When two parties invest in human capital and at the same time decide on know-how disclosure it can be shown that joint ownership with veto power is the optimal ownership structure, given that only incomplete contracts can be written.Incomplete contracts; Know-how disclosure; Joint ownership

Rosenkranz, Stephanie

Schmitz, Patrick W.

English

Research Papers in Economics

Know-how disclosure and incomplete contracts
Stephanie Rosenkranz, Patrick W. Schmitz∗
University of Bonn, Adenauerallee 24-42, D-53113 Bonn, Germany
January 1999
Abstract
When two parties invest in human capital and at the same time decide on
know-how disclosure it can be shown that joint ownership with veto power
is the optimal ownership structure, given that only incomplete contracts can
be written.
Keywords: Incomplete contracts; Know-how disclosure; Joint ownership
JEL classiﬁcation: D23, L22, O31
∗ This is the working paper version of the following article:
Rosenkranz, S. and Schmitz, P.W. (1999), “Know-How Disclosure and Incomplete Con-
tracts,” Economics Letters, Vol. 63, pp. 181—185.
11 Introduction
One of the most prominent results in the literature on incomplete contracts
and property rights as pioneered by Hart and Moore (see Hart and Moore,
1990, Moore, 1992, and Hart, 1995) says that not more than one agent should
have veto power over an asset. This conclusion crucially depends on Hart and
Moore’s assumption that property rights only matter as far as they inﬂuence
the parties’ incentives to make investments in human capital, which may be
called “self-investments” (following Che and Hausch, 1997).1 However, in
the context of research joint ventures, the surplus which may be generated
by the parties usually also depends on how much know-how they disclose to
each other.2 Since such disclosure is directly beneﬁcial to the other party, it
is a kind of “cooperative investment” in the sense of Che and Hausch (1997).
We argue that the necessity to provide incentives for investment in human
capital as well as for know-how disclosure may lead to conclusions which are
in sharp contrast to Hart and Moore’s ﬁndings. In particular, it may well be
1We follow Hart and Moore and do not consider investments in physical capital (cf.
Hart and Moore, 1990, p. 1132, and Hart, 1995, p. 68). Note that there are two other
papers which show that it may be beneﬁcial to give veto-power to more than one agent:
Halonen (1995), who considers a repeated game, and De Meza and Lockwood (1998), who
change Hart and Moore’s assumption about the renegotiation process.
2The importance of know-how disclosure in research joint ventures has been empha-
sized by Bhattacharya, Glazer and Sappington (1992), Gandal and Scotchmer (1993), and
d’Aspremont, Bhattacharya and Gérard-Varet (1995). However, their focus is on optimal
complete contracts.
2optimal to give both parties veto-power.3
2T h e m o d e l
Consider two parties, A and B, who can form a joint venture at date t =0
and generate a surplus v(a,b,α,β) ≥ 0 at some future date t =3 .A td a t e
t =1both parties decide simultaneously on two non-contractible actions
which positively inﬂuence the achievable surplus. Party A chooses a level of
relationship-speciﬁc investment a ∈ R+, which is measured by its cost, and
a level of know-how disclosure α ∈ [α,α], where α denotes A0s total know-
how and α ≥ 0 denotes the level of know-how that is immediately disclosed
to B by A0s mere presence at date t =1 . Analogously, B chooses b ∈ R+
and β ∈
£
β,β
¤
. Know-how disclosure by party A is assumed to increase the
eﬀectiveness of B0s investment and vice versa. Surplus can only be generated
with the help of an asset. At date t =0 , the parties write a contract on the
allocation of ownership rights over the asset.
At date t =2 , the parties can decide whether to continue their joint
venture. We assume that continuation is always eﬃcient. Hence, according
to the Coase-theorem, bargaining at t =2will always lead to an aﬃrmative
decision. However, how the surplus is shared depends on the allocation of
ownership rights which determine the threatpoint in the bargaining over the
3Che and Hausch (1997) brieﬂy consider the consequences of cooperative investments
