Specificity revisited: The role of cross-investments

Abstract

Previous analysis has shown that traders may opt for specific technologies with no joint productivity advantage as a way to commit themselves to trading jointly, but only when long-term contracting is infeasible. This paper proves that specificity can also be optimal (since it relaxes the budget balance constraint) insettings with long-term contracting. Traders will opt for specificity when one trader makes a cross-investment and either (1) this cross-investment has a direct externality on the other trader, (2) both parties invest or (3) private information is present The specificity (e.g. from non-salvageable investments, specific assets and technologies, narrow business strategies, and exclusivity restrictions) is equally effective regardless of which trader's alternative trade payoff is reduced Specificity supports long-term contracts in a broad range of settings - both with and without renegotiation. The theory also offers a novel perspective on franchising and vertical integration.