Contracting Still Matters! Or: How (and Why) to Design a Letter of Intent

Abstract

Any cooperation that involves relation-specific investments can suffer from the well-known hold-up problem. If the contract is not enforceable by an outside authority, individual opportunism, caused by a free-rider problem, may occur. If, in addition, individual investments exhibit positive cross-effects, Che and Hausch (1999) show that contracts will not be able to overcome the holdup due to a lack of verifiable commitment. This paper develops such a commitment device. This mechanism includes (1) an acknowledgment game that procures reliable information and (2) embeds the original contract in two institutional designs - a market-based one and a private one - that support enforcement. These two features make investment efficient as it can be enforced by way of the contract.

Keywords: cooperative investments, mechanism design, hold-up

JEL Classification: C72, D21, D82