Contract Design When Relationship-Specific Investment Produces Asymmetric Information

Abstract

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