Hold-up problem

In economics, the hold-up problem is central to the theory of incomplete contracts, and shows the difficulty in writing complete contracts. A hold-up problem arises when two factors are present:

1. Parties to a future transaction must make non-contractible relationship-specific investments before the transaction takes place.
2. The specific form of the optimal transaction (e.g. quality-level specifications, time of delivery, what quantity of units) cannot be determined with certainty on beforehand.^[1]

The hold-up problem is a situation where two parties 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. When party A has made a prior commitment to a relationship with party B, the latter can ‘hold up’ the former for the value of that commitment. The hold-up problem leads to severe economic cost and might also lead to underinvestment.

Underinvestment

It is often argued that the possibility of a hold-up can lead to underinvestment in relation-specific investment, and, hence, inefficiency. Underinvestment occurs because investors cannot guarantee themselves a sufficient share of the return through ex post bargaining.^[2] Consequently, predictions of the outcome are very sensitive to assumptions made about the bargaining process. The bargaining process can be seen as a game with multiple equilibriums. Underinvestment may occur only when the agent fails to coordinate on an efficient equilibrium..

The principle

In a scenario where two risk-neutral parties S (supplier) and B (Buyer) can make profit by working together. It is efficient to work together as long as the buyers’ valuation exceeds the sellers’ costs (Schmitz, 2001). When the two parties could agree on a binding contract covering the whole period of the investment and anticipating all possible outcomes and providing protection for both parties in every situation that may arise at the time the investment is made, then the parties would have enough confidence to make the investment, and both parties could enjoy high profits. Here you assume that there are no wealth constraints and that there is no private information. According to Coase theorem, voluntary bargaining results in trade whenever it is efficient.^[3] However, making such a contract is not often possible because of

• Unforeseeable external factors
• Lack of trust
• Quality problems
• Asymmetric information

The initial contract only can cover short term situations and at a certain point in time renegotiation is needed, which provides an opportunity for e.g. S to hold up B. S knows that the investment is a significant cost to B and tries to use this as leverage to negotiate an increase in its prices. In this case, S has got more bargaining power compared to B and tries to use it to its own advantage. The source of power lies in the investment of B. For B it is hard to find out whether or not the raise in prices is reasonable. In an extreme case, A could demand 100 percent of the profits, if the only alternative to B is to lose the entire initial investment. Even though the outcome would be Pareto efficient, B might not accept the agreement. When the renegotiations turn out to be unsuccessful both parties are worse off: B has made an investment that goes to waste and S lost a customer.

Inefficiency is caused by the hold-up problem when B is reluctant to make the investment ex ante because of the fear that S uses its extra bargaining power to its own advantage. In that case the supplier is ‘holding up’ the buyer.^[4]

Example

An historic example concerns the US car industry; however, this example is sharply disputed by Coase (2000).^[5] Fisher Body had an exclusive contract with General Motors (GM) to supply car body parts and, therefore, Fisher Body was the only company to deliver the components according to GM’s specifications. In 1920, a sharp increase in demand occurred that was above expectations. It is claimed that Fisher Body used this unforeseen situation to hold up GM by increasing the price for the additional parts produced. It is been said that this hold up led to GM acquiring Fisher Body in 1926.^[6]

Solutions to the hold-up problem

Contractual solutions to the hold-up problem

Rogerson (1992) showed that the first-best contractual solution to the hold-up problem in general exist in even extremely complex environments involving x agents with arbitrarily complex transaction decisions and utility functions. He shows that three important environmental assumptions must be made:

1. No externalities so that the investment of each agent directly affects only his own type. Therefore, the following situation is not allowed: a situation where a seller’s investment has influence on the quality of the product that he sells to the buyer;
2. Risk neutrality;
3. Only one investor has partially private information so that only one agent makes an investment decision.

Furthermore, this solution also requires that ‘powerful’ contracts can be written:

1. Complex contracts can be written;
2. Each party commits to participate so that all parties are willing to sign the contract at the time of signing;
3. And the contract prevents from renegotiating the outcomes of the contract so that renegotiation in equilibrium is not possible.

