Contractual Remedies to the Holdup Problem: A Dynamic Perspective Yeon-Koo Che * J´ ozsef S´ akovics † February 4, 2004 Abstract An important theme of modern contract theory is the role contracts play to protect parties from the risk of holdup and thereby encouraging their relationship specific investments. While this perspective has generated valuable insights about various contracts, the underyling models abstract from realistic investment dynamics. We reexamine the role of contracts in a dynamic model that endogenizes the timing of investments and trade. The resulting interaction between bargaining and investment significantly alters the insights learned from static models. We show that contracts that would exacerbate the parties’ vulnerability to holdup — rather than those protecting them from the risk of holdup — can be desirable. For this reason, separate ownership of complementary assets can be optimal, an exclusivity agreement can protect the investments of its recipient, trade contracts can be beneficial with a purely cooperative investment, and the property rule can offer a better legal protection against externalities loss than the liability rule, much in contrast to the existing results (based on static models). * Department of Economics, University of Wisconsin-Madison. † Edinburgh School of Economics, University of Edinburgh. Both authors are grateful for comments from Kyle Bagwell, Paul Milgrom, John Moore, Michael Riordan, Alan Schwartz, Jonathan Thomas and the seminar participants at the Universities of Amsterdam (CREED), Arizona, Edinburgh, Florida, UCLA, and Boston, Columbia, Duke, Northwestern (Kellogg School of Management), Ohio State, Vanderbilt Universities, and the 2003 SITE conference. The first author wishes to acknowledge financial support from the National Science Foundation (SES-0319061). 1