Credible Commitments: Using Options to Support Partnerships

Abstract: Opportunism---either governmental hold-up by unfair regulation and expropriation, or private monopoly pricing and investment and quality curbing---is a powerful deterrent from successful-to-be public-private partnerships with large sunk investments and welfare externalities. The agents can overcome this double-sided moral hazard by exchanging an exit (put) option for the investor and a bail-out (call) option for the public agent on the investor's outlay. The exit/bail-out option mechanism increases the set of payoffs by offsetting deviation, and thus facilitates cooperation. The mechanism is applicable to other settings with partially aligned goals and informational asymmetries.