The Korean Economic Review
The Value of Contracting with the Sequential Investments: The Role of Outside Values
Kyoung Won RheeYear 2007Vol. 23No. 1
This article addresses two issues in understanding whether contractingsubject to renegotiation can provide the right incentives for investments: thedegree of specificity of investments and the sequentiality of investments. Thepaper considers an environment in which the seller makes a specificinvestment and then the buyer undertakes an investment. Assuming thegeneral investment, recent articles argue that option contracts can achievethe first best outcome. This article shows, however, that their result is notrobust when the first investment is specific. In particular, option contractscannot do better than no contract. Moreover, this paper proves thatcontracting replicates at best no contract. Our results imply that the value ofcontracting depends heavily on whether the first investment is general orspecific in the sequential investment environment.