Research / BFI Working PaperFeb 23, 2018

Can Blockchain Solve the Holdup Problem in Contracts?

A basic problem in contracting is holdup: after one party has made relationship-specific investments, the other party refuses to perform unless the first one offers better terms than the original contract. Such renegotiation deters relationship-specific investments and reduces the value of trade via contract, which can either result in no trade or more trade within firms. A classic example is the case of Alaska Packers Association v. Demenico, 117 F. 99 (9th Cir. 1902). Economists have devised solutions – called renegotiation design and revelation mechanisms – to these problems, but they are presently difficult to implement as they require very strong commitment to specific trades, a feature that the current contract–writing wherewithal and court system cannot provide. However, blockchain, a new technology that creates a distributed, unalterable and open ledger, combined with so-called smart contracts, automated scripts that execute contracts, can provide such commitment. Blockchain can thereby either make original contracts unable to be renegotiated or enable the commitment required for renegotiation design or revelation mechanisms. In this manner, blockchain technology and smart contracts can increase the gains from contractual trade, reducing the size of firms and increasing economic output.

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