Breakup of Repeat Transaction Contracts, Specific Investment, and Efficient Rent-Seeking

In a repeat trade model with buyer's specific investment, a simple renegotiable contract implements an efficient outcome if premature termination of trade is governed by an appropriate contract breakup rule. In equilibrium, such a rule allows for termination with positive probability and gives the buyer a bargaining leverage over the seller when the contract is renegotiated ex-post. These returns ("breakup rents") from buyer's rent-seeking complement his ex-post bargaining power and restore his ex-ante investment incentives when he would otherwise underinvest due to a standard (ex-ante) hold-up problem. Buyer's opportunism thus creates social value and restores efficiency in case of frictionless renegotiation. When the contract is rigid and not renegotiable until after the first round of trade, however, a first-best breakup rule does not exist. A second-best rule trades off buyer's investment and seller's activity distortions that arise from excessive effort to curb the buyer's bargaining leverage. Conditions on existence of a first or second-best breakup rule as well as implications for the legal discussion on compliance standards for breach of contract are given.