Hold-Up with Unobservable Investment and the Value of Restricting to Simple Contracts

This manuscript examines the design of the contracting environment in a bilateral trade model with unobservable relationship-specific investment. Contracts can only be offered after the investment is sunk, inducing a classical hold-up problem. When the investment is cooperative and investment costs are intermediate, a restricted contracting environment where only single contracts can be offered, turns out optimal. Menus of contracts optimally trade-off information rents versus efficiency of production. A restriction to single contracts gives rise to larger information rents, inducing stronger investment incentives and thereby increasing overall payoffs. The result shows yet another pitfall of micromanagement, where too detailed contracting possibilities destroy investment incentives. A commitment to restrict contracting possibilities can be achieved by delegating the bargaining task together with limiting the delegate's contract options