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Strategic Capacity Investment under Holdup Threats: The Role of Contract Length and Width

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  • Durand-Viel, Laure
  • Villeneuve, Bertrand

Abstract

This article analyzes the impact of incomplete contracts’ length on investment in a bilateral relationship. The seller has the power to set the contract terms whereas the buyer decides on the investment level, which acts as a cap on future demand. Two-part tariffs succeed at implementing the optimal investment and consumption even if commitment is limited, and the contract’s duration is irrelevant. Interestingly, this efficient solution is rendered possible by subsidies on consumption during the contract. In other terms, duration matters hugely for the contract details (the timing of transfers), not for its performance. Under certain circumstances that we discuss, linear pricing may have to be used, which leads to suboptimal investment. We show that longer contracts are less efficient, meaning that a degree of completeness (pricing width) may be strictly complementary to another one (contract length). The buyer’s surplus increases with respect to the contract duration, whereas the seller loses more in profit than the social surplus decreases. A longer contract actually protects expropriable investors rather than investment itself.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 19015.

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Date of creation: 23 Nov 2009
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Handle: RePEc:pra:mprapa:19015

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Keywords: Long-term Contracts ; Incomplete Contracting ; Infrastructure Investment;

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  1. Creti, Anna & Villeneuve, Bertrand, 2004. "Long-term contracts and take-or-pay clauses in natural gas Markets," Economics Papers from University Paris Dauphine, Paris Dauphine University 123456789/5372, Paris Dauphine University.
  2. Joskow, Paul L, 1988. "Price Adjustment in Long-term Contracts: The Case of Coal," Journal of Law and Economics, University of Chicago Press, University of Chicago Press, vol. 31(1), pages 47-83, April.
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  5. Christian Hirschhausen & Anne Neumann, 2008. "Long-Term Contracts and Asset Specificity Revisited: An Empirical Analysis of Producer–Importer Relations in the Natural Gas Industry," Review of Industrial Organization, Springer, Springer, vol. 32(2), pages 131-143, March.
  6. Castaneda, Marco A., 2006. "The hold-up problem in a repeated relationship," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 24(5), pages 953-970, September.
  7. Michael Waldman, 2010. "Competition, Monopoly, and Aftermarkets," Journal of Law, Economics and Organization, Oxford University Press, Oxford University Press, vol. 26(1), pages 54-91, April.
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  11. Victor P. Goldberg, 1976. "Regulation and Administered Contracts," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 7(2), pages 426-448, Autumn.
  12. Masten, Scott E & Crocker, Keith J, 1985. "Efficient Adaptation in Long-term Contracts: Take-or-Pay Provisions for Natural Gas," American Economic Review, American Economic Association, American Economic Association, vol. 75(5), pages 1083-93, December.
  13. Dubin, Jeffrey A & McFadden, Daniel L, 1984. "An Econometric Analysis of Residential Electric Appliance Holdings and Consumption," Econometrica, Econometric Society, Econometric Society, vol. 52(2), pages 345-62, March.
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