ESRC Centre for Economic Learning and Social Evolution
Doi
Abstract
We consider a principal-agent model of adverse selection where, in order to trade with the principal,
the agent must undertake a relationship-specific investment which affects his outside option to trade,
i.e. the payoff that he can obtain by trading with an alternative principal. This creates a distinction
between the agent’s ex ante (before investment) and ex post (after investment) outside options to trade.
We investigate the consequences of this distinction, and show that whenever an agent’s ex ante and ex
post outside options differ, this may equip the principal with an additional tool for screening among
different agent types, by randomizing over the probability with which trade occurs once the agent
has undertaken the investment. In turn, this may enhance the efficiency of the optimal second-best
contract