EC537 Microeconomic Theory For Research Students, Part II: Lecture 5

EC537 Microeconomic Theory for Research Students,
Part II: Lecture 5
Leonardo Felli
CLM.G.4
6 December 2011
Property Rights Theory
The presence of inefficiencies due to the incompleteness of contracts

naturally leads to the question:
Do there exist institutions that ameliorates the inefficiencies that are

generated by contractual incompleteness?
The answer we are going to give is a positive one, in particular one of

these institutions is the building block of modern economy: ownership
of physical assets.
The analysis of this institutions will also help us to answer a key

question for economic analysis:
What is a firm? What determines the boundaries of a firm?
Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part II:
6 December
Lecture 5 2011 2 / 50
Property Rights Theory (2)
We will see that while ownership rights are irrelevant when the Coase
Theorem holds this is no longer the case when frictions prevent the
Coase Theorem from holding at least at an ex-ante stage.
The theory we present is known as property rights theory (Grossman

and Hart 1986, Hart and Moore 1990).
Ingredients:
incomplete contracts, and hence the presence of a potential hold-up

problem,
relationship specific investments, the lack of a well-functioning market

for the good that embodies the parties’ investments.
6 December
Lecture 5 2011 3 / 50
Specific Investments
Question: why specificity plays a critical role.
To understand this consider the following simple hold-up problem.

A buyer and a seller engage in trade.
At an ex-ante stage the seller can undertake an ex-ante investment e
that enhances the quality of the unit of good to the buyer at a cost
e2
2
The value to the buyer is then
ve
Assume for simplicity that the delivery cost for the seller c = 0.
6 December
Lecture 5 2011 4 / 50
Incomplete Contracts
We assume an extreme incomplete contract framework: no contract

will be drawn before the seller chooses the investment.
Timing:
The seller undertakes the ex-ante investment e;
A contract is agreed upon between the buyer and the seller to trade at
a given price p;
Trade occurs.
6 December
Lecture 5 2011 5 / 50
Efficient Outcome
Ex-post efficiency requires that trade occurs as long as e ≥ 0 from

v e ≥ 0.
Ex-ante efficiency requires that e ∗ is the solution to the following

problem:
e2
max v e − , or e ∗ = v
e 2
Assume first that at the contracting stage the buyer makes a

take-it-or-leave-it offer to the seller.
We solve backward for the SPE of this simple game.
6 December
Lecture 5 2011 6 / 50
Underinvestment
Let e be given, at the contracting stage the gains from trade are: v e.
The seller will accept the offer if and only if:
p≥0
The buyer’s offer is then obviously p̄ = 0

The seller’s ex-ante investment is then such that:
e2 e2
max p̄ − =−
e 2 2
In other words, the hold-up problem generated by incomplete

contracts implies:
ē = 0 < e ∗ = v
.
6 December
Lecture 5 2011 7 / 50
Underinvestment (2)
In general assume that the parties’ bargaining power is such that the
seller gets λ of the gain from trade while the buyer gets (1 − λ) of the
gains from trade:
λ(v e), (1 − λ)(v e)
The seller’s investment problem is then:

e2
max λ(v e) −
e 2
In other words we obtain that (hold-up problem):

e ∗∗ = λ v ≤ e ∗ = v
In particular, the equality will hold only if the seller has full bargaining
power.
6 December
Lecture 5 2011 8 / 50
Market for the Good
Assume now that instead of selling to a unique buyer in a situation of

bilateral monopolism, there is a market for the good.
In particular, assume that there are two potential buyers for the good.
Both buyers value the good v e and they Bertrand compete for the
good.
Let bi be the bid of buyer i ∈ {1, 2} for the good.
6 December
Lecture 5 2011 9 / 50
Bertrand Competition
Extensive form of the Bertrand competition game:
the good is allocated to the buyer who makes the highest bid, if the
bids are equal buyer 1 gets the good;
the buyer who gets the good pays his bid to the seller.
Buyer i’s expected payoff is then:



