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Holdups, Standard Breach Remedies, and Optimal Investment

  • Aaron S. Edlin
  • Stefan Reichelstein

We consider a bilateral trading problem in which one or both parties makes relationship-specific investments before trade. Without adequate contractual protection, the prospect of later holdups discourages investment. We postulate that the parties can sign noncontingent contracts prior to investing, and can freely renegotiate them after uncertainty about the desirability of trade is resolved. We find that such contracts can induce one party to invest efficiently when either a breach remedy of specific performance or expectation damages is applied. Specific performance can also induce both parties to invest efficiently, provided a separability condition holds. In contrast, expectation damages is poorly suited to solve bilateral investment problems.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5007.

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Date of creation: Feb 1995
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Publication status: published as American Economic Review, vol. 86, no. 3, pp. 478-501, June 1996.
Handle: RePEc:nbr:nberwo:5007
Note: LE
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