Contract Design When Relationship-Specific Investment Produces Asymmetric Information

Journal of Legal Studies, Forthcoming

U of Michigan Law & Econ Research Paper No. 19-014

34 Pages Posted: 8 Feb 2019 Last revised: 16 Jun 2021

See all articles by Albert H. Choi

Albert H. Choi

University of Michigan Law School

George G. Triantis

Stanford Law School

Date Written: June 16, 2021

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

Suggested Citation

Choi, Albert H. and Triantis, George G., Contract Design When Relationship-Specific Investment Produces Asymmetric Information (June 16, 2021). Journal of Legal Studies, Forthcoming, U of Michigan Law & Econ Research Paper No. 19-014, Available at SSRN: https://ssrn.com/abstract=3330973 or http://dx.doi.org/10.2139/ssrn.3330973

Albert H. Choi (Contact Author)

University of Michigan Law School ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States

HOME PAGE: http://www.law.umich.edu/FacultyBio/Pages/FacultyBio.aspx?FacID=alchoi

George G. Triantis

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305-8610
United States

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