Hold-up problem

In economics, the hold-up problem is a situation where two parties (such as a supplier and a manufacturer or the owner of capital and workers) 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. It has been described as the "most influential work" in recent decades on why firms exist and what determines their boundaries.^[1]

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.

A hold-up problem inherent in binary software transactions has been proposed as one of the reasons for the success of open source software.^[2]

See also

• Specific asset
• Vertical monopoly
• Game theory
• Theory of the firm

Notes

References

• Cabral, Luis M. B., 2000. Introduction to Industrial Organisation, Massachusetts Institute of Technology Press.
• Che, Yeon-Koo, and József Sákovics, 2008. "hold-up problem," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Edlin, Aaron and Reichelstein, Stefan, 1996. "Holdups, Standard Breach Remedies, and Optimal Investment." American Economic Review, 86(3), pp. 478-501.
• Grossman, S. J. and O. D. Hart, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, 94(4), p. 691-719.
• Holmström, Bengt,& John Roberts (1998). "The Boundaries of the Firm Revisited," Journal of Economic Perspectives, 12(4), pp. 73-94 (close Bookmarks).
• Tirole, Jean (1988). The Theory of Industrial Organization, "The Theory of the Firm" (Specific Investment and the Hold-Up Problem), pp. 24-27, and pp. 16, 34, 401, 434.[1].
• Williamson, Oliver E., 1979. "Transactions-Cost Economics: The Governance of Contractual Relations," Journal of Law and Economics, 22(2), pp. 233-62.
• _____. "Credible Commitments: Using Hostages to Support Exchange." American Economic Review, 1983, 73(4), pp. 519-40.
• Rogerson, William, 1992. "Contractual Solutions to the Hold-Up Problem," Review of Economic Studies, 59(4), pp. 774-94.