Incomplete Contracts and the Use of Options to Prevent Hold-Up in Investments Under Uncertainty

I consider the unilateral investment problem, in which a principal makes an asset specific investment not knowing the quality of the asset at the time of investing, and not knowing if the asset will end up being most productive if owned by the principal or not. The paper shows that unconditional ownership cannot provide first-best incentives for investment. A striking result is that giving the principal ownership leads to overinvestment, even without the investment affecting his outside option. In some cases first-best incentives for investment can be provided using an option contract where the principal after observing the quality of the asset is given the option to buy it at a pre-negotiated price.