Buyer-Option Contracts, Renegotiation, and the Hold-Up Problem

Eric Bennett Rasmusen, Kelley School of Business, Indiana University
Thomas P. Lyon, Kelley School of Business

Abstract

Hart & Moore (1999) construct a model to show that contracts perform poorly when the state of the world is unverifiable and renegotiation cannot be ruled out. They implicitly assume that one player can extort payment from another by threatening to take an inefficient action which hurts both of them. Without this assumption, a simple ``buyer option" contract can implement the first-best even as complexity becomes severe. The model is a good illustration of the need to be careful with the ideas of ``one party has all the bargaining power'' and ``one party can make a take-it-or-leave-it offer.''