped fix.)

Q: Your work demonstrates that before and after rights actually work to the disadvantage of the holder. Why is this so, and is it always true?

A: Most rights of first refusal give the right holder a last-mover advantage. As we discuss in the paper, that conveys a lot of benefits: It allows the right holder to move in and take good deals if they become available to third parties. And if, as is often the case, the right holder is the incumbent user of the asset, the fact that he has such a last mover advantage may discourage third parties from investing in trying to purchase the asset.

But all that is turned upside down by the before and after rights we studied, since in those, the right holder has to exercise his right at a high price before a third party has a chance, but retains the right for any lower price. This allows the asset owner to present any third party with an ultimatum offer: Buy at the high price, or not at all. By increasing the bargaining power of the asset owner in this way, the right works to the disadvantage of the right holder.

Q: How did the traditional ultimatum game and reverse ultimatum game help explain the dynamics of BA-ROFR?

A: You might as well ask how experiments helped explain the BA-ROFR. Contracts exist in a complicated world, and there's a lot more going on in the renegotiation of the "Frasier" deal, or in British landlord-tenant law, than just the form of the right of first refusal clause. So, in the laboratory, we can look at simpler situations in order to isolate the effect that particular clause has. The ultimatum game is one of the workhorses of experimental economics, and we invented the reverse ultimatum game to allow us to study situations just like this one. Together they allowed us to study how the clause influenced outcomes in situations in which the right holder starts off in a powerful position, or a weak one.

Q: Where BA-ROFR has been implemented, has it met the objectives of the sponsors?

A: We doubt it.

This allows the asset owner to present any third party with an ultimatum offer: Buy at the high price, or not at all.

Q: Why are these types of rights still used though they clearly benefit one party over another? Why do the parties that don't benefit, such as the tenants cited in your study, agree to these arrangements?

A: Contracts are big, complicated things with lots of clauses, some of which get exercised rarely if at all. So it's sometimes hard for bad clauses to be eliminated on the basis of experience, since the experience comes only rarely, and then too late. Also, there are lots of parties to these contracts, e.g., in the case of British landlord-tenant law, the clause is in national legislation. So the correct people have to notice that it's a bad clause, and they may be concentrating on other, more immediately important clauses.

Also, it wasn't obvious that this was a bad clause—that was something that Brit and I showed. (That isn't to say that right holders may have noticed the clause was no good once it was too late.) But there's a good chance clauses like that have been eliminated in more recent entertainment contracts.

Q: What should managers and executives who deal in contracts take away from your study?

A: Details matter. What turned out to be the problem for the rights of first refusal we studied was that the order of events that the clause specified worked to the disadvantage of the right holder. If the right holder had instead retained the right to move last, and pick up the contract at any price agreed on with a third party, the bargaining power would have gone to the right holder, as it appeared to, but didn't.

Q: What are you working on now?

A: Lots of problems of economic design. Not only do contracts need to be designed, but also markets as a whole. (Details matter there, too, and the wrong details can lead to bad outcomes.)

My colleagues and I have recently helped redesign the labor market for gastroenterologists, the high school choice system for New York City, and the school choice system at all levels for Boston. And we've helped set up the New England Program for Kidney Exchange. And I'm the chair of a committee of the American Economic Association to recommend changes that we should make in the marketplace for new Ph.D. economists. As is the case with the study of contracts, we learn a lot about how to design successful markets by examining failures. The market for law clerks for appellate court judges is one we're watching closely in that regard.