for the issue of asset ownership in their footnote 29. However, they suggest that Hart and
Moore’s ﬁndings are conﬁrmed and do not further pursue the issue.
3use of the asset. The threatpoints reﬂect the payoﬀse a c hp a r t yc a nr e a l i z eo n
i t so w n .W ec o n s i d e rf o u rd i ﬀerent ownership structures, o ∈ {A,B,JV,JN}.
If party A is the owner of the asset (o = A), it earns wA(a,β) if bargaining
breaks down, and it can prevent the other party from using the asset, hence
B0s payoﬀ is 0.N o t et h a twA does not depend on b, since B0s investment is in
human capital. Of course, A can use its total know-how α, which we suppress
in the notation. If party B is the owner (o = B), its threatpoint payoﬀ is
given by wB(b,α), while A gets a payoﬀ of 0. We additionally consider two
kinds of joint ownership: If there is one physical asset joint ownership usually
m e a n st h a te a c hp a r t yh a sv e t op o w e ra n dc a nb l o c kt h eo t h e rp a r t yf r o m
using the asset, i.e., each party receives a payoﬀ of 0 if negotiation breaks
down. We call this case joint ownership with veto power (o = JV). On the
other hand, if the asset is a patent, joint ownership can also mean that each
party may use the asset for its own purpose (see Hart, 1995, p. 48, and the
literature cited there). In this case A receives a payoﬀ of wA(a,β) and B of
wB(b,α) if negotiation breaks down. This case we call joint ownership with
no veto power (o = JN).4
We assume for simplicity that v(a,b,α,β)=vA(a,β)+vB(b,α), where
vA(a,β) is strictly concave in the investment level and (in order to guarantee
interior solutions) we impose lima→0 vA
a (0,β)=∞ and lima→∞ vA
a (a,β)=0
4Hence we assume that ﬁrms do not compete on the same product market after nego-
tiations have broken down. One could simply relax this assumption and assume that the
payoﬀs are smaller than wA(a,β) and wB(b,α). However, our aim is to show that o = JN
may be the worst ownership structure, even though the ﬁrms do not compete.
4∀β.5 Similar conditions are supposed to hold for vB,w A, and wB. In order
to capture the idea of relationship speciﬁcity, we assume in correspondence
to Hart and Moore that the total surplus as well as the marginal returns
of investment are larger if the joint venture is continued, i.e., ∀a,b,α,β :
v(a,b,α,β) >w A(a,β)+wB(b,α),v A
a (a,β) >w A
a (a,β) > 0, and vB
b (b,α) >
wB
b (b,α) > 0.
The know-how of a party is assumed to be a less-than-perfect substitute
for the presence of this party in the joint venture. If no know-how has been
disclosed, the continued presence of B in the joint venture increases A0s
payoﬀ from wA(a,β) to vA(a,β) >w A(a,β). Know-how disclosure increases
both of these payoﬀs. The more know-how has been disclosed by party B,
the less important is its further presence in the joint venture. But some part
of B0s abilities is not transferable and therefore cannot be communicated via
know-how disclosure. Hence, vA(a,β)−wA(a,β) >v A(a,β)−wA(a,β) > 0,
and similarly for party B. Thus, it seems natural to assume wA
β(a,β) >
vA
β (a,β) > 0 ∀a and wB
α(b,α) >v B
α(b,α) > 0 ∀b.
Under these assumptions the ﬁrst-best know-how disclosure levels are
given by αFB = α and β
FB = β, and the ﬁrst-best investment levels are
uniquely deﬁned by the ﬁrst-order conditions vA
a (aFB,β)=1and vB
b (bFB,α)=
1.
Provided that the surplus from bargaining at date t =2is split according
to the Nash-bargaining solution with equal bargaining powers, it is easily
5Throughout, all functions are assumed to be twice continuously diﬀerentiable. Partial
derivatives are denoted by subscripts.
5checked that ﬁnal payoﬀsa r eg i v e nb y :
U
A(a,b,α,β|o)=
⎧
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩
1
2
£
v(a,b,α,β)+wA(a,β)
¤
− a if o = A
1
2
£
v(a,b,α,β) − wB(b,α)
¤
− a if o = B
1
2v(a,b,α,β) − a if o = JV
1
2
£
v(a,b,α,β) − wB(b,α)+wA(a,β)
¤
− a if o = JN
U
B(a,b,α,β|o)=
⎧
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩
1
2
£
v(a,b,α,β) − wA(a,β)
¤
− b if o = A
1
2
£
v(a,b,α,β)+wB(b,α)
¤
− b if o = B
1
2v(a,b,α,β) − b if o = JV
1
2
£
v(a,b,α,β) − wA(a,β)+wB(b,α)
¤
− b if o = JN
3 Optimal ownership structures
Separate ownership as well as joint ownership with veto power induce the
owners to fully disclose their know-how: UA
α (a,b,α,β|o) > 0 for o ∈ {A,
