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The Value of Contracting with the Sequential Investments: The Role of Outside Values

Author

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  • Kyoungwon Rhee

    (Dongguk University)

Abstract

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.

Suggested Citation

  • Kyoungwon Rhee, 2007. "The Value of Contracting with the Sequential Investments: The Role of Outside Values," Korean Economic Review, Korean Economic Association, vol. 23, pages 89-110.
  • Handle: RePEc:kea:keappr:ker-200706-23-1-05
    as

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    File URL: http://keapaper.kea.ne.kr/RePEc/kea/keappr/KER-200706-23-1-05.pdf
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    References listed on IDEAS

    as
    1. William P. Rogerson, 1984. "Efficient Reliance and Damage Measures for Breach of Contract," RAND Journal of Economics, The RAND Corporation, vol. 15(1), pages 39-53, Spring.
    2. Ilya Segal & Michael D. Whinston, 2002. "The Mirrlees Approach to Mechanism Design with Renegotiation (with Applications to Hold-up and Risk Sharing)," Econometrica, Econometric Society, vol. 70(1), pages 1-45, January.
    3. Steven Shavell, 1980. "Damage Measures for Breach of Contract," Bell Journal of Economics, The RAND Corporation, vol. 11(2), pages 466-490, Autumn.
    4. Tai-Yeong Chung, 1991. "Incomplete Contracts, Specific Investments, and Risk Sharing," Review of Economic Studies, Oxford University Press, vol. 58(5), pages 1031-1042.
    5. M'hand Fares, 2006. "Renegotiation Design and Contract Solutions to the Hold-Up Problem," Journal of Economic Surveys, Wiley Blackwell, vol. 20(5), pages 731-756, December.
    6. Eric Maskin & Jean Tirole, 1999. "Unforeseen Contingencies and Incomplete Contracts," Review of Economic Studies, Oxford University Press, vol. 66(1), pages 83-114.
    7. De Fraja, Gianni, 1999. "After You Sir. Hold-Up, Direct Externalities, and Sequential Investment," Games and Economic Behavior, Elsevier, vol. 26(1), pages 22-39, January.
    8. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
    9. Georg Noldeke & Klaus M. Schmidt, 1995. "Option Contracts and Renegotiation: A Solution to the Hold-Up Problem," RAND Journal of Economics, The RAND Corporation, vol. 26(2), pages 163-179, Summer.
    10. Edlin, Aaron S & Hermalin, Benjamin E, 2000. "Contract Renegotiation and Options in Agency Problems," Journal of Law, Economics, and Organization, Oxford University Press, vol. 16(2), pages 395-423, October.
    11. Jean Tirole, 1999. "Incomplete Contracts: Where Do We Stand?," Econometrica, Econometric Society, vol. 67(4), pages 741-782, July.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Sequential investments; Contract renegotiation; Specific investments; Value of Contracting;

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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