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:
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 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. 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, 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, 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, many white elites feared that democratization would result in tyranny of the majority. Now that fair elections were held, many wealthy whites feared that the longtime poor blacks (or their elected representatives) would expropriate land or 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 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 democratic regime sufficiently attractive to whites in South Africa, otherwise they would not have agreed to transition out of minority rule. This problem arises more generally in a political context: dictators such as Saddam Hussein do not surrender to superior force and leave power when it should be rational to do so, because they have no means of assurance that their property and their lives will be protected if they leave power.
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 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. 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.
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