According to Rogerson (1992) the hold-up problem does not necessarily creates inefficiencies; when it does, one of the above requirements is not satisfied. These requirements are necessary to come to a first-best solution.^[7]

Option contracts and renegotiation as a solution to the hold-up problem

Research of Nöldeke & Schmidt (1995) argued that the underinvestment problem due to the hold-up problem is eliminated if parties are able to write a simple option contract. Such a contract gives the seller the right (but not the obligation) to deliver a fixed quantity of the good and makes the contractual payment of the buyer dependent on the delivery decision of the seller. Thus, this contract does not depend on renegotiation or complicated mechanisms, but its crucial feature is that one of the parties unilaterally can decide whether the trade takes place. However, such a contract is only achievable when it is possible to enforce the payments conditional on the delivery decision of the seller. This means that the court must be able to verify delivery of the good to the buyer by the seller.^[8] This possibility was ruled out in earlier research where was assumed that when trade fails, it is not possible for the court to distinguish if the buyer did not accept the delivery or that the seller refused to supply.^[9]

Vertical integration as a solution to the hold-up problem

The organization and governance structure of a firm might me seen as a mechanism for dealing with a hold-up problem. A popular, but feasible, solution to the hold-up problem is vertical integration such as a merger, where all parts of the body being produced internally rather than outside.^[10] Vertical integration shifts the ownership of the organizational asset of the firm and therewith creates more flexibility and avoids potential of a hold-up. In that way you save the (transaction) costs associated with contractually induced hold-ups, but also the costs associated with the number of contracts written and executed. Hold-up problems are not merely created from the existence of firm-specific investments, but also from the set of long-term contracts that are used in the presence of the certain investments. Whether a vertical integration is adopted as a solution to the hold-up problem depends on the magnitude of the specific investment and the ability to write long-term contracts that are flexible enough to avoid a potential hold-up. However, this ability to write flexible long-term contracts strongly depends upon the underlying market uncertainty and the reputation of the company. Therefore, these factors will also influence the likelihood of vertical integration.^[11]

See also

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

Notes

References

• Balkenborg, D., Kaplan, T.R., & Miller, T. (2010). A simple economic teaching experiment on the hold-up problem. MPRA Paper No. 24772.
• Che, Y.K., & Sákovics, J. (2008). Hold-up Problem. The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
• Edlin, A. & Reichelstein, S. (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.
• Coase, R.H. (2000). The Acquisition of Fisher Body by General Motors. Journal of Law and Economics, 1(43), 15-32.
• Ellingsen, T., & Johannesson, M. (2004). Is There a Hold-Up Problem? The Scandinavian Journal of Economics, 3(106), 475-494.
• Hart, O. (1995). Firms, contracts, and financial structure. Oxford & New York: Oxford University Press, Clarendon Press.
• Hart, O., & Moore, J. (1988). Incomplete Contracts and Renegotiation. Econometrica, 4(56), 755-785.
• Holmström, B., & Roberts, J. (1998). The Boundaries of the Firm Revisited. The Journal of Economic Perspectives, 4(12), 73-94.
• Klein, B. (1998). Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited. Journal of Law, Economics, and Organization, 1(4), 199-213.
• Nöldeke, G., & Schmidt, K. (1995). Option Contracts and Renegotiation: A Solution to the Hold-up Problem. The RAND Journal of Economics, 2(26), 163-179.
• Rogerson, W.P. (1992). Contractual Solutions to the Hold-Up Problem. The Review of Economic Studies, 4(59), 777-793. Retrieved from http://www.jstor.org/stable/2297997
• Schmitz, P.W. (2001). The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory. Bulletin of Economic Research, 1(53), 1-17.
• Tirole, J. (1988). The Theory of Industrial Organization. Massachusetts : Massachusetts Institute of Technology.
• Williamson, O.E., 1979. Transactions-Cost Economics: The Governance of Contractual Relations. Journal of Law and Economics, 22(2), pp. 233–62.