 v e − bi if bi > b−i and if bi = b−i
and i gets the good

πi =

 0 if bi < b−i and if bi = b−i
and i does not get the good

Leonardo Felli (LSE) EC537 Microeconomic Theory for Research Students, Part6II:December
Lecture 52011 10 / 50
Bertrand Competition (2)
Buyer i’s best reply is then to choose:



 v e > bi > b−i if b−i < v e and when bi = b−i
then i does not get the good



bi = b−i if b−i ≤ v e and when bi = b−i
then i gets the good




bi < b−i if b−i ≥ v e

All Nash equilibria of this Bertrand competition game are such that:
bi = b−i = v e
Lecture 52011 11 / 50
General Investment
Then the unique equilibrium price paid to the seller is:
p̃ = v e
The seller’s ex-ante investment problem is then:

e2 e2
max p̃ − =ve−
e 2 2
The first order conditions imply:
ẽ = v = e ∗
In other words, even in the presence of incomplete contracts the

existence of a market for the commodity implies that the investment
is efficient: ex-ante efficiency arises.
Lecture 52011 12 / 50
Back to Specific Investments
Assume now that the seller’s investment is specific to the buyer.
The investment e has different returns depending on whether the

buyer is 1 or 2:
v ∈ {v1 , v2 }, v1 > v2
If buyer 1 buys the good then the returns are v1 e while if buyer 2
buys the good the returns are v2 e.
Assume the same Bertrand competition game.
Lecture 52011 13 / 50
Bertrand Competition Again
Buyer i’s expected payoff is then:



 vi e − bi if bi > b−i and if bi = b−i
and i gets the good

πi =

 0 if bi < b−i and if bi = b−i
and i does not get the good

Buyer i’s best reply is then to choose:



 v e > bi > b−i if b−i < vi e and when bi = b−i
then i does not get the good



bi = b−i if b−i ≤ vi e and when bi = b−i
then i gets the good




bi < b−i if b−i ≥ vi e

Lecture 52011 14 / 50
Equilibrium of Bertrand Competition
Then the unique (trembling-hand-perfect, cautious) Nash equilibria of

this Bertrand competition game is such that:
the buyers’ equilibrium bids are such that:
b1 = b2 = v2 e
buyer 1 gets the good.
Notice that the last condition implies ex-post efficiency.
Lecture 52011 15 / 50
Underinvestment with a Market
Notice that in this case the equilibrium price paid to the seller is such
that:
p̂ = v2 e
The seller’s investment problem is then:

e2 e2
max p̂ − = v2 e −
e 2 2
The first order conditions of this problem imply:
ê = v2 < e ∗ = v1
In other words, specificity of the ex-ante investment implies a hold-up

problem and hence ex-ante inefficiencies even in the presence of a
market for the good.
Lecture 52011 16 / 50
Competition
Objective: to analyze the role that market competition for a match

has in determining the parties’ outside option in the bargaining stage.
Question: can this market competition reduce the inefficiency of the

hold-up problem?
Answer: yes but possibly at the cost of a related inefficiency.
Coordination failure: a situation in which a group of agents can realise

a mutual gain only by a change in behaviour by each member of the
group.
Ingredients: complementarities among parties’ investments and

incomplete contracts.
Lecture 52011 17 / 50
Ingredients
Observation: given the specific nature of investments where is the

competition coming from?
Competition: Bertrand competition among heterogeneous agents. We

assume that workers bid for firms.
Specificity: we assume a discrete number of heterogeneous workers

that matches with a discrete number of heterogeneous firms.
Complementarity: Both workers and firms undertake complementary

investments.
Contracts: we take contracts to be incomplete, they are bilateral

agreements to trade at a constant price (wage).
Lecture 52011 18 / 50
Results
Workers undertake constrained (by the match) efficient investments.
Coordination failures may arise that take the form of additional

