How (Not) to Purchase Novel Goods and Services: Specific Performance Versus At-Will Contracts

Schmitz, Patrick W. (2022): How (Not) to Purchase Novel Goods and Services: Specific Performance Versus At-Will Contracts. Published in: Economic Journal , Vol. 132, No. ueac024

Abstract

A buyer wants to purchase an innovative good from a seller. Both parties are risk-neutral, and payments from the buyer to the seller must be non-negative. After the contract is signed, the seller privately observes a signal, which may be informative about the seller's costs. We compare two contracting regimes. In the case of specific performance, the courts enforce the trade level specified in the contract. In the case of at-will contracting, the seller is free to walk away from the contract after the signal has been realized. While the buyer prefers specific performance and the seller prefers at-will contracting, the optimal regime from an economic efficiency point-of-view depends on the informativeness of the signal.

• Item Type: MPRA Paper
• Language: English
• Keywords: contract theory; specific performance; at-will contracts; asymmetric information; ex-post inefficiencies
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D86 - Economics of Contract: Theory; H - Public Economics > H5 - National Government Expenditures and Related Policies > H57 - Procurement; K - Law and Economics > K1 - Basic Areas of Law > K12 - Contract Law; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L14 - Transactional Relationships ; Contracts and Reputation ; Networks

References

Aghion, P., Dewatripont, M., Rey, P. (1994). Renegotiation design with unverifiable information. Econometrica 62, 257--282.

At, C., Friehe, T., Gabuthy, Y. (2019). On lawyer compensation when appeals are possible. BE Journal of Economic Analysis and Policy 19, 1--11.

Axelson, U., Bond, P. (2015). Wall street occupations. Journal of Finance 70, 1949--1996.

Baliga, S., Sjöström, T. (1998). Decentralization and collusion. Journal of Economic Theory 83, 196--232.

Bar-Isaac, H., Leaver, C. (2021). Investment in human capital under endogenous asymmetric information. Working Paper.

Bolton, P., Dewatripont, M. (2005). Contract Theory. MIT Press.

Bös, D. (1996). Incomplete contracting and target-cost pricing. Defence and Peace Economics 7, 279--296.

Bös, D., Lülfesmann, C. (1996). The hold-up problem in government contracting. Scandinavian Journal of Economics, 98, 53--74.

Buso, M., Greco, L. (2021). The optimality of public-private partnerships under financial and fiscal constraints. Working Paper.

Cato, S., Ishihara, A. (2017). Transparency and performance evaluation in sequential agency. Journal of Law, Economics, and Organization 33, 475--506.

Chemla, G., Habib, M.A., Ljungqvist, A. (2007). An analysis of shareholder agreements. Journal of the European Economic Association 5, 93--121.

Chen, B.R., Chiu, Y.S. (2013). Interim performance evaluation in contract design. Economic Journal 123, 665--698.

Choi, A.H., Triantis, G. (2021). Contract design when relationship-specific investment produces asymmetric information. Journal of Legal Studies 50, 219--260.

Chung, T.Y. (1991). Incomplete contracts, specific investments, and risk sharing. Review of Economic Studies 58, 1031--1042.

Coughlan, P.J., Gates, W. (2009). Innovations in defense acquisition: Asymmetric information and incentive contract design. Report, Naval Postgraduate School, Monterey, CA.

Crémer, J., Khalil, F., Rochet, J.-C. (1998). Contracts and productive information gathering. Games and Economic Behavior 25, 174--193.

De Fraja, G. (1999). After you sir. Hold-up, direct externalities, and sequential investment. Games and Economic Behavior 26, 22--39.

Downs, J. (2021). Information gathering by overconfident agents. Journal of Economics and Management Strategy 30, 554--568.

Edlin, A.S., Reichelstein, S. (1996). Holdups, standard breach remedies, and optimal investment. American Economic Review 86, 478--501.

Epstein, R.A. (1984). In defense of the contract at will. University of Chicago Law Review 51, 947--982.

