Holdup with Subsidized Investment

Abstract

A holdup model is analyzed in which one party, the seller, has an investment project that the other party, the buyer, can subsidize. The investment project remains the seller's; she cannot transfer her entire control rights to it. In particular, she can always refuse to allow the buyer to subsidize her investment if the subsidy would put the buyer in too strong a bargaining position ex post. Even with the subsidization opportunity, the holdup inefficiency is still present, except in the special cases in which one party has all the bargaining power. The adoption of a contract, however, allows full efficiency to be achieved more generally. In particular, if the seller's investment project imposes a positive externality on the buyer but does not reduce her own production costs, a buyer's option contract exists that achieves full efficiency. This is in contrast to the result of Che and Hausch (1999) that without a subsidization opportunity, contracting has no value in this "purely cooperative" case. If the investment lowers the seller's costs as well as raises the buyer's value, whether full efficiency can be achieved depends on how cooperative the investment is. Full efficiency can be achieved if the cooperativeness of the investment is either sufficiently high or sufficiently lowHoldup, renegotiation, contractual remedies, subsidized investment