Contract, renegotiation, and holdup: Results on the technology of trade and investment

Abstract

This paper examines a class of contractual relationships with specific investment, a nondurable trading opportunity, and renegotiation. Trade actions are modeled as individual and trade-action-based option contracts ("nonforcing contracts") are explored. The paper introduces the distinction between divided and unified investment and trade actions, and it shows the key role this distinction plays in determining whether efficient investment and trade can be achieved. Under a nonforcing dual-option contract, the party without the trade action is made the residual claimant with regard to the investment action, which induces efficient investment in the divided case. The unified case is more problematic: here, efficiency is typically not attainable, but the dual-option contract is still optimal in a wide class of settings. More generally, the paper shows that, with ex post renegotiation, constraining parties to use "forcing contracts" implies a strict reduction in the set of implementable value functions.The holdup problem arises in situations in which contracting parties can renegotiate their contract between the time they make unverifiable relation-specific investments and the time at which they can trade. 1 The severity of the holdup problem depends critically on the productive technology and on the timing of renegotiation opportunities. This paper contributes to the literature by examining how the nature of the "trade

Contractual signaling, relationship-specific investment and exclusive agreements

“…A distinction has been made in the contract-theory literature between public and private actions (see Watson, 2007, andBuzard andWatson, 2012). As shown by Watson (2007), this distinction is important because, in some cases, considering trade actions as public instead of as individual actions, restricts implementation.…”

“…The exclusivity variable e denotes the probability that the agreement is exclusive; i.e., that the principal cannot trade with an external party. 5 When exclusivity is contractible, E = [0; 1]. Noncontractible exclusivity is modeled by imposing…”

“…This is because the existing literature on the hold-up problem (e.g., Grossman and Hart, 1986 Buzard and Watson, 2012), and in particular that on the interaction between exclusivity and relationship-speci…c investment (e.g., Segal and Whinston, 2000;and De Meza and Selvaggi, 2007), has focused on situations where parties' information is symmetric at the initial contracting stage. This paper extends the literature on the hold-up problem to the case in which there is asymmetric information at the contracting stage.…”

“…The disagreement payo¤s of the principal and agent are the payo¤s in the event they do not reach a renegotiation agreement and the initial contract is executed. 8 Given 5 The quantity and exclusivity variables can be interpreted as proportions of trade capacity. Under this interpretation, quantity q represents the proportion of the trade capacity of the principal that is contractually allocated to the agent, and exclusivity e represents the proportion of the remaining (1 q) of the trade capacity of the principal that cannot be traded with an external party.…”

Contract and Game Theory: Basic Concepts for Settings with Finite Horizons

“…By "technological details," I mean the nature of productive actions, the actions available to external enforcers, the manner in which agents communicate and negotiate with one another, and the exact timing of these various elements in a given contractual relationship. In other papers, I and coauthors focus on the nature of productive actions [1][2][3], the mechanics of evidence production ( [4,5]), and contract writing and renegotiation costs [6,7]. These papers and the present one show that the technological details can matter significantly.…”