Hold-up Problem
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In
economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and intera ...
, 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: #Parties to a future transaction must make noncontractible relationship-specific investments before the transaction takes place. #The specific form of the optimal transaction (such as quality-level specifications, time of delivery, what quantity of units) cannot be determined with certainty beforehand. The hold-up problem is a situation where two parties may be able to work most efficiently by cooperating but refrain from doing so because of concerns that they may give the other party increased bargaining power and thus 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 Economic cost is the combination of losses of any goods that have a value attached to them by any one individual. Economic cost is used mainly by economists as means to compare the prudence of one course of action with that of another. The comparis ...
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 thus
inefficiency Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...
. Underinvestment occurs because investors cannot guarantee themselves a sufficient share of the return through ex post bargaining. 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 equilibria. Underinvestment may occur only when the agent fails to coordinate on an efficient equilibrium.


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, the parties would have enough confidence to make the investment, and both parties could enjoy high profits. Then, it can be assumed that there are no wealth constraints and there is no private information. According to the
Coase theorem In law and economics, the Coase theorem () describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low tra ...
, voluntary bargaining results in trade whenever it is efficient. However, making such a contract is often not possible for these four reasons: *Unforeseeable external factors *Lack of trust *Quality problems * Asymmetric information The initial contract can cover only short-term situations. Eventually, renegotiation is needed, which provides an opportunity for e.g. S to hold up B. As 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 that case, S has 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, S could demand 100% of the profits if the only alternative to B is to lose the entire initial investment. Even if the outcome would be
Pareto efficient Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engin ...
, B might not accept the agreement. If 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 from the fear that S uses its extra bargaining power to its own advantage. In that case the supplier is 'holding up' the buyer.


Examples


Auto Industry

A historic example concerns the US car industry, but the example is sharply disputed by Coase (2000). Fisher Body had an exclusive contract with General Motors (GM) to supply car body parts and so 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 the unforeseen situation to hold up GM by increasing the price for the additional parts produced. It has been said that the hold up led to GM acquiring Fisher Body in 1926.


Democratization of South Africa

During transition out of South African
apartheid Apartheid (, especially South African English: , ; , "aparthood") was a system of institutionalised racial segregation that existed in South Africa and South West Africa (now Namibia) from 1948 to the early 1990s. Apartheid was ...
, many white elites feared that democratization would result in
tyranny of the majority The tyranny of the majority (or tyranny of the masses) is an inherent weakness to majority rule in which the majority of an electorate pursues exclusively its own objectives at the expense of those of the minority factions. This results in oppres ...
. Now that fair elections were held, many wealthy whites feared that the longtime poor blacks (or their elected representatives) would expropriate wealth from the white minority. For this reason there was white resistance against democratic and fair elections. To ensure a peaceful transition (and to uphold the credibility of the elections), the
African National Congress The African National Congress (ANC) is a Social democracy, social-democratic political party in Republic of South Africa, South Africa. A liberation movement known for its opposition to apartheid, it has governed the country since 1994, when ...
needed to make a commitment to protect the incomes and wealth of the white minority. This commitment allowed whites to respect the results of a democratic election which would put the majority blacks in power. That credible commitment from the ANC made the new democractic regime sufficiently attractive to whites in South Africa, otherwise they would not have agreed to transition out of minority rule.


Solutions


Contractual

Rogerson (1992) showed the existence of a first-best contractual solution to the hold-up problem 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: #No
externalities In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
so that the investment of each agent directly affects only its 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. #
Risk neutrality In economics and finance, risk neutral preferences are preferences that are neither risk averse nor risk seeking. A risk neutral party's decisions are not affected by the degree of uncertainty in a set of outcomes, so a risk neutral party is indif ...
. #Only one investor has partially private information so that only one agent makes an investment decision. Furthermore, the solution also requires 'powerful' contracts to be written. #Complex contracts can be written. #Each party commits to participate so all parties are willing to sign the contract at the time of signing. #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 create inefficiencies; when it does, one of the above requirements is not satisfied. The requirements are necessary to come to an absolutely best solution. If there are direct externalities and renegotiation cannot be prevented, even under symmetric information, underinvestment cannot be avoided. If there are direct externalities, the seller's investment is a hidden action and the buyer has private information about its valuation, the absolutely best solution may not be attained even when the parties have full commitment power. In the absence of direct externalities, simple contracts may solve the hold-up problem even when each party has private information about its valuation. Maskin and Tirole (1999) argue that complex contracts can solve the hold-up problem when there are ex ante indescribable contingencies, and
Hart Hart often refers to: * Hart (deer) Hart may also refer to: Organizations * Hart Racing Engines, a former Formula One engine manufacturer * Hart Skis, US ski manufacturer * Hart Stores, a Canadian chain of department stores * Hart's Reptile Wo ...
and Moore (1999) argue that the solution does not work when renegotiation cannot be ruled out. Taken together, whether or not suitable contracts can solve the hold-up problem is disputed in contract theory. In an experimental study, Hoppe and Schmitz (2011) found that option contracts may alleviate the hold-up problem even when renegotiation is possible, which may be explained by Hart and Moore's (2008) idea that contracts may serve as reference points.


