Unobserved investment, endogenous quality, and trade

Abstract

A seller can make investments that affect a tradable asset’s future returns. The potential buyer of the asset cannot observe the seller’s investment prior to trade, nor does he receive any signal of it, nor can he verify it in any way after trade. Despite this severe moral‐hazard problem, this article shows the seller will invest with positive probability in equilibrium and that trade will occur with positive probability. The outcome of the game is sensitive to the distribution of bargaining power between the parties, with a holdup problem existing if the buyer has the bargaining power. A consequence of the holdup problem is surplus‐reducing distortions in investment level. Perhaps counterintuitively, in many situations, this distortion involves an increase in the expected amount invested vis‐à‐vis the situation without holdup.