Strategic Shirking in Bilateral Trade*

Abstract

AbstractIn this paper, I study bilateral trade, where the seller can undertake specific investments before the binary trade transaction takes place. I identify a novel reason for hold‐up and contractual inefficiency in this canonical setting. The investing party can shirk for strategic reasons; that is, exert an effort so low that trade becomes inefficient and is being rescinded. Under a fixed‐price contract (the second‐best mechanism in the absence of the shirking problem), strategic shirking can arise regardless of the initially contracted trade price. Moreover, if a fixed‐price contract leads to strategic shirking, there exists no general revelation mechanism to restore equilibrium trade. I show that the shirking problem is more severe when the parties trade after having learned the buyer's valuation, as opposed to the case of an “experience good” where trade is finalized before this information materializes. Finally, when both buyer and seller undertake specific investments, shirking and non‐shirking equilibria are shown to coexist.