SFB 303 Discussion Paper No. A-482

Author: Lülfesmann, Christoph
Title: Incomplete Contracts, Non-Verifyable Quality, and Renegotiation
Abstract: This paper reconsiders the hold-up problem in long term, bilateral trade relationships with specific investments. In contrast to the canonical framework of Hart and Moore (1988), we assume that the parties face several trading opportunities (goods) whose characteristics are observable but non-verifiable. Specifically, the parties can trade either an 'innovative' good of high quality or a 'standard' good of low quality. The latter is unaffected by specific investments and quality is non-contradictible ex ante. In this framework, we show that a first-best result may be supported by the appropriate choice of an at-will contract even in the general case of both-sided investments. The solution to the hold-up problem requires that the alternative trade opportunity must be valuable with positive probability. Furthermore, we demonstrate that in the context of non-verifiable quality, at-will contracts strictly outperform option (specific-performance) contracts. Finally, the paper extends the renegotiation game originally developed by Hart and Moore to incorporate bargaining over multiple objects.
Keywords: Incomplete Contracts, Hold-Up Problem, Quality-Choice Problem
JEL-Classification-Number: D23, K12, L23
Creation-Date: August 25, 1997
URL: ../1997/a/bonnsfa482.pdf

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