RAND Journal of Economics Vol. 26, No. 2, Summer 1995 pp. 163-179 Option contracts and renegotiation: a solution to the hold-up problem Georg Noldeke* and Klaus M. Schmidt* In this article, we analyze the canonical hold-up model of Hart and Moore under the assumption that the courts can verih deliveq of the good by the seller. [t is shown that no further renegotiation design is necessary to achieve the first best: simple option contracts, which give the seller the right to take the delivery decision and specify payments depending on whether delivery takes place, allow and eflicient trade, implementation of e~icient investment decisions 1. Introduction ■ In a seminal article, Hart and Moore (1988) considered a buyer-seller relationship with observable but unverifiable investment decisions. They argued that contractual iri- completeness, due to nonverifiability of the relevant state of the world, combined with the parties’ inability to prevent e-xpost renegotiation will lead to underinvestment in such a classical hold-up problem. This result has attracted considerable attention because it seems to provide a theoretical foundation for the rapidly growing literature on incomplete contracts, which tries to explain economic institutions, such as the allocation of ownership rights or the financial structure of the fiw, as second-best solutions to incentive problems in a world in which comprehensive contracts cannot be written. In this article, we argue that the underinvestment problem in the Hart-Moore model can be overcome if the parties can write simple option contracts. An option contract gives the seller the right (but not the obligation) to deliver a fixed quantity of the good and makes the buyer’s contractual payment contingent on the seller’s delivery decision. Note that an option contract is feasible only if it is possible to enforce payments conditional on the seller’s delivery decision, that is, the court must be able to observe whether the seller * University of Bonn. An earlier version of this article was circulated under the title “Unverifiable Information, Incomplete Contracts, and Renegotiation. ” We would like to thank Dieter Balkenborg, Frank Bickenbach, Oliver Hart, Bengt Holmstr6m, Kai-Uwe Kuhn, Albert Ma, Bentley MacLeod, Benny Moldovanu, John Moore, Monika Schnitzer, Urs Schweizer, two anonymous referees, and in particular Mike Riordan for helpful comments and discussions. This research was initiated during the International Summer School of the Center for the Study of the New Institutional Economics in Wallerfangen, Germany, August 1990. We are grateful to Professor Rudolf Richter for providing this stimulating atmosphere. Financial support by Deutsche Forschungsgemeinschaft, SFB 303 at the University of Bonn, is gratefully acknowledged. Copyright 01995, RAND 163