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→Question B2: Relationship Specific Investments
====Question B2: Relationship Specific Investments====
Consider a buyer-seller transaction in which the buyer makes a relationship specific investment x in period 1. This investment costs the buyer <math>x^2</math>, and it only pays off if the buyer is supplied with a “widget” by the seller in period 2. The return from investment (assuming the widget is supplied) is x + v, where v is a random variable uniformly distributed on <math>[–h– h,h]</math>. Assume that <math>h\in[0.25,0.5]</math>. Neither x nor v is observed by the seller, and the buyer only learns v in period 2 so that investment x is made prior to learning v. The seller's cost of producing the widget is zero.
Assume that no long-term contracts are possible and that the seller makes a take-it-or- leave-it offer to the buyer in period 2 (after the buyer has learned v). This offer is based on the seller's conjecture about the buyer's choice of x which will be correct in equilibrium (rational expectations).
