Bargaining Between Collaborators of a Stochastic Project

Abstract

Some projects require collaboration between two firms. The expected return from such alliance can change over time due to evolving market conditions or arrival of new information. In such cases, when do firms agree to collaborate, and how do they split the profit? To address these questions, the paper studies a continuous-time model of bargaining with a stochastic surplus. The paper shows that the existence of outside options creates a hold-up problem that leads to inefficiencies. Firms act too impatiently, causing both the probability of collaborating and its timing to be sub- optimal. Increasing the frequency of counteroffers in bargaining, which has the effect of balancing their bargaining power, improves efficiency by reducing the hold-up. More importantly, the paper finds that a more balanced bargaining power can lead to Pareto improvement. The model illustrates the effect of outside options and bargaining power on firms’ decision to collaborate, and shows how potential collaborators should (not) bargain.