Can a contract solve hold-up when investments have externalities? A comment on De Fraja (1999)

This comment finds an error in De Fraja (1999), the correction of which overturns its main result. In contrast to his claim, under a mild condition, the suggested contract is not only unable to solve the hold-up problem but it can provide almost no incentive for specific investments, when they exhibit sufficiently large direct externalities. His result holds primarily when the investments have no externalities. We remark on a related result in the literature and propose an alternative contract that achieves efficiency. Journal of Economic Literature Classification Numbers: C70, J41, K12, L22. (C) 2000 Academic Press.