Managing Strategically Outside Options under Incomplete Contracts

This paper studies an incomplete contract framework in which specific investments affect parties’ outside options. We show that the ‘direction’ of standard hold-up in this new framework strictly depends on the impact generated by investments on ex-post parties’ outside options. This conclusion reverses some of the main results raised by the standard literature on incomplete contracts. Under given conditions, parties may even over-invest in assets specificity, as the changes induced in outside options improve their ex-post bargaining power. We discuss the implications for competition policy and for the management of incomplete contracts.