equilibria (besides the efficient one) with inefficient matches.
Firms undertake constrained inefficient investments.
These investment are near-efficient.
No coordination failures arise: the unique equilibrium exhibits

constrained efficient matches (trade-off).
Lecture 52011 19 / 50
A Matching Model
S workers s = 1, . . . , S match with
T firms t = 1, . . . , T : S > T;
s indexes workers innate ability: s = 1 highest;
t indexes firms innate ability: t = 1 highest;
both workers and firms choose match-specific investments: xs and yt
Investemnt have an increasing and convex cost C (·);
Lecture 52011 20 / 50
Complementarities
workers’ and firms’ qualities:
σ(s, xs ) τ (t, yt );
decreasing in s and t and increasing and concave in xs and yt .

single crossing conditions:
σ12 < 0, τ12 < 0.
the surplus of each match

v (σ, τ )
increasing and concave in σ and τ .
complementarity:
v12 > 0.
Lecture 52011 21 / 50
Period 1: Investment Game
workers choose investments xs simultaneously and independently;
firms choose investments yt simultaneously and independently;
firms and workers decision are also taken simultaneously and

independently;
the game moves to the second period.
Lecture 52011 22 / 50
Period 2: Bertrand Competition Game
All workers simultaneously and independently make wage offers to

every one of the T firms.
Firm t = 1 (the most efficient) observes the offers she receives and
decides which offer to accept.
This commits the worker selected to work for firm 1 and

automatically withdraws all offers this worker made to other firms.
All other firms and workers observe this decision and then firm t = 2
decides which offer to accept.
This process is repeated until firm T decides which offer to accept

(generalized).
Lecture 52011 23 / 50
Bertrand Competition Game
We look for the trembling-hand-perfect (cautious) equilibrium of the

game.
Let the ordered vectors of qualities be given:
(τ1 , . . . , τT ), where τ1 > . . . > τT ,
(σ1 , . . . , σT ), where σ1 > . . . > σT .
Result
Every equilibrium of the Bertrand competition game is characterized by
assortative matching:
(σk , τk ), ∀k = 1, . . . , T .
Lecture 52011 24 / 50
Bertrand Competition Game
Proof: By contradiction. Equilibrium matches: (σ 0 , τ 00 ),(σ 00 , τ 0 ) where
σ 0 < σ 00 and τ 0 < τ 00 .
Let B(τ 0 ) and B(τ 00 ) be equilibrium accepted bids by firm τ 0 & τ 00 .

Necessary conditions for (σ 00 , τ 0 ) and (σ 0 , τ 00 ) to be equilibrium
matches:
v (σ 00 , τ 0 ) − B(τ 0 ) ≥ v (σ 00 , τ 00 ) − B(τ 00 );
v (σ 0 , τ 00 ) − B(τ 00 ) ≥ v (σ 0 , τ 0 ) − B(τ 0 ).
Both inequalities imply:
v (σ 00 , τ 0 ) + v (σ 0 , τ 00 ) ≥ v (σ 00 , τ 00 ) + v (σ 0 , τ 0 ).
A contradiction to the complementarity assumption.
Lecture 52011 25 / 50
Runner-up
Definition
The runner-up worker to the firm τt is the worker σr (t) such that
σr (t) ∈ {σt+1 , . . . , σS } and has the highest willingness to pay for firm τt .
Result
The runner-up worker to firm τt is such that:
σr (t) = max {σi | i is un-matched, σi ≤ σt } .
The equilibrium payoffs to each firm and worker, for t = 1, . . . , T , are:
πσWt = [v (σt , τt ) − v (σr (t) , τt )] + πσWr (t)

