Self-enforcing cooperation via strategic investment

We investigate how, in a situation with two players in which noncooperation is the only equilibrium, cooperation can be achieved via costly investment. We find that in the resulting equilibria, cooperation is an all-or-nothing outcome, that is, either there is full cooperation by both players, or no cooperation at all. The cost of investment is unrelated to the degree of cooperation that is ultimately achieved, unless the cost is too high, in which case investment cannot in any degree overcome the disincentive to cooperate. Moreover, the positive externalities that players have on each other in the course of play, although they affect investment, are ultimately irrelevant to the degree of cooperation achieved. We view our model as an explanation for the formation and stable existence of business alliances, where the players are firms forming a partnership defined and sustained by contractual agreements, but which is short of a merger or acquisition.