Paper #799

Title:

Specificity revisited: The role of cross-investments

Author:

Matthew Ellman

Date:

November 2004 (Revised: January 2005)

Abstract:

Previous analysis has shown that traders may opt for specific technologies with no joint productivity advantage as a way to commit themselves to trading jointly, but only when long-term contracting is infeasible. This paper proves that speciÞcity can also be optimal (by relaxing the budget-balance constraint) in settings with long-term contracting. Traders will opt for specificity when one trader makes a cross-investment and either (1) this cross-investment has a direct externality on the other trader, (2) both parties invest, or (3) private information is present. The specificity (e.g. from non- salvageable investments, specific assets and technologies, narrow business strategies, and exclusivity restrictions) is equally effective regardless of which trader's alternative trade payoff is reduced. Specificity supports long-term contracts in a broad range of settings - both with and without renegotiation. The theory also offers a novel perspective on franchising and vertical integration.

Keywords:

Specificity, hostages long-term contracting, cross-investments, budget-balance, renegotiation

JEL codes:

D23, K40

Area of Research:

Management and Organization Studies

Published in:

Journal of Law Economics and Organization, Vol. 22, No. 1, 2006

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