Investment and Stochastically Stable Division

Abstract

I apply stochastic stability (Kandori, Mailath and Rob, Econometrica 1993, and Young Econometrica 1993) to a contracting game. There are three stages to this game. In the first, a surplus sharing transfer is made. This is followed by a relationship specific investment and finally bargaining over the gross surplus from investment. In the stochastically stable outcome, the investing party gets (almost) all of the surplus in the final stage, and makes the efficient investment. However, the transfer is set so that over half of the net surplus goes to the party who does not make an investment. That is, while hold up does not occur, its possibility increase the surplus received by the non-investing party.

Keywords: Investment, Stable division, Contracting, Surplus sharing, Transfer

JEL Classification: K12, D86