Hold-Up under Costly Litigation and Imperfect Courts of Law

Two main results have been obtained on the literature on contractual solutions to the hold-up problem. First, a contract specifying a price and quantity of the final good to be traded will, fairly generally, induce efficient investments if these are 'selfish' in nature, i.e., each party's investment directly affects only his own profit (Edlin and Reichelstein, 1996). Second, and in contrast, no contract however complicated is of any value in reducing the inefficiency if the investments are 'cooperative', i.e., each party's investment affects directly only the other party's payoff (Che and Hausch, 1999). We show that courts of law may play a more important role in real contract disputes than has been realized. The key observation is that the presence of a court can make it valuable to specify putative investment levels in a contract - even if the court remains ignorant of the parties' actual investment levels. This is because the putative investment levels influence the expected damages the court awards if it decides that breach occurred. The probability of the court deciding breach occurred is independent of the actual investment levels - they remain entirely unverifiable. It depends at most on the parties' court expenditures. These expenditures make litigation costly for the parties, and, therefore, in equilibrium they settle before trial. The presence of even such an imperfect court has a significant impact on whether contracts alleviate hold-up inefficiencies. In the case of one-sided cooperative investment, we show that the first-best outcome can sometimes be achieved by the adoption of a simple non-contingent contract, contrary to the negative result of Che and Hausch (1999). Our result extends to the case of hybrid investment, provided the investment is mainly cooperative.