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Contractual Remedies to the Holdup Problem: A Dynamic Perspective

  • Yeon-Koo Che
  • Jozsef Sakovics

    ()

An important theme of modern contract theory is the role contracts play to protect parties from the risk of holdup and thereby encouraging their relationship specific investments. While this perspective has generated valuable insights about various contracts, the underyling models abstract from realistic investment dynamics. We reexamine the role of contracts in a dynamic model that endogenizes the timing of investments and trade. The resulting interaction between bargaining and investment significantly alters the insights learned from static models. We show that contracts that would exacerbate the parties’ vulnerability to holdup — rather than those protecting them from the risk of holdup — can be desirable. For this reason, separate ownership of complementary assets can be optimal, an exclusivity agreement can protect the investments of its recipient, trade contracts can be beneficial with a purely cooperative investment, and the property rule can offer a better legal protection against externalities loss than the liability rule, much in contrast to the existing results (based on static models).

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Paper provided by Edinburgh School of Economics, University of Edinburgh in its series ESE Discussion Papers with number 100.

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Length: 40
Date of creation: Mar 2004
Date of revision:
Handle: RePEc:edn:esedps:100
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  1. Oliver Hart & John Moore, 1998. "Foundations of Incomplete Contracts," Harvard Institute of Economic Research Working Papers 1846, Harvard - Institute of Economic Research.
  2. George Baker & Robert Gibbons & Kevin J. Murphy, 2002. "Relational Contracts And The Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 39-84, February.
  3. Che,Y.-K. & Sakovics,J., 2001. "A dynamic theory of holdup," Working papers 25, Wisconsin Madison - Social Systems.
  4. George Baker & Robert Gibbons & Kevin J. Murphy, 2001. "Bringing the Market inside the Firm?," American Economic Review, American Economic Association, vol. 91(2), pages 212-218, May.
  5. 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.
  6. Macleod, W.B. & Malcomson, J.M., 1991. "Investments, Hold Up And The Reform Of Market Contracts," Cahiers de recherche 9114, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  7. Maija Halonen, 2002. "Reputation And The Allocation Of Ownership," Economic Journal, Royal Economic Society, vol. 112(481), pages 539-558, July.
  8. Ilya Segal & Michael D. Whinston, 2000. "Exclusive Contracts and Protection of Investments," RAND Journal of Economics, The RAND Corporation, vol. 31(4), pages 603-633, Winter.
  9. Aghion, Philippe & Dewatripont, Mathias & Rey, Patrick, 1994. "Renegotiation Design with Unverifiable Information," Scholarly Articles 12375014, Harvard University Department of Economics.
  10. Hart, Oliver D. & Moore, John, 1990. "Property Rights and the Nature of the Firm," Scholarly Articles 3448675, Harvard University Department of Economics.
  11. Edlin, Aaron S & Reichelstein, Stefan, 1996. "Holdups, Standard Breach Remedies, and Optimal Investment," American Economic Review, American Economic Association, vol. 86(3), pages 478-501, June.
  12. Chiu, Y Stephen, 1998. "Noncooperative Bargaining, Hostages, and Optimal Asset Ownership," American Economic Review, American Economic Association, vol. 88(4), pages 882-901, September.
  13. Williamson, Oliver E, 1979. "Transaction-Cost Economics: The Governance of Contractural Relations," Journal of Law and Economics, University of Chicago Press, vol. 22(2), pages 233-61, October.
  14. David De Meza & Ben Lockwood, 1998. "Does Asset Ownership Always Motivate Managers? Outside Options And The Property Rights Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, vol. 113(2), pages 361-386, May.
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