Overinvestment in partially relationship-specific assets and R&D

This paper considers a firm that can engage in partially relationship specific investments. The firm does not have the option to engage in investments that are not at all relationship specific. I show that, in such a setting, equilibrium investment may exceed the socially optimal level. This is contrary to the intuition obtained from standard idiosyncratic (i.e., relationship-specific) investment models, in which the possibility of “hold-up” leads to underinvestment. The driving force behind this result is that when assets are only partially relationship-specific, marginal investment may yield higher benefits when transacting with the market at large even though cumulative investment yields higher benefits within a bilateral relationship. This finding is relevant to many bilateral relationships in which investments that are targeted to improve the joint payoff of the relationship inevitably have spillover effects that improve the payoff of transacting with the market.