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Formal Contracts, Relational Contracts, and the Holdup Problem

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Author Info
Hideshi Itoh ()
Hodaka Morita ()

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Abstract

We study the holdup problem in repeated transactions between a seller and a buyer such that the seller makes relation-specific investments in each period. We show that where, under spot transaction, formal contracts have no value because of the cooperative nature of investment, writing a simple fixed-price contract can be valuable under repeated transactions: There is a range of parameter values in which a higher investment can be implemented only if a formal price contract is written and combined with a relational contract. We also show that there are cases in which not writing a formal contract but entirely relying on a relational contract increases the total surplus of the buyer and the seller. The key condition is how the investment affects the renegotiation price in general, and the alternative-use value in particular.

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Publisher Info
Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number CESifo Working Paper No. 1786.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1786

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Related research
Keywords: holdup problem; formal contract; relational contract; cooperative investment; fixed-price contract; relation-specific investment; renegotiation; repeated transactions; long-term relationships;

Find related papers by JEL classification:
D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
L24 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Contracting Out; Joint Ventures

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-32, September. [Downloadable!] (restricted)
    Other versions:
  2. Yeon-Koo Che & Donald B. Hausch, 1999. "Cooperative Investments and the Value of Contracting," American Economic Review, American Economic Association, vol. 89(1), pages 125-147, March. [Downloadable!] (restricted)
  3. Jonathan Levin, 2000. "Relational Incentive Contracts," Working Papers 01002, Stanford University, Department of Economics. [Downloadable!]
    Other versions:
  4. Coase, R H, 1988. "The Nature of the Firm: Influence," Journal of Law, Economics and Organization, Oxford University Press, vol. 4(1), pages 33-47, Spring.
  5. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August. [Downloadable!] (restricted)
    Other versions:
  6. Gul, Faruk, 2001. "Unobservable Investment and the Hold-Up Problem," Econometrica, Econometric Society, vol. 69(2), pages 343-76, March.
    Other versions:
  7. Shelanski, Howard A & Klein, Peter G, 1995. "Empirical Research in Transaction Cost Economics: A Review and Assessment," Journal of Law, Economics and Organization, Oxford University Press, vol. 11(2), pages 335-61, October.
  8. Asanuma, Banri, 1989. "Manufacturer-supplier relationships in Japan and the concept of relation-specific skill," Journal of the Japanese and International Economies, Elsevier, vol. 3(1), pages 1-30, March. [Downloadable!] (restricted)
  9. Holmstrom, Bengt & Roberts, John, 1998. "The Boundaries of the Firm Revisited," Journal of Economic Perspectives, American Economic Association, vol. 12(4), pages 73-94, Fall. [Downloadable!] (restricted)
  10. Abhijit V. Banerjee & Esther Duflo, 2000. "Reputation Effects And The Limits Of Contracting: A Study Of The Indian Software Industry," The Quarterly Journal of Economics, MIT Press, vol. 115(3), pages 989-1017, August. [Downloadable!] (restricted)
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  11. Maija Halonen, 2002. "Reputation And The Allocation Of Ownership," Economic Journal, Royal Economic Society, vol. 112(481), pages 539-558, July. [Downloadable!] (restricted)
  12. Cai, Hongbin, 2003. " A Theory of Joint Asset Ownership," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 63-77, Spring.
  13. 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. [Downloadable!] (restricted)
    Other versions:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Oliver Gürtler, 2005. "On Delegation under Relational Contracts," Bonn Econ Discussion Papers bgse32_2005, University of Bonn, Germany. [Downloadable!]
  2. Thiele, Veikko, 2008. "Firms' Procurement Decisions: Is Input Specificity Always an Argument for Vertical Integration?," MPRA Paper 2471, University Library of Munich, Germany. [Downloadable!]
  3. Hueth, Brent & Ligon, Ethan & Melkonyan, Tigran, 2008. "Interactions between Explicit and Implicit Contracting: Evidence from California Agriculture," 2008 Annual Meeting, July 27-29, 2008, Orlando, Florida 6068, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association). [Downloadable!]
  4. Oliver Gürtler, 2006. "On Delegation under Relational Contracts," Discussion Papers 113, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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