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Breakup of Repeat Transaction Contracts, Specific Investment, and Efficient Rent-Seeking

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Author Info
Bernhard Ganglmair () (Institute for Empirical Research in Economics, University of Zurich)

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Abstract

In a repeat trade model with buyer's specific investment, a simple renegotiable contract implements an efficient outcome if premature termination of trade is governed by an appropriate contract breakup rule. In equilibrium, such a rule allows for termination with positive probability and gives the buyer a bargaining leverage over the seller when the contract is renegotiated ex-post. These returns ("breakup rents") from buyer's rent-seeking complement his ex-post bargaining power and restore his ex-ante investment incentives when he would otherwise underinvest due to a standard (ex-ante) hold-up problem. Buyer's opportunism thus creates social value and restores efficiency in case of frictionless renegotiation. When the contract is rigid and not renegotiable until after the first round of trade, however, a first-best breakup rule does not exist. A second-best rule trades off buyer's investment and seller's activity distortions that arise from excessive effort to curb the buyer's bargaining leverage. Conditions on existence of a first or second-best breakup rule as well as implications for the legal discussion on compliance standards for breach of contract are given.

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Paper provided by JEPS in its series JEPS Working Papers with number 08-001.

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Length: 37 pages
Date of creation: Jan 2008
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Handle: RePEc:jep:wpaper:08001

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Related research
Keywords: Repeat transaction trade; contract breakup; specific investment; hold-up; rent-seeking; installment contracts; compliance standards; breach of contract;

Find related papers by JEL classification:
D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
K12 - Law and Economics - - Basic Areas of Law - - - Contract Law
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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