Interlinkage, limited liability and strategic interaction

The literature on interlinkage is inconclusive regarding the strict superiority of this arrangement. We analyze a landlord and a moneylender as two players making non-cooperative decisions regarding the terms of their respective contracts with a tenant. In the sequential game where the landlord moves first and the tenant has limited liability, we demonstrate that there exist circumstances in which interlinkage is superior, even with nonlinear loan contracts, a result that carries over when there is moral hazard. The incorporation of risk aversion yields strict superiority in general. The main result is unaffected by changes in the seniority of claims, but is sensitive to changes in the order of moves: limited liability ceases to ensure the strict superiority of interlinked contracts if the principal who provides the variable factor of production moves first, even if he has junior claims to the output. © 2000 Elsevier Science B.V. All rights reserved. JEL classification: C7; D8; O1