Relationship-Specific Investment, Asymmetric Information, and the Role of Knowledge-Based Obligations in Contracts

Abstract

Relationship-specific investments that increase the contracting surplus can also endow the investing party with private information over efficient terms of trade. Investment by a manufacturer to learn about the idiosyncratic needs of its buyers is one example; another is research and development expenditure in a joint venture. The presence of private information can lead to ex post bargaining failure which, in turn, can dampen the ex ante relationship-specific investment incentive. This paper examines how contract design can mitigate these problems. The paper first demonstrates that these inefficiencies may be exacerbated when the parties enter into a binding agreement before the investment and rely on ex post renegotiation to incorporate the information obtained through the investment. This is because the informed party is protected from bargaining failure at the renegotiation stage by its ability to fall back on the terms of the initial agreement. This finding offers an explanation for why preliminary agreements in commercial transactions are often expressly non-binding, even when they contain all or most of the essential terms of the deal. Conventional scholarship, in contrast, holds that such agreements should be binding in order to protect relationship-specific investments from hold-up. Second, we examine the role of frequently used “knowledge-based” contract provisions, such as representations made to the best of the party’s knowledge or obligations to negotiate in good faith. While litigating over such provisions entail cost and judicial error, we show that, with appropriately calibrated damages, they can improve ex ante and ex post efficiency. This result supports why, in certain circumstances, commercial parties agree to the obligation to negotiate in good faith in an otherwise non-binding initial agreement. Third, the paper identifies conditions under which backing the knowledge-based obligations with expectation damages allows the parties to achieve both the ex ante and ex post efficiencies better than reliance damages.