The Effect of Sunk Costs on the Outcome of Alternating-Offers Bargaining Between Inequity-Averse Agents

When investments are specific to a relationship and contracting possibilities are incomplete, the efficiency of a joint venture may be severely impaired by ex-post opportunistic and hold-up type behavior. How is the logic of this argument affected by inequity aversion? In this paper I show that incentives to invest are stronger with inequity aversion because a higher investment by an individual agent increases not only the total surplus to be divided, but also, generally, the relative share of the surplus obtained by this agent in the ex-post negotiation. In fact, when production is sufficiently profitable and agents are sufficiently patient, then first-best investment levels may be approximated without any contract.