πτFt = v (σr (t) , τt ) − πσWr (t)
and for every i = T + 1, . . . , S: πσWi = 0
Lecture 52011 26 / 50
Runner-up (2)
Proof: By induction. Consider firm τt .
Worker σt ’s maximum willingness to bid is
v (σt , τt ) − π̂σWt ;
where
π̂σWt = v (σt , τr (t) ) − v (σr 2 (t) , τr (t) ) + πσW2 ;
r (t)
or
v (σt , τt ) − v (σt , τr (t) ) + v (σr 2 (t) , τr (t) ) − πσW2 .
r (t)
Worker σr (t) ’s maximum willingness to bid is

v (σr (t) , τt ) − πσWr (t) .
where
πσWr (t) = v (σr (t) , τr (t) ) − v (σr 2 (t) , τr (t) ) + πσW2 ;
r (t)
or
v (σr (t) , τt ) − v (σr (t) , τr (t) ) + v (σr 2 (t) , τr (t) ) − πσW2 .
r (t)
Lecture 52011 27 / 50
Runner-up (3)
Therefore
v (σt , τt ) − π̂σWt > v (σr (t) , τt ) − πσWr (t)
since, from v12 > 0:
v (σt , τt ) − v (σt , τr (t) ) > v (σr (t) , τt ) − v (σr (t) , τr (t) ).
We get:
Bσt = Bσr (t) = v (σr (t) , τt ) − πσWr (t)
while payoffs are
πσWt = [v (σt , τt ) − v (σr (t) , τt )] + πσWr (t)

πτFt = v (σr (t) , τt ) − πσWr (t) .
Lecture 52011 28 / 50
Equilibrium of Bertrand Competition Game
Result
Given the ordered vectors
(σ1 , . . . , σS ), (τ1 , . . . , τT ),
if firms select bids in the order of their qualities the unique equilibrium of
the Bertrand competition game is such that the runner-up worker to firm
τt is:
σr (t) = σt+1
T
X
πσWt = [v (σh , τh ) − v (σh+1 , τh )]
h=t
T
X
πτFt = v (σt+1 , τt ) − [v (σh , τh ) − v (σh+1 , τh )]
h=t+1
Lecture 52011 29 / 50
Observations:
The order in which firms select their bid is determined by an

endogenous variable.
Worker σt ’s equilibrium payoff is:
πσWt = v (σt , τt ) + Wσt
where Wσt is independent of σt .

Firm τt ’s equilibrium payoff is
πτFt = v (σt+1 , τt ) + Pτt .
where Pτt is independent of τt .

In the general case (randomly determined order) the difference is in
the identity of the runner-up worker.
Lecture 52011 30 / 50
Properties
Result
Given the ordered vectors of investments
(σ1 , . . . , σi−1 , σi+1 , . . . , σS ), (τ1 , . . . , τi−1 , τi+1 , . . . , τS )
the net payoffs to worker i below is continuous in σ:
πiW (σ) = v (σ, τi ) − v (σi+1 , τi ) +

T
X
+ [v (σh , τh ) − v (σh+1 , τh )] − C (x(i, σ))
h=i+1
and the net payoff to firm i below is continuous in τ :
πiF (τ ) = v (σi+1 , τ ) − [v (σi+1 , τi+1 ) − v (σi+2 , τi+1 )] −

T
X
− v (σ(h) , τh ) − v (σh+1 , τh ) − C (y (i, τ ))
h=i+2
Lecture 52011 31 / 50
Workers’ Investment Game
Assume that σ(s, xs ) and τt = τ (t).
Clearly the order of firms’ innate abilities coincides with the order of
their qualities, hence the Result above applies.
Given a match (s, t) the workers’ investment choice xs (t) is defined

as:
W
xs (t) = arg max πσ(s,x) − C (x)
x
= arg max v (σ(s, x), τt ) − Wσ(s,x) − C (x).
x
Lecture 52011 32 / 50
Workers’ Investment Game (2)
Result
Worker s’s investment choice xs (t) is constrained efficient (given the
match (s, t)).
Proof: The worker is residual claimant of the match surplus.
Notice that from the definition of xs (t) we obtain also:
d σ(s, xs (t)) d σ(s, xs (t))

