The Optimal Length of Contracts with Application to Outsourcing.” Economics Working Paper No. 965, Universitat Pompeu Fabra

This paper resolves three empirical puzzles in outsourcing by formalizing the adaptation cost of long-term performance contracts. Side-trading with a new partner alongside a long-term contract (to exploit an adaptation-requiring investment) is usually less effective than switching to the new partner when the contract expires. So long-term contracts that prevent holdup of speciÞc investments may induce holdup of adaptation investments. Contract length therefore trades off speciÞc and adaptation investments. Length should increase with the importance and speciÞcity of self-investments, and decrease with the importance of adaptation investments for which side-trading is ineffective. My general model also shows how optimal length falls with cross-investments and wasteful investments