Incomplete Contracts, Market Competition and Investment Decisions

This paper studies a two stage incomplete contract between a buyer and a seller, with specific investments and endogenous outside options. Given that a party's outside option identifies counterpart's competitors, with such endogenous outside options, some of the main conclusions of the standard literature on hold-up in incomplete contracts--which generally assume exogenous outside options--might be reversed. First, according to the degree of ex-post market competition induced by the type (specific or general-purpose) of investment made, each agent might reach a monopolistic position by deterring his competitors and/or by encouraging contractual counterpart's competitors; second, even in an incomplete contract, agents may both overinvest in assets' specificity and use specific investments as a strategic discipline device in order to deter counterpart's post-contractual opportunism. The resulting complex institutional context, coined as cross competition, provides an explanation of the nature of the firm along the original intuitions of J.R. Commons and R. Coase. We suggest that firm organisation introduces appropriate forms of pre-commitment on the agents' behaviours by introducing some form of outside options' rigidity so as to transform multilateral market cross competition into a network of bilateral cross competition relationships between management and the workers, within the firm