A Theory of Bargaining Costs and Price Terms in the Absence of Specific Investments

Giorgio Zanarone (CUNEF)
Desmond Lo (Santa Clara University)

Abstract: Firms often bring pre-existing capabilities such as brands and market strength into cooperative ventures. We model price terms in these ventures as a choice between ex ante design costs and ex post opportunism, in the shadow of judicial behavior. On the one hand, to save on design costs, parties can leave the price open for future negotiations. This will induce them to gather proprietary information during the venture’s exploratory stage in the hope of using it as a bargaining chip. Eventually, the parties may prefer to use this information for actions that yield them private benefits but dilute the counterpart’s capabilities, resulting in ex post inefficiencies. On the other hand, parties can incur the cost of specifying contract terms at the outset, thus preventing ex post bargaining through a credible threat of having those terms reinstated by courts. This reduces their incentives to gather information ex ante and, therefore, their ability to dilute each other’s capabilities ex post. Consequently, firms will choose specific contracts when pre-existing capabilities are valuable and contract design costs are low. Our theory adds to Transaction Cost Economics by (1) formalizing in a novel way the idea that contracts reduce ex post inefficiencies and (2) showing that contracts also protect non-specific assets, such as firms’ capabilities.

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