The role of the agent's outside options in principal-agent relationships

We consider a principal-agent model of adverse selection where, in order to trade with the principal, the agent must undertake a relationship-speci...c investment which a¤ects his outside option to trade, i.e. the payo¤ that he can obtain by trading with an alternative principal. This creates a distinction between the agent’s ex ante (before investment) and ex post (after investment) outside options to trade. We investigate the consequences of this distinction, and show that whenever an agent’s ex ante and ex post outside options di¤er, this equips the principal with an additional tool for screening among di¤erent agent types, by randomizing over the probability with which trade occurs once the agent has undertaken the investment. In turn, this may enhance the e¢ciency of the optimal second-best contract. JEL Classi...cation: D21, L14.