Formal Contracts, Relational Contracts, and the Holdup Problem
53 Pages Posted: 12 Sep 2004
Date Written: August 4, 2006
We study the holdup problem in repeated transactions between a seller and a buyer such that the seller makes relation-specific investments in each period. We show that where, under spot transaction, formal contracts have no value because of the cooperative nature of investment, writing a simple fixed-price contract can be valuable under repeated transactions: There is a range of parameter values in which a higher investment can be implemented only if a formal price contract is written and combined with a relational contract. We also show that there are cases in which not writing a formal contract but entirely relying on a relational contract increases the total surplus of the buyer and the seller. The key condition is how the investment affects the renegotiation price in general, and the alternative-use value in particular.
Keywords: Holdup problem, formal contract, relational contract, cooperative investment, fixed-price contract, relation-specific investment, renegotiation, repeated transaction, long-term relationships
JEL Classification: D23, L14, L22, L24
Suggested Citation: Suggested Citation