Interlinkage, limited liability, and strategic interaction

The authors analyze the example of a landlord, a moneylender, and a tenant (the landlord having access to finance on the same terms as the money lender). It is natural to assume that the landlord has first claim on the tenant's output (as a rule, if they live in the same village, he may have some say in when the crop is harvested). The moneylender is more of an outsider, not well placed to exercise such a claim. A landless, asset-less tenant will typically not get a loan unless he has a tenancy. Without inter-linkage, the landlord is likely to move first. In the non-cooperative sequential game where the landlord is the first mover and also enjoys seniority of claims if the tenant defaults, inter-linkage is superior, even if contracts are non-linear - a result unchanged with the incorporation of moral hazard. The main result is that if a"passive"principal - one whose decisions are limited to exercising his property rights to determine his share of returns - is the first mover, allocative efficiency is impaired unless his equilibrium payoffs are uniform across states of nature. The limited liability of the tenant creates the strict superiority of inter-linkage by making uniform rents non-optimal when, with non-collusive principals, the landlord (the passive principal) is the first mover. A change in seniority of claims from the first to the second mover (the moneylender) further strengthens this result. But uniform payoffs for the first mover are not essential for allocative efficiency if he is the only principal with a continuously variable instrument of control. So, the main result is sensitive to changes in the order of play but not to changes in the priority of claims.