< 0, < 0.
ds dt
Lecture 52011 33 / 50
Definition
A permutation (s1 , . . . , sS ) of (1, . . . , S) is an equilibrium of the workers’
investment game if and only if:
σ(i) = σ(si , xsi (i)) < σ(i−1) = σ(si−1 , xsi−1 (i − 1)).
where (σ(1) , . . . , σ(S) ) is an ordered vector.
Result
The equilibrium with efficient matches of the workers’ investment game
characterized by si = i, i = 1, . . . , S always exists.
Lecture 52011 34 / 50
Proof: The net surplus to each worker
πiW (σ) − C (x(i, σ))
is continuous in σ at σ(j) , j = 1, . . . , S;
is strictly concave with a local maximum at σ(i) in the interval

(σ(i+1) , σ(i−1) );
is monotonic increasing in any interval (σ(k) , σ(k−1) ), for ever

k = i + 2, . . . , S, to the left of (σ(i+1) , σ(i−1) );
is monotonic decreasing in any interval (σ(h) , σ(h−1) ), for ever

h = 2, . . . , i − 1, to the right of (σ(i+1) , σ(i−1) ).
Lecture 52011 35 / 50
Notice that in this equilibrium there are no hold-up problems and no

coordination failures.
Result
Given (τ1 , . . . , τT ), it is possible to construct an inefficient equilibrium of
the workers’ investment game such that si < si−1 .
Result
Given (σ(s1 , ·), . . . , σ(sS , ·)), it is possible to construct (τ1 , . . . , τT ) such
that there does not exist any inefficient equilibrium of the workers’
investment game.
Lecture 52011 36 / 50
Proof: If two workers have very similar innate abilities the difference in
workers’ qualities is determined mainly by the difference in firms’ qualities.
Then an argument similar to the one of the Result above applies and an
inefficient equilibrium exists.
If firms have very similar innate abilities then the equilibrium condition for
an inefficient equilibrium is necessarily violated.
Lecture 52011 37 / 50
Observations
When workers invest competition solves the hold-up problem.
Inefficiencies may arise that take the form of coordination failures:

equilibria with inefficient matches.
This inefficiency is less likely the higher is the degree of specificity due
to the workers’ characteristics with respect to the specificity due to
the firms’ characteristics.
Lecture 52011 38 / 50
Firms’ Investment Game
Assume that σs = σ(s) and τ (t, yt ).

Notice that in general in this case the Result above does not provide
the characterization of the payoffs in the Bertrand competition game.
Result
If firms select their most preferred bid in the order of their innate abilities
the unique equilibrium of the firms’ investment game is such that firm t
chooses the simple investment:
y (t, t + 1) = arg max v (σt+1 , τ (t, y )) − Pτ (t,y ) − C (y ).

y
Proof: Notice first that the last firm to select its bid always chooses simple
investments. Let t + 1 be the last firm to choose simple investments.
Lecture 52011 39 / 50
Firms’ Investment Game (2)
Using the Result above we can identify the qualities (τt+1 , . . . , τT ) and
payoffs in the t + 1 subgames of firms t + 1, . . . , T .
σi τi τi0 t
σ1 τ1 τ10 1
.. .. .. ..
. . . .
σt−2 τt−2 τt∗ t −2
σt−1 τt−1 τt−2 t −1
σt τt τt−1 t
σt+1 τt+1 τt+1 t +1
.. .. .. ..
. . . .
σT τT τT T
Lecture 52011 40 / 50
Firms’ Investment Game (3)
Hence τk > τ ∗ > τt+1 for all k < t, implying that this Result applies and
hence:
y (t, t + 1) = arg max v (σt+1 , τ (t, y )) − Pτ (t,y ) − C (y ).

y
Notice this Result implies that firm under-invest:
y (t, t + 1) < y (t, t).
There exist inefficiencies generated by hold-up problems.

