1

The Hold-up Problem

What is the hold-up problem? Some projects require the participation of more than one party, and an investment made by at least one of them. The hold-up problem arises when the party who undertakes the investment (the investor) cannot recover the xed cost of the investment ex-post because once the investment has been made, it is sunk and has no other use. As a result, the other party (the contractor) will have every incentive to squeeze the investor ex-post so that it makes only enough to cover its operating costs! The investor will realize this will happen ex-ante, and will only make the investment if he is able to recover both his sunk and operating costs. If there are no mechanisms that will prevent the contractor from squeezing the investor ex-post, the investor will not undertake the investment because it knows that it will not be able to recover its sunk cost. This is the hold-up problem. What are some examples of the hold-up problem? The hold-up problem is a very common one not only in economics, but also in life in general. There are several examples, both historical and modern.

1.1

Maghribi Traders

During the 11th century, a Jewish trader in the Muslim Mediterranean involved in overseas trade had two options: either he could sail himself or hire an agent who would take his goods overseas, sell them there and take a share of the prot. The second alternative was the more e cient one. However, once a merchant hired an agent and gave his goods to him, there was the possibility that the agent would embezzle the goods entrusted to him. In the absence of a coalition, there was no guarantee that the agent would behave honestly, and therefore the merchant would not trust him. This would prevent a protable joint project, hiring over seas agents. We will see more on this later.

1.2

Merchant Guilds

In medieval Europe, trade between cities, although potentially protable due to price dierences that could be arbitraged, was a risky project for the traders involved. A trader who went to a foreign city needed some protection to ensure that his goods would not be stolen. As a single trader he was not powerful enough to deter the rulers of the city from ripping him o. In the absence of a merchant guild, no trader would take the risk, and therefore there would be no inter-city trading. The possibility of being burglarized, and even being killed, would have help up any trading investments and would have prevented inter-city trade.

1.3

Oil Pipelines

Both oil drilling and rening are economic activities that require large sums of money being invested for exploration, building, and machinery. However,

an oil well is much less valuable if there is no pipeline that will ship the oil from the well to the renery. Similarly, a renery is useless if it has no oil to process. Once wells and reneries are established, operating costs are not large. Therefore, a rm that builds a pipeline can buy oil at a low price from the well owners, and can sell it at a high price to the renery owners. This will reduce the protability of investing in the wells and renery. (Pipelines are natural monopolies, and therefore there will be no competition to prevent this.) However, reasoning backwards, both the oil well owners and the renery owners know that if they don t have control over the prices oered to them by the pipeline, or the price charged by the pipeline, they will not be likely to recover their xed costs of investment. Therefore, they will not invest. The possibility that investors in the oil wells and reneries will not be able to recover their investment may result in no investment being made.

1.4

Union Workers in a Strawberry Field

Consider a hypothetical strawberry farmer who has to spend a large sum of money to grow strawberries. If the only source of labor is a labor union, the farmer may face a di cult situation when it is time to pick and sell his strawberries. The union can take advantage of him by asking a total wage payment equal to the market value of strawberries minus transportation costs. The farmer with ripe strawberries will have no choice but to say yes! However, reasoning backwards, the farmer will see this and not grow strawberries unless he can prevent being taken advantage of at the end. It is possible to nd many other examples. What all these examples have in common is the following: The possibility that not being able to recover xed costs due to opportunistic behavior prevents an ex-ante protable investment being carried out.

1.5

Solutions to the Hold-up Problem

There are several ways to solve the hold-up problem. These include repeated interaction, coalitions, contracts, and vertical integration. 1.5.1 Repeated interactions:

When the investment needs to be made periodically, all parties involved know that if the investor cannot get su cient returns to cover his investment costs he will not invest again. The threat of losing future prots may deter the potential cheater to behave nicely, and give a su cient payo to the investor so that costs of investment will be covered. In our historical examples, this will work through ring a dishonest agent, or not visiting a city that did not protect the trade commodity. However, if the benet of cheating once exceeds the future value of cooperation, having repeated interaction will not be su cient to resolve the hold-up problem. In this case, we need a joint action against the cheater.

1.5.2

Coalitions:

Sometimes repeated interaction is not enough to resolve the hold-up problem if the one time gain from cheating is greater than the future value of cooperation, i.e., the cost of punishment. However, if the cheater is facing a coalition that will ostracize him both economically and socially, then the punishment will be larger, and it will be more likely to resolve the problem. This was the case in the Maghribi trader coalition. This coalition severed their relation with agents who cheated. The fear of losing commercial contact with the entire coalition was a strong enough incentive to keep a majority of agents to behave honestly. Both merchants and overseas agents had an incentive to be a part of the coalition. The wage that will keep an agent who is a member of the coalition and never cheated before to be honest was lower than the wage that will keep an agent who cheated before or is not a member of the coalition. Therefore, merchants beneted from hiring coalition member agents who never cheated before. On the other hand, the probability of being hired was considerably higher for a coalition member agent who has never cheated before. Thus, agents had an incentive to be a part of the coalition and behave honestly when they are hired. A similar mechanism helped trade ourish in medieval Europe. 1.5.3 Contracts:

Contracts may change the payos from cheating, thus enabling the investor to trust the other party. In Williamson s terms, if one party gives a hostage to the other to be taken if he does not carry out his contractual obligations, his incentives to cheat will be minimized. Knowing that it is not in the best interest of his opponent to take advantage of him after he incurs the investment costs, the investing party will carry out the investment. 1.5.4 Vertical Integration:

Although contracts may solve the hold up problem, sometimes they will be ineffective if there are many contingencies and therefore loopholes in the contract, or due to litigation costs. In those cases, the hold-up problem can only be solved through vertical integration. Then, there is no possibility of a cheating and an e cient investment will be always carried out. The problem with vertical integration is the increase in administrative costs.