The author thanks Aaron Edlin, Jim Hosek, Steve Tadelis, two anonymous referees, and seminar participants at the University of California, Berkeley, and the University of California, Davis, for useful discussions and valuable feedback on earlier drafts. They are, of course, exonerated with respect to the article’s residual shortcomings. The financial support of the Thomas and Alison Schneider Distinguished Professorship in Finance is gratefully acknowledged.
Unobserved investment, endogenous quality, and trade
Article first published online: 5 APR 2013
Copyright © 2013, RAND.
The RAND Journal of Economics
Volume 44, Issue 1, pages 33–55, Spring 2013
How to Cite
Hermalin, B. E. (2013), Unobserved investment, endogenous quality, and trade. The RAND Journal of Economics, 44: 33–55. doi: 10.1111/1756-2171.12009
- Issue published online: 5 APR 2013
- Article first published online: 5 APR 2013
A seller can make investments that affect a tradable asset’s future returns. The potential buyer of the asset cannot observe the seller’s investment prior to trade, nor does he receive any signal of it, nor can he verify it in any way after trade. Despite this severe moral-hazard problem, this article shows the seller will invest with positive probability in equilibrium and that trade will occur with positive probability. The outcome of the game is sensitive to the distribution of bargaining power between the parties, with a holdup problem existing if the buyer has the bargaining power. A consequence of the holdup problem is surplus-reducing distortions in investment level. Perhaps counterintuitively, in many situations, this distortion involves an increase in the expected amount invested vis-à-vis the situation without holdup.