A Solution to the Hold-Up Problem Involving Gradual Investment

Abstract:     
We consider a setting in which the buyer's ability to hold up a seller's investment is so severe that there is no investment in equilibrium of the static game typically analyzed. We show that there exists an equilibrium of a dynamic game generating positive investment. The seller makes a sequence of gradually smaller investments, each repaid by the buyer under the threat of losing further seller investment. As modeled frictions converge to zero, the equilibrium outcome converges to the first best. We draw connections between our work and the growing literature on gradualism in public good contribution games and bargaining games.

Keywords: hold-up problem, gradualism, incomplete contracts, investment, contribution games

JEL Classifications: D23, C73, L14

Working Paper Series