Asset Specificity, Long-Term Contracts, and the Good Faith Requirement

This paper analyzes the effect of court intervention on the choice between contracts and vertical integration when a specialized investment is required for least-cost production. It shows that: 1) differences in subjective probability estimates of the future bargaining power may cause the parties to contract when they should integrate and vice versa; 2) court intervention in the form of the good faith requirement improves efficiency by reducing the degree to which a shift in bargaining power allows a contractor to take a larger share of the gains to the contract and by compensating for differences in expected bargaining power; and 3) as the average difference between the buyer's and seller's estimates of future bargaining power increase, the net benefits of the good faith requirement rise.