Ambivalent Investment and the Hold-Up Problem

Sönje Reiche

Journal of the European Economic Association, 2006, vol. 4, issue 6, 1148-1164

Abstract: In this paper we add to the foundations of incomplete contracting literature. We study the hold-up problem with ambivalent investment, where investment benefits the investing party if ex post the right decision is undertaken but harms the investing party if the wrong decision is made. In this context, we show that the power of contracts to provide investment incentives depends on three factors: the commitment value of contracts, the amount of quasirents that the investing party can expect in the case of out-of-contract renegotiation, and the degree of ambivalence of investment. First, contracts provide first-best investment incentives when parties can commit to a contract regardless of the type of investment. Second, with sufficiently ambivalent investment, if parties cannot commit not torenegotiate a contract and if the investing party's bargaining power is intermediate, contracts cannot improve investment incentives above those provided by no contract. In contrast, a simple buyer or seller option contract is optimal when the investing party's bargaining power is extreme. (JEL: D23, K12, L22) (c) 2006 by the European Economic Association.

Date: 2006
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