Fares, M.H. (2006). Renegotiation design and contract solutions to the hold-up problem. Journal of Economic Surveys 20, 731--756.

Fudenberg, D., Tirole, J. (1991). Game Theory. Cambridge, MA: MIT Press.

Goldlücke, S., Schmitz, P.W. (2014). Investments as signals of outside options. Journal of Economic Theory 150, 683--708.

Goldlücke, S., Schmitz, P.W. (2018). Pollution claim settlements reconsidered: Hidden information and bounded payments. European Economic Review 110, 211--222.

Goltsman, M. (2011). Optimal information transmission in a holdup problem. Rand Journal of Economics 42, 495--526.

Hart, O., Moore, J. (1988). Incomplete contracts and renegotiation. Econometrica 56, 755--785.

Hart, O., Moore, J. (2008). Contracts as reference points. Quarterly Journal of Economics 123, 1--48.

Herbst, P., Walz, U. (2017). The design of vertical R&D collaborations. Economica 84, 54--77.

Hoppe, E.I., Schmitz, P.W. (2013a). Public-private partnerships versus traditional procurement: Innovation incentives and information gathering. Rand Journal of Economics 44, 56--74.

Hoppe, E.I., Schmitz, P.W. (2013b). Contracting under incomplete information and social preferences: An experimental study. Review of Economic Studies 80, 1516--1544.

Hoppe, E.I., Schmitz, P.W. (2021). How (not) to foster innovations in public infrastructure projects. Scandinavian Journal of Economics 123, 238--266.

Innes, R.D. (1990). Limited liability and incentive contracting with ex-ante action choices. Journal of Economic Theory 52, 45--67.

Iossa, E., Martimort, D. (2015). Pessimistic information gathering. Games and Economic Behavior 91, 75--96.

Iossa, E., Stroffolini, F. (2005). Price cap regulation, revenue sharing and information acquisition. Information Economics and Policy 17, 217--230.

Kessler, A. (1998). The value of ignorance. Rand Journal of Economics 29, 339--354.

Khalil, F., Kim, D., Shin, D. (2006). Optimal task design: To integrate or separate planning and implementation? Journal of Economics and Management Strategy 15, 457--478.

Kragl, J., Schöttner, A. (2014). Wage floors, imperfect performance measures, and optimal job design. International Economic Review 55, 525--550.

Kräkel, M. (2021). On the delegation of authority. Journal of Economic Behavior and Organization 191, 965--981.

Kräkel, M., Schöttner, A. (2016). Optimal sales force compensation. Journal of Economic Behavior and Organization 126, 179--195.

Laffont, J.-J., Martimort, D. (2002). The Theory of Incentives: The Principal-Agent Model. Princeton University Press.

Lau, S. (2011). Investment incentives in bilateral trading. Games and Economic Behavior 73, 538--552.

Lewis, T.R., Sappington, D.E. (1993). Ignorance in agency problems. Journal of Economic Theory 61, 169--183.

Lülfesmann, C. (2001). Incomplete contracts, non-contractible quality, and renegotiation. Contributions to Theoretical Economics 1, Article 2.

Markowski, S., Hall, P., Wylie, R. (2009). Buyer-seller interaction in defence procurement. In: Markowski, S., Hall, P., Wylie, R. (Eds). Procurement and Industry Policy. Routledge, 135--172.

Martimort, D., Straub, S. (2016). How to design infrastructure contracts in a warming world: A critical appraisal of public-private partnerships. International Economic Review 57, 61--88.

Moore, J. (2016). Introductory remarks on Grossman and Hart (1986). In: Aghion, P., Dewatripont, M., Legros, P., Zingales, L. (Eds). The Impact of Incomplete Contracts on Economics. Oxford University Press.

Müller, D., Schmitz, P.W. (2021). The right to quit work: An efficiency rationale for restricting the freedom of contract. Journal of Economic Behavior and Organization 184, 653--669.

Myerson, R.B. (1982). Optimal coordination mechanisms in generalized principal-agent problems. Journal of Mathematical Economics 10, 67--81.

