Pay for Play: A Theory of Hybrid Relationships

Abstract

Numerous “arrangements,” such as hybrids, alliances, joint ventures, are formed with the goal of creating a new product, such as a new drug or software application. Arrangements commonly require parties to make sunk-cost investments that the arrangement partner cannot observe, to disclose private information, and to make financing commitments. The requirements of efficient contracting—individual rationality, incentive compatibility, and budget balance—are difficult to satisfy in arrangement contexts, so that, as the literature suggests, parties’ best response is to form firms. We show, in contrast, that flexible and efficient contracting is possible for arrangements. With the arrival of new information, each party is asked to “pay-to -play” which requires the firms to agree to future terms of exchange that are mutually beneficial. When properly negotiated, these payments to play support the efficient multistage joint development of the new product, with hybrid relationships that are governed by conventional control rights and legal enforcement.