A Hold-Up Problem With Behavioral Considerations

Abstract

Incomplete contracts may involve a hold-up problem, resulting in inefficient levels of investment. In this paper, we model the phenomenon as a sequential move game with asymmetric information regarding quality. Absence behavioral considerations, the unique Perfect Bayesian Equilibrium implies zero investment. However, with reciprocal motives, the hold-up problem may be mitigated due to vengeance as a credible threat. We propose a model that incorporates reciprocal motives, and solve for the vengeance equilibrium. In addition, we look at a nonbinding handshake as an alternative mechanism for mitigating the hold-up problem. This mechanism would work under the assumption of relationship norms entering the utility function. We incorporate relationship norms into the model and solve for the handshake equilibrium. Finally, we propose and conduct an experimental test to gauge the value of the analytical predictions in environments with human players.

Keywords: Dynamic Psychological Game; Hold-Up Problem; Incomplete Contract; Vengeance; Handshake

JEL Classification: C61, M11, M20, C70, D00