The Limitations of Buyer-Option Contracts in Solving the Hold-up Problem

Abraham L. Wickelgren, Northwestern University

Abstract

In a recent paper, Lyon and Rasmusen (2004) argue that buyer-option contracts are more effective at solving the hold-up problem than has been previously recognized. This paper examines the robustness of that claim to changes in the bargaining game they analyze and to changes in the nature of the trade between the buyer and seller. I find that the possibility of renegotiation in a model of cooperative investment (Che and Hausch 1999) does generate a hold-up problem if the players discount the future and the bargaining game is sufficiently long. This change in the bargaining game does not resurrect the hold-up problem in the basic product complexity model (of Hart and Moore 1999). However, if the good to be traded must be supplied continually rather than only one time, then the hold-up problem re-emerges (even with buyer-option contracts) for some parameter values.