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Optimal Contracts with Lock-In

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  • Farrell, Joseph
  • Shapiro, Carl

Abstract

The authors analyze incomplete long-term contracts when buyers incur relationship-specific set-up costs and sellers choose product or service quality that is not verifiable to third parties. If set-up costs are observable, the first-best outcome can be achieved even though contracts cannot enforceably specify quality; this does not even require long-term contracts. If set-up costs are unobservable, however, then long-term price contracts can strictly outperform short-term contracts. Equilibrium may involve either inefficiently low quality with no buyer switching or efficient quality with inefficient switching. A policy of taxing switching, or the availability of "budget-breaking" third parties, can improve welfare. Copyright 1989 by American Economic Association.

Suggested Citation

  • Farrell, Joseph & Shapiro, Carl, 1989. "Optimal Contracts with Lock-In," American Economic Review, American Economic Association, vol. 79(1), pages 51-68, March.
    • Handle: RePEc:aea:aecrev:v:79:y:1989:i:1:p:51-68
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