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Optimal Contracts with Lock-In

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  • Joseph Farrell and Carl Shapiro.

Abstract

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.
(This abstract was borrowed from another version of this item.)
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Joseph Farrell and Carl Shapiro., 1987. "Optimal Contracts with Lock-In," Economics Working Papers 8758, University of California at Berkeley.
  • Handle: RePEc:ucb:calbwp:8758
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