JV}, and UB
β (a,b,α,β|o) > 0 for o ∈ {B, JV}. There is no disclosure by the
party who is not the owner when there is separate ownership as well as in
case of joint ownership with no veto power: UA
α (a,b,α,β|o) < 0 for o ∈ {B,
JN}, and UB
β (a,b,α,β|o) < 0 for o ∈ {A, JN}. Given ownership structure
o, the parties’ investments in human capital, ao and bo, are determined by
the ﬁrst order conditions UA
a (a,b,α,β|o)=1and UB
b (a,b,α,β|o)=1:
61
2
£
vA
a (aA,β)+wA
a (aA,β)
¤
=1 , 1
2vB
b (bA,α)=1 ,
1
2vA
a (aB,β)=1 , 1
2
£
vB
b (bB,α)+wB
b (bB,α)
¤
=1 ,
1
2vA
a (aJV,β)=1 , 1
2vB
b (bJV,α)=1 ,
1
2
£
vA
a (aJN,β)+wA
a (aJN,β)
¤
=1 , 1
2
£
vB
b (bJN,α)+wB
b (bJN,α)
¤
=1 .
For comparison we ﬁrst consider the standard case without know-how
disclosure.
Proposition 1 Assume that α = α and β = β. The investment levels under
the four diﬀerent ownership structures can be ordered as follows:
a
FB >a
A = a
JN >a
B = a
JV
b
FB >b
B = b
JN >b
A = b
JV
The proposition immediately follows from the preceding discussion. Note
that there is always underinvestment with respect to the ﬁrst-best, so that
an ownership structure that induces both parties to invest more also yields
a larger total surplus. Hence, we have reproduced Hart and Moore’s result
that joint ownership with veto power is always weakly dominated by separate
ownership. Moreover, we ﬁnd that joint ownership with no veto power is the
optimal ownership structure in our model. We can now state our main result.
Proposition 2 Assume that α < α and β < β, (such that know-how can
7actually be disclosed), and that the following two inequalities hold:6
v
A
a (a,β)+w
A
a (a,β) <v
A
a (a,β)
v
B
b (b,α)+w
B
b (b,α) <v
B
b (b,α)
Then it follows:
a
FB >a
JV = a
B >a
A = a
JN
b
FB >b
JV = b
A >b
B = b
JN
This is exactly the opposite to the standard result. Here bilateral veto
power induces parties to disclose their know-how and also to invest more
into human capital than ownership structures with unilateral or without veto
power. Although possible threat from product market competition is left out
of the analysis, parties still do not disclose their know-how: Given they have
no veto power, know-how disclosure improves the other party’s bargaining
position at date t =2 . Therefore joint ownership with veto power can be
optimal even if investment is in human capital only. If the asset to be owned
is an innovation or a patent which can be used by both parties at the same
time, joint ownership with no veto power would be optimal in the standard
model, while it may be the worst scenario with know-how disclosure.
6Note that the conditions may well be satisﬁed if the marginal return of investment
is increasing with know-how disclosure, i.e., vA
aβ > 0 and vB
bα > 0, which seems to be
plausible. Even if only one of the two inequalities holds, o = JV is better than at least
one of the separate ownership structures. Moreover, bilateral veto-power can be optimal
even if the inequalities do not hold, since full know-how disclosure may overcompensate
lower investment levels.
84 References
d’Aspremont, C., S. Bhattacharya and L. - A. Gérard-Varet, 1995, Bargain-
ing and sharing knowledge, GREQAM Discussion Paper No. 95A43.
Bhattacharya, S., J. Glazer and D. Sappington, 1992, Licensing and the
sharing of knowledge in research joint ventures, Journal of Economic
Theory 56, 43-69.
Che, Y. - K. and D. B. Hausch, 1997, Cooperative investments and the
value of contracting, American Economic Review, forthcoming.
De Meza, D. and B. Lockwood, 1998, Does asset ownership always motivate
managers? Outside options and the property rights theory of the ﬁrm,
Quarterly Journal of Economics 113, 361-386.
Gandal, N. and S. Scotchmer, 1993, Coordinating research through research
joint ventures, Journal of Public Economics 51, 173-193.
Halonen, M., 1995, Reputation and allocation of ownership, LSE Discussion
Paper No. TE/95/289.
Hart, O. and J. Moore, 1990, Property rights and the nature of the ﬁrm,
Journal of Political Economy 98, 1119-1158.
Hart, O., 1995, Firms, contracts, and ﬁnancial structure (Clarendon Press,
Oxford).
Moore, J., 1992, The ﬁrm as a collection of assets, European Economic
Review 36, 493-507.
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