The Value of Contracting with the Sequential Investments: The Role of Outside Values
This article addresses two issues in understanding whether contracting subject to renegotiation can provide the right incentives for investments: the degree of specificity of investments and the sequentiality of investments. The paper considers an environment in which the seller makes a specific investment and then the buyer undertakes an investment. Assuming the general investment, recent articles argue that option contracts can achieve the first best outcome. This article shows, however, that their result is not robust when the first investment is specific. In particular, option contracts cannot do better than no contract. Moreover, this paper proves that contracting replicates at best no contract. Our results imply that the value of contracting depends heavily on whether the first investment is general or specific in the sequential investment environment.
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- Georg Noldeke & Klaus M. Schmidt, 1995.
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