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Breakup of Repeat Transaction Contracts, Specific Investment, and Efficient Rent-Seeking

  • Bernhard Ganglmair


    (Institute for Empirical Research in Economics, University of Zurich)

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    In a repeat trade model with buyer's specific investment, a simple renegotiable contract implements an efficient outcome if premature termination of trade is governed by an appropriate contract breakup rule. In equilibrium, such a rule allows for termination with positive probability and gives the buyer a bargaining leverage over the seller when the contract is renegotiated ex-post. These returns ("breakup rents") from buyer's rent-seeking complement his ex-post bargaining power and restore his ex-ante investment incentives when he would otherwise underinvest due to a standard (ex-ante) hold-up problem. Buyer's opportunism thus creates social value and restores efficiency in case of frictionless renegotiation. When the contract is rigid and not renegotiable until after the first round of trade, however, a first-best breakup rule does not exist. A second-best rule trades off buyer's investment and seller's activity distortions that arise from excessive effort to curb the buyer's bargaining leverage. Conditions on existence of a first or second-best breakup rule as well as implications for the legal discussion on compliance standards for breach of contract are given.

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    Paper provided by JEPS in its series JEPS Working Papers with number 08-001.

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    Length: 37 pages
    Date of creation: Jan 2008
    Date of revision:
    Handle: RePEc:jep:wpaper:08001
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