This Result also implies that the unique equilibrium of the firms’
investment game is characterized by efficient matches.
In other words, there are no coordination failures.
Lecture 52011 41 / 50
The Near-Efficiency of Firms’ Investments
Extra assumptions:
responsive complementarity:
Define
y (t, s) = arg max v (σs , τ (t, y )) − C (y )
y
then

∂ ∂y
> 0.
∂t ∂s
marginal complementarity:
∂ 2 v2 (σ, τ )
> 0.
∂σ ∂τ
Lecture 52011 42 / 50
The Near-Efficiency of Firms’ Investments (2)
Define now for convenience:
ω(s, t) = v (σ(t), τ (t, y (t, s))) − C (y (s, t)).
A measure of firm t’s induced inefficiency is:
ω(t, t) − ω(t, t + 1).
The overall inefficiency induced by firms’ under-investments is then:

T
X T
X
L= ω(t, t) − ω(t, t + 1).
t=1 t=1
How large is the loss L?
Lecture 52011 43 / 50
Define M the efficiency loss resulting from firm 1 choosing an

investment level when matched with worker 1.
Firm 1’s investment choice is then:
y (1, T + 1)
Define now:
M = ω(1, 1) − ω(1, T + 1).
Lecture 52011 44 / 50
Result
Assume T ≥ 2. If both responsive complementarity and marginal
complementarity hold then
L < M.
Proof: Firms have an incentive to invest to improve their outside option:

ω(t, t + 1) + Pτt .
The under-investment of each firm is relatively small and total inefficiency
is then obtained by aggregating these relatively small under-investments.
The decreasing returns to investment and the assumptions on how optimal
firms’ investments change across different matches guarantees that
L < M.
Lecture 52011 45 / 50
Ex-Ante Competition
Properties of the firms’ investments depend on firms selecting their

most preferred bid in the order of their innate abilities.
Question: does this order arise endogenously if firms compete ex-ante

for the order in which they select their most preferred bid?
Answer: there always exists an equilibrium of the ex-ante competition

among firms that leads to the firms selecting their most preferred bid
in the order of their innate ability.
Restrict attention to the equilibrium of the firms’ investment game

(always exists) such that firms’ investments induce an order of firms’
qualities that coincides with the order of their innate abilities.
Lecture 52011 46 / 50
Ex-Ante Competition (2)
Assume that there exists an equilibrium of the ex-ante competition

stage such that the order in which firms select their bids is:
τt ∗ < τt ∗ +1 > τt ∗ +2 > . . . > τT
Let t 0 be such that t 0 ∈ {t ∗ , t ∗ + 1, . . . , T } and
τt ∗ +1 > τt ∗ +2 > . . . > τt 0 > τt ∗ > τt 0 +1 > . . . > τT
If firm τt ∗ swaps place with firm τt 0 then both firms gain.
The runner-up worker for firm τt ∗ it is still the worker σt 0 +1 that in

equilibrium matches with firm τt 0 +1 , hence the payoff of firm τt ∗ does
not change: πtF∗ = π̃tF∗ .
Lecture 52011 47 / 50
By one of the previous Results the runner-up worker to firm τt 0 is now

the worker σt ∗ that in equilibrium matches with firm τt ∗ (while before
the change it was worker σt 0 +1 ).
The difference in firm τt 0 payoffs after (π̃tF0 ) and before (πtF0 ) the
change is then:
π̃tF0 − πtF0 = v (σt ∗ , τ̃t 0 ) − v (σt ∗ , τ̃t ∗ ) + v (σt 0 +1 , τ̃t ∗ ) − v (σt 0 +1 , τt 0 )
By v12 > 0, τ̃t 0 > τ̃t ∗ , τ̃t 0 > τt 0 and σt ∗ > σt 0 +1 we get:
π̃tF0 − πtF0 > 0
Lecture 52011 48 / 50
Result
If firms select their preferred bid in any order other than the decreasing
order of their innate abilities then there exists a pair of firms who gain —
one strictly and one weakly – from swapping positions in the order in
which they select their bid.
The equilibrium in which firms select their bid in the order of their innate
abilities is unique if firms’ ability are sufficiently far apart.
Lecture 52011 49 / 50
Bertrand competition between workers and firms for matches may

