Specific Investments, Flexible Adaptation, and Requirement Contracts

By Zhu, Tian | Economic Inquiry, April 2003 | Go to article overview

Specific Investments, Flexible Adaptation, and Requirement Contracts


Zhu, Tian, Economic Inquiry


I. INTRODUCTION

In bilateral procurement relationships, ex post opportunism may cause underinvestment in relationship-specific investments, as is shown by Klein et al. (1978) and Williamson (1985). In such situations, long-term contracts can help to mitigate this so-called hold-up problem. In a world of positive transaction costs, long-term contracts are necessarily incomplete. (1) An inflexible incomplete contract may lead to ex post maladaptation in the presence of uncertainty, as in Williamson (1985). Therefore, a transaction cost-economizing contract needs to provide both incentives for efficient relationship-specific investments and flexibility for efficient adaptation. (2)

In a simple hold-up model with contractible cost-related variables, I show that efficient adaptation and investments can be achieved through a requirement contract, which gives the buyer the right to decide on how much to buy ex post and contains a price provision with a two-part tariff structure, including a fixed component and a unit charge that may vary with quantities and cost-related variables. This result Provides a formal explanation of contractual arrangements observed in vertical procurement relationships.

Formally, my result can be viewed as an extension of Williamson's (1983) hostage model in which only the seller makes investments, the procurement quantity is fixed, and there is no cost uncertainty. My result is also related to previous formal studies on the take-or-pay contracts as in Hubbard and Weiner (1986), Crocker and Masten (1988), and Masten (1988). In a simpler model without cost uncertainty and specific investments, they show that a unilateral options contract with a take-or-pay feature gives the buyer the right incentives to make efficient quantity decisions. Particularly, Crocker and Masten (1988) and Masten (1988) emphasize the take-or-pay contract's ability to induce efficient adaptation. Another related paper is by Bos (1996), who shows that when the production cost is contractible, a target-cost pricing contract that requires the seller to share a portion of the cost overrun can achieve the first best outcome.

The rest of the article is organized as follows. Section II provides the background of the issue studied. Section III lays out the model and characterizes the first best benchmark. Section IV derives the optimal contract. Section V concludes.

II. BACKGROUND

A growing recent literature has attempted to find contractual solutions to the hold-up problem. Most of the papers in the literature use Hart and Moore's (1988) classical model (or its variation). In that model, there are two risk-neutral firms: a buyer and a seller of an intermediate good. Each firm can, before production, make a relationship-specific investment to enhance the future value of the good (in the case of the buyer) or to reduce the production cost of the good (in the case of the seller). Neither the investments nor the value nor the cost of the intermediate good are contractible ex ante. In the absence of a contract, there will generally be underinvestment.

Some of the contractual solutions to the underinvestment problem rely on complex direct-revelation mechanisms that utilize private or unverifiable information to implement efficient investments as in, for example, Rogerson (1992) and Maskin and Tirole (1999), but they are not robust to renegotiation. Several articles have focused on contracts that make explicit use of ex post renegotiation to achieve efficiency. Particularly, Aghion et al. (1994), Chung (1991), and Edlin and Reichelstein (1996) show that simple fixed-price-fixed-quantity contracts may suffice to achieve the first best outcome. Such contracts are, in general, not efficient ex post. But as long as mutually beneficial renegotiation of the initial contract is allowed, both ex ante and ex post efficiency can be achieved either by a properly designed renegotiation game (as in Aghion et al. …

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