Department of Economics, UCSD

This paper examines a class of contractual relationships with specific investment, a non-durable trading opportunity, and renegotiation. Trade actions are modeled as individual and trade-action-based option contracts (“non-forcing contracts”) are explored. The paper identifies an important distinction, between divided and unified investment and trade actions, that plays a key role in determining whether efficient investment and trade can be achieved. By using non-forcing contracts, the party without the trade action can be made residual claimant with regard to the investment action, which implies that an efficient outcome can be achieved in the divided case but not typically in the unified case. More generally, the paper shows that, with ex post renegotiation, constraining parties to use “forcing contracts” implies a strict reduction in the set of implementable value functions. Tools are developed for calculating the “punishment values” that determine the sets of implementable post-investment value functions.