help solve the hold-up problems at the cost of coordination failures.
Notice that when both workers and firms undertake ex-ante

investments:
workers’ investments are still constrained efficient;
firms’ investments are still near-efficient.
However, inefficiency arise that takes the form of coordination failures.
In other words, competition does a fairly good job at solving hold-up

problems.
Lecture 52011 50 / 50

EC537 Microeconomic Theory For Research Students, Part II: Lecture 5

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EC537 Microeconomic Theory For Research Students, Part II: Lecture 5

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EC537 Microeconomic Theory for Research Students,

Part II: Lecture 5

The presence of inefficiencies due to the incompleteness of contracts

Do there exist institutions that ameliorates the inefficiencies that are

The answer we are going to give is a positive one, in particular one of

The analysis of this institutions will also help us to answer a key

What is a firm? What determines the boundaries of a firm?

The theory we present is known as property rights theory (Grossman

incomplete contracts, and hence the presence of a potential hold-up

relationship specific investments, the lack of a well-functioning market

To understand this consider the following simple hold-up problem.

The value to the buyer is then

We assume an extreme incomplete contract framework: no contract

The seller undertakes the ex-ante investment e;

Ex-post efficiency requires that trade occurs as long as e ≥ 0 from

Ex-ante efficiency requires that e ∗ is the solution to the following

Assume first that at the contracting stage the buyer makes a

We solve backward for the SPE of this simple game.

The buyer’s offer is then obviously p̄ = 0

In other words, the hold-up problem generated by incomplete

The seller’s investment problem is then:

In other words we obtain that (hold-up problem):

Assume now that instead of selling to a unique buyer in a situation of

Let bi be the bid of buyer i ∈ {1, 2} for the good.

Extensive form of the Bertrand competition game:

Buyer i’s expected payoff is then:

Buyer i’s best reply is then to choose:

The seller’s ex-ante investment problem is then:

In other words, even in the presence of incomplete contracts the

Assume now that the seller’s investment is specific to the buyer.

The investment e has different returns depending on whether the

Assume the same Bertrand competition game.

Buyer i’s expected payoff is then:

Buyer i’s best reply is then to choose:

Then the unique (trembling-hand-perfect, cautious) Nash equilibria of

the buyers’ equilibrium bids are such that:

buyer 1 gets the good.

Notice that the last condition implies ex-post efficiency.

The seller’s investment problem is then:

In other words, specificity of the ex-ante investment implies a hold-up

Objective: to analyze the role that market competition for a match

Question: can this market competition reduce the inefficiency of the

Answer: yes but possibly at the cost of a related inefficiency.

Coordination failure: a situation in which a group of agents can realise

Ingredients: complementarities among parties’ investments and

Observation: given the specific nature of investments where is the

Competition: Bertrand competition among heterogeneous agents. We

Specificity: we assume a discrete number of heterogeneous workers

Complementarity: Both workers and firms undertake complementary

Contracts: we take contracts to be incomplete, they are bilateral

Workers undertake constrained (by the match) efficient investments.

Coordination failures may arise that take the form of additional

Firms undertake constrained inefficient investments.

These investment are near-efficient.

No coordination failures arise: the unique equilibrium exhibits

S workers s = 1, . . . , S match with

s indexes workers innate ability: s = 1 highest;

t indexes firms innate ability: t = 1 highest;

both workers and firms choose match-specific investments: xs and yt

Investemnt have an increasing and convex cost C (·);

workers’ and firms’ qualities:

decreasing in s and t and increasing and concave in xs and yt .