Sunk Investment, Bargaining and Choice of Capital Structure.

This paper shows how a firm might optimally choose debt to affect the outcome of bilateral bargaining with workers or other input suppliers. It is shown that debt may alleviate the well-known underinvestment problem associated. with the inability to write precommitment contracts. Also, in such circumstances, debt could be Pareto improving over complete equity financing. The relationship between the optimal level of debt and asset specificity of investmen t and bargaining power of the firm vis-a-vis the workers is explored. The Williamson conjecture that higher asset specificity will lead to less debt is shown not to be valid in general. Copyright 1993 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.