Contract Design When Relationship-Specific Investment Produces Asymmetric Information
50:2 Journal of Legal Studies 219 (2021)
34 Pages Posted: 8 Feb 2019 Last revised: 18 Nov 2021
Date Written: June 16, 2021
Under conventional contract theory, contracts may be efficient by protecting relationship-specific investment from hold-up in subsequent (re)negotiation over terms of trade. This paper demonstrates a different problem than hold-up when specific investment also provides significant private information to the investing party. This is fairly common: e.g., a manufacturer invests to learn about its buyer’s idiosyncratic needs or a collaborator invests to learn about a joint venture. We show how such private information can lead to subsequent bargaining failure and sub-optimal ex ante relationship-specific investment. We also show that this inefficiency is worse if the parties enter into a binding and renegotiable contract to trade before the investment is made. This may explain why some preliminary agreements are expressly non-binding. Finally, we demonstrate that parties may reduce the inefficiency by agreeing to negotiate in good faith or other such “knowledge-based” provisions, especially when these promises are backed by expectation rather than reliance damages.
Keywords: Preliminary Agreement, Letter of Intent, Memorandum of Understanding, Term Sheet, Duty to Negotiate in Good Faith
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