Early Contract Termination and Specific Investment

Abstract

Default rules in contract law grant a buyer the right to terminate an installment contract (i.e., a contract over the recurrent delivery in multiple periods) and cancel future deliveries if, and only if, past deliveries by the seller are sufficiently defective (putting the seller in breach). This form of endogenous reversibility of the contract introduces memory and renders the installment contract non-divisible. Using an incomplete contracts framework with buyer's relationship-specific investment, I show that absent other contractual solutions an installment contract with endogenous reversibility can solve the buyer's holdup problem and implement the first-best outcome. Multiple independent contracts over one delivery each, installment contracts without the right to terminate, or installment contracts with exogenous reversibility cannot solve the buyer's holdup problem. I further show that the optimal termination right is not too buyer-friendly when the buyer has low bargaining power in ex post renegotiations. This result serves as an economic rationale for the restriction of termination rights to cases of material breach of contract.