Interlinkage, limited liability and strategic interaction

The literature on interlinkage is inconclusive regarding the strict superio rity of this arrangement. We analyze a landlord and a moneylender as two pl ayers making non-cooperative decisions regarding the terms of their respect ive contracts with a tenant. In the sequential game where the landlord move s first and the tenant has limited liability, we demonstrate that there exi st circumstances in which interlinkage is superior, even with nonlinear loa n contracts, a result that carries over when there is moral hazard. The inc orporation of risk aversion yields strict superiority in general. The main result is unaffected by changes in the seniority of claims, but is sensitiv e to changes in the order of moves: limited liability ceases to ensure the strict superiority of interlinked contracts if the principal who provides t he variable factor of production moves first, even if he has junior claims to the output. (C) 2000 Elsevier Science B.V. All rights reserved.