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Optimal Contracts with Lock-In

  • Joseph Farrell and Carl Shapiro.

The authors analyze incomplete long-term contracts when buyers incur relationship-specific set-up costs and sellers choose product or service quality that is not verifiable to third parties. If set-up costs are observable, the first-best outcome can be achieved even though contracts cannot enforceably specify quality; this does not even require long-term contracts. If set-up costs are unobservable, however, then long-term price contracts can strictly outperform short-term contracts. Equilibrium may involve either inefficiently low quality with no buyer switching or efficient quality with inefficient switching. A policy of taxing switching, or the availability of "budget-breaking" third parties, can improve welfare. Copyright 1989 by American Economic Association.

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Paper provided by University of California at Berkeley in its series Economics Working Papers with number 8758.

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Date of creation: 01 Oct 1987
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Handle: RePEc:ucb:calbwp:8758
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