Theoretical Economics, Volume 7, Number 2 (May 2012)

Theoretical Economics 7 (2012), 283–322

Contract, renegotiation, and hold up: Results on the technology of trade and investment

Kristy Buzard, Joel Watson


This paper examines a class of contractual relationships with specific investment, a non-durable trading opportunity, and renegotiation. Trade actions are modeled as individual and trade-action-based option contracts ("non-forcing contracts") are explored. The paper introduces the distinction between divided and unified investment and trade actions, and it shows the key role this distinction plays in determining whether efficient investment and trade can be achieved. Under a non-forcing dual-option contract, the party without the trade action is made residual claimant with regard to the investment action, which induces efficient investment in the divided case. The unified case is more problematic; here, efficiency is typically not attainable but the dual-option contract is still optimal in a wide class of settings. More generally, the paper shows that, with ex post renegotiation, constraining parties to use "forcing contracts" implies a strict reduction in the set of implementable value functions.

Keywords: Contract, renegotiation, hold up, forcing contracts, non-forcing contracts, specific investment, technology of trade, mechanism design

JEL classification: C70, D23

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