DP8366 Investments as Signals of Outside Options

Author(s): Susanne Goldlücke, Patrick W. Schmitz
Publication Date: April 2011
Keyword(s): hold-up problem, incomplete contracts, relationship-specific investments, signaling games
JEL(s): D23, D82, D86
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8366

Consider a seller who can make an observable but non-contractible investment to improve an intermediate good that is specialized to a particular buyer's needs. The buyer then makes a take-it-or-leave-it offer to the seller. The seller has private information about the fraction of the ex post surplus that he can realize on his own. Compared to a situation with complete information, additional investment incentives are generated by the seller's desire to pretend a strong outside option. On the other hand, ex post efficiency is not attained whenever the buyer mistakenly tries to call the seller's bluff with a low offer.