The hold-up problem in government contracting

A two-period procurement model is considered in an incomplete-contract framework. In contrast to Hart and Moore (1988), the welfare-maximizing government, as the buyer, is able to accomplish er-ante optimal contracts which guarantee first-best specific investments of both buyer and seller. These contracts are precisely characterized. Regardless of the underlying supports of cost and benefit distributions, renegotiation inevitably occurs in some states of nature. This renegotiation always increases the eu-ante fixed trade price. Hence, the empirical observation of soft budget constraints in government contracting can be rationalized. Furthermore, in accordance with common beliefs, the seller's rents accrue only at the production stage.