Bargaining, Competition and E¢ cient Investment

This paper explores the interplay between choice of investment type (speci…c vs. general), bargaining extensive form and endogenous outside options in the framework of incomplete contracts introduced formally in the work of Grossman, Hart and Moore. We …nd that the bargaining procedure chosen has signi…cant implications for choice of investment and for the usefulness of the assignment of property rights in enhancing e¢ ciency. Somewhat paradoxically an “auctionlike” procedure might need the correct assignment of property rights while a sequential o¤ers procedure might do as well as the best assignment of property rights. 1 Introduction 1.1 Main features The aim of this paper is to investigate investment choice by agents in a “thin” market where transactions take place by bilateral bargaining. We study the simplest non-trivial model of this type with two buyers and one seller. Our model has the following features. 1. Both seller and buyers potentially invest. The seller chooses both the type of the investment and the level. The type of the investment varies continuously from 0 (investment speci…c to the …rst buyer’s product) to 1 (investment speci…c to the second buyer’s product) with a value of 1/2 being the most “generalist”type. Investment speci…c to one buyer creates the most value in a transaction with that buyer per unit of investment chosen and the least value in a transaction with the other buyer. We assume the seller’s investment is “more important”than the buyers’in a sense to be explained later. 2. The environment is one of incomplete contracting. Neither investment level or type or value can be contracted on. Each agent owns an asset in the benchmark model and the investment is in learning how to use the asset for a speci…c purpose, either for one speci…c buyer or for something generalist. (The investment is “inalienable”). 3. The “outside option”of the seller in a negotiation with one buyer is the value of an agreement with the other buyer. (The alternative to a negotiated agreement for a buyer is an inside option, that is he produces the item himself.) Since the bargaining institution a¤ects not only the payo¤ within a negotiation but also the outside option, the nature of the investment chosen depends crucially on it. We consider two extensive