Before Death Do Us Part: on Premature Contract Breakup and Partial Property Rights

Bernhard Ganglmair (University of Zurich and IZA, Bonn)

Abstract: In the presence of specific investment, sophisticated contracts or vertical integration have been proposed as solutions to a holdup problem that arises when parties cannot commit not to renegotiate an agreement ex-post. In a repeat transaction framework, I argue that if parties are assigned a property rights bundle with ex-post decision rights on (1) the terms of trade and (2) the durability of trade, a first-best outcome is implementable even with a simple contract. This is because the durability decision, motivated by actual legal practice, gives rise to an exit option that allows the otherwise underinvesting buyer to appropriate breakup rents that restore her investment incentives at the cost of seller's moral hazard from trying to avoid the buyer's breakup threat. For three cases of renegotiation rigidity, I present conditions under which a simple contract allows for an efficient outcome. The results imply that a strict compliance standard in (2) with high quality requirements for the seller may be necessary to induce efficient investment if buyer's weight in (1) is sufficiently low. This implication competes with the legal literature on compliance standards in U.S. and international contract law that promotes a restriction of buyer's exit options.


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