Renegotiation Design by Contract
Professor Ronald Coase famously asked why, if markets are an efficient method of allocating resources, does so much economic activity take place within firms. Coase proposed that there are costs to using the price mechanism: transaction costs. What Coase had in mind was traditional, ex post haggling: arguing over price and quantity and committing the agreement to paper. As the literature on the boundary of the firm developed over the past three-quarters of a century, a more challenging transaction cost was identified: the so-called “hold-up problem.” If one party to a contract makes a relationship-specific investment, the second party can use the threat not to perform to extract part of the difference between the value of the investment to the relationship and the value in its next best use. This risk of renegotiation will reduce incentives to invest and thus the value of market transactions relative to within-firm transactions. The holdup problem has strong empirical support, is the basis for the modern theory of the firm (or Property Rights Theory), and was an impetus for Oliver Williamson’s Nobel Prize.
Coase’s question is fundamental for economists because of the positive and normative implications for economic efficiency. It is also an important question for lawyers: a significant body of law deals with firms, their ownership, and their interactions. It is understandable, then, that enormous attention has been paid to methods for overcoming, or at least ameliorating, the holdup problem. The dominant economic theory of the firm, known as Property Rights Theory (PRT), was pioneered by Grossman and Hart and further developed by Hart and Moore. PRT equates the firm with asset ownership and asset ownership, in turn, with residual rights of control over those assets. Although it would be incorrect to think of PRT as a formalization of the holdup problem, it certainly features heavily in the theory.
PRT assumes that contracts are incomplete, in the sense that some payoff-relevant states of the world are either unforeseeable by the parties or indescribable to a court. Since they cannot be (enforceably) contracted on ex ante, they must be bargained over ex post—after the state is revealed. Asset ownership affects this bargaining because it reflects outside options that parties to a transaction have if renegotiation breaks down, and this, in turn, affects incentives for ex ante relationship-specific investments. This is the manner in which asset ownership, and thus the economic notion of a firm, can help alleviate the holdup problem.
If it is possible to write a complete, enforceable contract, then there would be no holdup, and thus asset ownership would be irrelevant in determining the boundary of the firm. It is typically implicitly assumed that the parties cannot foresee all possible future contingencies or that not all contingencies are describable, and therefore a complete contract is not possible. Instead, the bulk of the contract-theory literature has taken a mechanism-design approach to the problem. That is, it asks: How can the environment, including the process under which renegotiation takes place, be structured to avoid or ameliorate holdup?
The difficulty of the problem depends on two factors. One is whether one or both parties must make specific investments and whether those investments are selfish or cooperative. If both parties must make investments, then the problem begins to resemble the moral-hazard-in-teams problem: if you give one party high-powered incentives to take effort (invest), then the other party has fewer incentives to invest. The second factor is whether each party makes investments that increase the value of a contract to itself or to the other party. The former we call self-serving investment. The latter, called cooperative investments (or direct externalities), are double trouble. First, the investing party is subject to holdup. Second, by directly benefiting the counterparty, investment increases the counterparty’s bargaining power during renegotiation.
Whereas asset ownership can solve only the problem of selfserving, one-sided investment, Professor Tai-Yeong Chung and, importantly, Professor Philippe Aghion, Professor Mathias Dewatripont, and Professor Patrick Rey (ADR) demonstrate that a contract with two simple components (hereafter “renegotiation design” or “RD” contracts) can achieve optimal self-serving, bilateral investment. The first component (called a “default option”) is a trade that guarantees one party a full return to its investment and can be enforced with a specific performance remedy. The second component (called a “take-it-or-leave-it” or “TIOLI” offer) is a provision that gives all bargaining power during a renegotiation to the second party. This ensures that the second party also invests by making it a residual claimant on its investment. Moreover, Professors Aaron Edlin and Stefan Reichelstein show that, in certain circumstances, parties can ensure efficient bilateral investment simply with a default option: there is no need to give the second party all bargaining power during renegotiation.
One drawback to all the contracts above, however, is that they cannot solve the bilateral-investment problem when investments are cooperative. In fact, the only context in which simple contracts are theoretically an inadequate substitute for firm boundaries is when investments are both bilateral and cooperative and it is important for parties to be able to adjust to changed circumstances.
Of course, theoretical mechanisms are of little use if they cannot be implemented in the real world. We suspect that the reason why asset ownership gets so much attention in the literature on the holdup problem and contracts get so little attention is that economists see variation in asset ownership everywhere, while few see actual contracts that look like the theoretical contracts proposed as solutions to holdup in the mechanism-design literature. In this Article we propose to correct that misunderstanding about real-world contracts by describing actual contracts that implement the RD mechanism. In other words, this Article demonstrates that RD contracts are not merely a theoretical novelty but actually feasible and observed in the real world.