Myerson, R.B., Satterthwaite, M.A. (1983). Efficient mechanisms for bilateral trading. Journal of Economic Theory 29, 265--281.

Nöldeke, G., Schmidt, K.M. (1995). Option contracts and renegotiation: A solution to the hold-up problem. Rand Journal of Economics 26, 163--179.

Norman, L., Dalton, M., Pancevski, B. (2021). World news: EU presses AstraZeneca to deliver shots -- clash escalates after drugmaker says problems at factory cut supplies to continent. Wall Street Journal, January 28.

Nosal, E. (2001). Optimal at-will labour contracts. Economica 68, 187--201.

Ohlendorf, S., Schmitz, P.W. (2012). Repeated moral hazard and contracts with memory: The case of risk-neutrality. International Economic Review 53, 433--452.

Pancevski, B., Norman, L. (2021). World news: EU's bad bets on inoculations leave bloc short. Wall Street Journal, February 3.

Peel, M., Mancini, D.P. (2021). EU and AstraZeneca fail to resolve vaccine supply dispute. Financial Times, January 28.

Pi, J. (2021). An investigation of seeming favoritism in public procurement. Manchester School 89, 128--137.

Pitchford, R. (1998). Moral hazard and limited liability: The real effects of contract bargaining. Economics Letters 61, 251--259.

Rachman, G. (2021). Why the European Commission failed the vaccine challenge. Financial Times, February 1.

Reuters Staff (2017). Report shows 1,300 unfilled jobs, strain for German defense procurement. Reuters, December 13.

Rogerson, W.P. (1995). Incentive models of the defense procurement process. Handbook of Defense Economics 1, 309--346.

Rotemberg, J.J., Saloner, G. (1994). Benefits of narrow business strategies. American Economic Review 84, 1330--1349.

Sadeh, A., Dvir, D., Shenhar, A. (2000). The role of contract type in the success of R&D defense projects under increasing uncertainty. Project Management Journal 31, 14--22.

Sappington, D. (1983). Limited liability contracts between principal and agent. Journal of Economic Theory 29, 1--21.

Schmitz, P.W. (2006). Information gathering, transaction costs, and the property rights approach. American Economic Review 96, 422--434.

Schmitz, P.W. (2008). Incomplete contracts, the hold-up problem, and asymmetric information. Economics Letters 99, 119--122.

Schmitz, P.W. (2013). Job design with conflicting tasks reconsidered. European Economic Review 57, 108--117.

Schmitz, P.W. (2017). Asymmetric information and the property rights approach to the theory of the firm. Economics Letters 159, 96--99.

Schmitz, P.W. (2021). Optimal ownership of public goods under asymmetric information. Journal of Public Economics 198, 104424.

Shavell, S. (2006). Specific performance versus damages for breach of contract: An economic analysis. Texas Law Review 84, 831--876.

Smirnov, V., Wait, A. (2004). Timing of investments, holdup and total welfare. International Journal of Industrial Organization 22, 413--425.

Su, A.P.-J. (2017a). Information acquisition and the equilibrium incentive problem. Journal of Economics and Management Strategy 26, 231--256.

Su, A.P.-J. (2017b). Information revelation in the property right theory of the firms. International Journal of Industrial Organization 52, 133--164.

Tamada, Y., Tsai, T.-S. (2014). Delegating the decision-making authority to terminate a sequential project. Journal of Economic Behavior and Organization 99, 178--194.

Ulen, T.S. (1984). The efficiency of specific performance: Toward a unified theory of contract remedies. Michigan Law Review 83, 341--403.

Vasconcelos, L. (2014). Contractual signaling, relationship-specific investment and exclusive agreements. Games and Economic Behavior 87, 19--33.

Williamson, O.E. (1985). The Economic Institutions of Capitalism. New York: Free Press.

Williamson, O.E. (2000). The new institutional economics: Taking stock, looking ahead. Journal of Economic Literature 38, 595--613.

Ye, B., Li, S. (2018). Competitive contracts with productive information gathering. Journal of Economics 124, 1--17.