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Contractual remedies to the holdup problem : a dynamic perspective

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Author Info

  • Che,Y.-K.
  • Sakovics,J.

    (University of Wisconsin-Madison, Social Systems Research Institute)

Abstract

An important theme of modern contract theory is the role contracts play to protect parties from the risk of holdup and thereby encouraging their relationship specific investments. While this perspective has generated valuable insights about various contracts, the underyling models abstract from realistic investment dynamics. We reexamine the role of contracts in a dynamic model that endogenizes the timing of investments and trade. The resulting interaction between bargaining and investment significantly alters the insights learned from static models. We show that contracts that would exacerbate the parties’ vulnerability to holdup — rather than those protecting them from the risk of holdup — can be desirable. For this reason, separate ownership of complementary assets can be optimal, an exclusivity agreement can protect the investments of its recipient, trade contracts can be beneficial with a purely cooperative investment, and the property rule can offer a better legal protection against externalities loss than the liability rule, much in contrast to the existing results (based on static models).

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Bibliographic Info

Paper provided by Wisconsin Madison - Social Systems in its series Working papers with number 3.

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Date of creation: 2004
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Handle: RePEc:att:wimass:20043

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Postal: UNIVERSITY OF WISCONSIN MADISON, SOCIAL SYSTEMS RESEARCH INSTITUTE(S.S.R.I.), MADISON WISCONSIN 53706 U.S.A.

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References

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  1. Mathias Dewatripont & Philippe Aghion & Patrick Rey, 1994. "Renegotiation design with unverifiable information," ULB Institutional Repository 2013/9591, ULB -- Universite Libre de Bruxelles.
  2. Georg Nöldeke & Klaus M. Schmidt, 1992. "Option Contracts and Renegotiation - A Solution to the Hold-Up Problem," Discussion Paper Serie A 417, University of Bonn, Germany, revised Aug 1993.
  3. Che,Y.-K. & Sakovics,J., 2001. "A dynamic theory of holdup," Working papers 25, Wisconsin Madison - Social Systems.
  4. Hart, Oliver & Moore, John, 1999. "Foundations of Incomplete Contracts," Review of Economic Studies, Wiley Blackwell, vol. 66(1), pages 115-38, January.
  5. Macleod, W.B. & Malcomson, J.M., 1991. "Investments, Hold Up And The Reform Of Market Contracts," Cahiers de recherche 9114, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  6. David De Meza & Ben Lockwood, 1998. "Does Asset Ownership Always Motivate Managers? Outside Options And The Property Rights Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, vol. 113(2), pages 361-386, May.
  7. Oliver Hart & John Moore, 1988. "Property Rights and the Nature of the Firm," Working papers 495, Massachusetts Institute of Technology (MIT), Department of Economics.
  8. Maija Halonen, 2002. "Reputation And The Allocation Of Ownership," Economic Journal, Royal Economic Society, vol. 112(481), pages 539-558, July.
  9. Edlin, Aaron S & Reichelstein, Stefan, 1996. "Holdups, Standard Breach Remedies, and Optimal Investment," American Economic Review, American Economic Association, vol. 86(3), pages 478-501, June.
  10. Williamson, Oliver E, 1979. "Transaction-Cost Economics: The Governance of Contractural Relations," Journal of Law and Economics, University of Chicago Press, vol. 22(2), pages 233-61, October.
  11. George Baker & Robert Gibbons & Kevin J. Murphy, 2002. "Relational Contracts And The Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 39-84, February.
  12. George Baker & Robert Gibbons & Kevin J. Murphy, 2001. "Bringing the Market inside the Firm?," American Economic Review, American Economic Association, vol. 91(2), pages 212-218, May.
  13. Ilya Segal & Michael D. Whinston, 2000. "Exclusive Contracts and Protection of Investments," RAND Journal of Economics, The RAND Corporation, vol. 31(4), pages 603-633, Winter.
  14. Chiu, Y Stephen, 1998. "Noncooperative Bargaining, Hostages, and Optimal Asset Ownership," American Economic Review, American Economic Association, vol. 88(4), pages 882-901, September.
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Cited by:
  1. Bar-Isaac, Heski & Gavazza, Alessandro, 2013. "Brokers' contractual arrangements in the Manhattan residential rental market," MPRA Paper 43967, University Library of Munich, Germany.
  2. Matthew Ellman, 2006. "Specificity Revisited: The Role of Cross-Investments," Journal of Law, Economics and Organization, Oxford University Press, vol. 22(1), pages 234-257, April.
  3. Watson, Joel, 2006. "Contract and Mechanism Design in Settings with Multi-Period Trade," University of California at San Diego, Economics Working Paper Series qt63s1s3j6, Department of Economics, UC San Diego.
  4. Chrysovalantou Milliou, 2004. "Exclusive Dealing And Compatibility Of Investments," Economics Working Papers we044919, Universidad Carlos III, Departamento de Economía.
  5. Matthew Ellman, 2006. "The optimal length of contracts with application to outsourcing," Economics Working Papers 965, Department of Economics and Business, Universitat Pompeu Fabra.

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