Hold-up problem

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The hold-up problem is a term used in economics to describe a situation where two parties (such as a supplier and a manufacturer) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.

For example: Imagine a scenario where profit can be made if agents X and Y work together, so they form an agreement to do so, after X buys the necessary equipment. The hold-up problem occurs when X might not be willing to accept that agreement, even though the outcome would be Pareto efficient, because after X buys the necessary equipment, Y would have bargaining power and might decide to demand a larger proportion of the profits than before. The source of Y's power lies in X's investment. Since X is now deeply invested in the project, but Y is not, X stands to lose money, should the deal not be completed, but Y has no such risk. Thus, Y has some bargaining power that did not exist before X's investment. In the extreme, Y could demand 100% of the profits, if X's only alternative is to lose the initial investment entirely.

One way to avoid the hold-up problem is for the firms to merge, a tactic known as vertical integration, or to enter vertical agreements, e.g. an agreement with a non-compete clause.

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[edit] References

Luis M. B. Cabral: Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000.

Williamson, Oliver. "Transactions-Cost Economics: The Governance of Contractual Relations." Journal of Law and Economics, October 1979, 22(2), pp. 233-62.

Williamson, Oliver. "Credible Commitments: Using Hostages to Support Exchange." American Economic Review, September 1983, 73(4), pp. 519-40.

Rogerson, William. "Contractual Solutions to the Hold-Up Problem." Review of Economic Studies, October 1992, 59(4), pp. 774-94.

Edlin, Aaron and Reichelstein, Stefan. "Holdups, Standard Breach Remedies, and Optimal Investment." American Economic Review, June 1996 86(3), pp. 478-501