Inefficiency in a Bilateral Trading Problem with Cooperative Investment

Abstract

A bilateral trading model with investment is considered. In a “cooperative” investment version of the model, the seller's investment stochastically determines the buyer's valuation of the good. The value and cost of the good are realized only after the investment is made, and the investment level and the realization of the good's value and cost are private information. I show that, under these assumptions, no contract made before the investment can simultaneously induce efficient investment and efficient ex post trade when the buyer's type is continuously distributed. This inefficiency result contrasts sharply with the efficiency result under the standard “selfish” investment model, where the seller's investment stochastically determines the seller's cost.