Option contracts and renegotiation

Nöldeke and
Schmidt Schmidt may refer to: * Schmidt (surname), including list of people with the surname * Schmidt (singer) (born 1990), German pop and jazz singer * Schmidt (lunar crater), a small lunar impact crater * Schmidt (Martian crater), a List of craters on ...
(1995) argued that the underinvestment problem due to the hold-up problem is eliminated if parties are able to write a simple
option contract An option contract, or simply option, is defined as "a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer". Option contracts are common in professional sports. An option contrac ...
. Such a contract gives the seller the right but not the obligation to deliver a fixed quantity of the good and also 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 can unilaterally decide whether the trade takes place. However, such a contract is unachievable unless it is possible to enforce the payments conditional on the delivery decision of the seller. That means that the court must be able to verify delivery of the good to the buyer by the seller. The possibility was ruled out in earlier research where it was assumed that when trade fails, it is not possible for the court to distinguish whether the buyer did not accept the delivery or the seller refused to supply.


Vertical integration

The organization and governance structure of a firm might be seen as a mechanism for dealing with a hold-up problem. A solution to the hold-up problem is
vertical integration In microeconomics, management and international political economy, vertical integration is a term that describes the arrangement in which the supply chain of a company is integrated and owned by that company. Usually each member of the suppl ...
such as a
merger Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, other business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspect ...
in which all parts of the body are being produced internally rather than outside. 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, the (transaction) costs associated with contractually induced hold-ups are saved and also the costs associated with the number of contracts written and executed. Hold-up problems are 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, flexible enough to avoid a potential hold-up. However, the ability to write flexible long-term contracts strongly depends upon the underlying market uncertainty and the reputation of the company. Therefore, those factors will also influence the likelihood of vertical integration. The extent to which vertical integration can alleviate the hold-up problem also depends on the information structure. While traditional incomplete contracting models of vertical integration such as Grossman and
Hart Hart often refers to: * Hart (deer) Hart may also refer to: Organizations * Hart Racing Engines, a former Formula One engine manufacturer * Hart Skis, US ski manufacturer * Hart Stores, a Canadian chain of department stores * Hart's Reptile Wo ...
(1986) assume symmetric information, Schmitz (2006) has extended the incomplete contracting framework to allow for asymmetric information.


See also

* Specific asset *
Vertical monopoly In microeconomics, management and international political economy, vertical integration is a term that describes the arrangement in which the supply chain of a company is integrated and owned by that company. Usually each member of the supply ...
*
Game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appli ...
*
Theory of the firm The theory of the firm consists of a number of economic theories that explain and predict the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market. Firms are key drivers in ec ...
* Commitment Device * Precommitment * Corporate finance approaches: **
Contingent value rights In corporate finance, Contingent Value Rights (CVR) are rights granted by an acquirer to a company’s shareholders, facilitating the transaction where some uncertainty is inherent. CVRs may be separately tradeable securities; they are occasiona ...
** Strip financing **
Earnout Earnout or earn-out refers to a pricing structure in mergers and acquisitions where the sellers must "earn" part of the purchase price based on the performance of the business following the acquisition. Description Earnouts are often employed when ...


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). ''H old-up Problem''. ''
The New Palgrave Dictionary of Economics ''The New Palgrave Dictionary of Economics'' (2018), 3rd ed., is a twenty-volume reference work on economics published by Palgrave Macmillan. It contains around 3,000 entries, including many classic essays from the original Inglis Palgrave Diction ...
'', 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. *Hoppe, E. I., & Schmitz, P. W. (2011). Can contracts solve the hold-up problem? Experimental evidence. ''Games and Economic Behavior'', ''73''(1), 186-199. *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. {{jstor, 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. *Schmitz, P.W. (2006). Information Gathering, Transaction Costs, and the Property Rights Approach. ''American Economic Review'', 96(1): 422–434. * 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. Industrial organization Business terms Market failure