Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/301943 
Year of Publication: 
2024
Series/Report no.: 
Queen’s Economics Department Working Paper No. 1518
Publisher: 
Queen's University, Department of Economics, Kingston (Ontario)
Abstract: 
In many capital-intensive markets, sellers sign long-term contracts with buyers before committing to sunk cost investments. Ex-ante contracts mitigate the risk of under-investment arising from ex-post bargaining. However, contractual rigidities reduce the ability of firms to respond flexibly to demand shocks. This paper provides an empirical analysis of this trade-off, focusing on the liquefied natural gas (LNG) industry, where long-term contracts account for over 70% of trade. I develop a model of contracting, investment and spot trade that incorporates bargaining frictions and contractual rigidities. I structurally estimate this model using a rich dataset of the LNG industry, employing a novel estimation strategy that utilizes the timing of contracting and investment decisions to infer bargaining power. I find that without long-term contracts, sellers would decrease investment by 27%, but allocative efficiency would significantly improve. Negative contracting externalities lead to inefficient over-use of long-term contracts in equilibrium. Policies aimed at eliminating contractual rigidities reduce investment by 16%, but raise welfare by 9%.
Subjects: 
Long-term Contracts
Spot Markets
Under-investment
Nash Bargaining
ContractingExternalities
Market Power
Liquefied Natural Gas
JEL: 
D22
D23
L14
L22
L42
Q41
Document Type: 
Working Paper

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