"Investing in a Relationship"
Publication type: Working paper
A principal makes an upfront investment before starting a repeated relationship with an agent. The investment increases the value of the relationship; however, because the parties bargain after the investment is sunk, the principal may have to share the returns with the agent. I study how this hold-up problem and overall efficiency are affected by the contracting environment. When the returns to the investment are commonly known, informal contracting environments ex post may be more efficient as they induce higher investment ex ante: the principal invests not only to generate direct returns, but also to relax contracting constraints and improve relational incentives. Unobservability of investment returns increases the principal's ability to appropriate the returns, but it reduces the parties' ability to improve relational incentives. The optimal control of information depends on the parties' bargaining powers.
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