6.4 The Hold-Up Problem
[6.2 Asymmetric Information and Signalling] [6.3 Incentives and Compensation]
In segment 2,
when the outcomes of negotiations were examined, it was presumed that parties
would find agreements that maximise total value created. One reason why parties
may be able to achieve such outcomes is that all of the relevant variables and
decisions are part of the negotiations. That is, any negotiated outcome in
effect yields a contract that specifies, in a manner enforceable by a court of
law, all the rights and obligations of parties to the contract. Nothing is left
to chance and, if there is any uncertainty (say, about market conditions), what
each party would do in every contingency is still specified.
In reality, while there are many contractual
relationships for which most relevant variables are included in the (formal)
contract, there are just as many that leave important decisions and obligations
outside of any negotiations. In effect, those contracts are incomplete. If an
action is not specified within the contract, it will be implemented if the agent
able to implement it has an incentive to do so. Importantly, that agent will
have to bear the full costs of those actions and may only be able to partially
appropriate any resulting value created in subsequent negotiations.
Consequently, the outcome from the contract may not maximise total value created. This is because these actions have an effect on the payoffs, and sometimes the incentives, of other agents. When such effects are positive, an action may not be undertaken even though it may have increased overall value. This is because a single agent bears all of the costs but receives only part of the benefit. Alternatively, an incomplete contract may leave room for some agents to take actions that, while personally beneficial, confer negative effects on other agents. In this case, contractual incompleteness prevents an agreement being reached that compensates one agent for refraining from an action that would impose a negative effect on others. Once again, total value created may be less than it could be.
Animation: Effort in the Face of Contractual Incompleteness
This topic analyses the type of “hold-up”
problem that arises when contracts are not complete. It describes contractual
incompleteness and how it can reduce the incentives of agents to take actions
that improve value and may increase their incentives to take actions that lower
value. The solution to hold-up problems requires parties to find ex-contractual
means of committing to rewards and prices. In general, these involve improving
the ex post-bargaining power of the agent taking the non-contractible action.
Such mechanisms include commitments to inflexibility, group bargaining,
increased competition and changes in asset ownership.
Possibly the primary benefit of being able to
agree to a contract is its commitment value. Because it specifies all of the
rights, obligations and payments to parties, a contract creates an environment
in which agents can rely on others to take certain actions and refrain from
others. The resulting outcome is one that potentially maximises the total value
created.
In contrast, without clear contractual
commitments, some rights and obligations are either not specified, or the
payments for them will arise only after later rounds of negotiation. Recall that
what gives an agent power in negotiations is the amount they can take away from
value created if they leave the game, that is, their added value. However, when
they have already taken an action, they cannot threaten to undo it. This reduces
an agent’s bargaining position.
To see this, let us put some numbers to the
manager-worker relationship described earlier. Assume that to the manager (and
firm) the benefits from an increase in the worker’s skills would be US$100. If
the worker expends the necessary effort to acquire these skills, this will cost,
in monetary terms, $60. As this is less than the benefit of those skills to the
firm, it would increase value by $40 (= $100 - $60) if those skills were
acquired.
Suppose first that the worker and the manager
can write a contract that specifies what the worker will receive if the skills
are acquired. During negotiations about this payment, if the worker and the
manager cannot agree, the skills will not be acquired. As such, the worker’s
added value is $40. This is also the manager/firm’s added value, as the worker
cannot acquire those skills and use them elsewhere. Under our usual assumption
of equal bargaining power, the worker and manager may agree to a payment of $80
to the worker if the skills are acquired. With this price, it is indeed
worthwhile for the worker to acquire the skills.
If such a contract cannot be written, this
value-maximising outcome is unlikely to arise. Suppose that the worker and
manager agree to the payment of $80 if the skills are acquired but that this
cannot be committed to in a formal contract. The worker will then consider what
might happen after the skills have been acquired. At that point, because there
is no legal obligation to pay anything, the manager may want to negotiate a new
payment to the worker. By threatening not to work, the worker still has some
bargaining power. However, the skill-acquisition costs cannot be recovered as
part of this threat. They are sunk. In this respect, the worker and manager are
now negotiating over $100 of potential value created, rather than $40. The
worker has a diminished bargaining position, even though their added value
appears to be higher (also $100 rather than $40).
If the worker anticipates this ex post
bargaining, no skills will be acquired. This is because, if both parties have
equal bargaining power at that stage, the worker will only receive a payment of
$50. This will not justify the initial investment. In general, by not being able
to commit to a contract price before skills are acquired, the worker has a
diminished ability to negotiate a price that covers the costs incurred. The
worker must bear all of the costs at the risk of not recovering them later on.
The importance of contracts is that they
provide commitments to certain payments after valuable actions are taken. As
such, during initial negotiations, parties can assure themselves that, at the
very least, any personal costs associated with those actions will be recovered.
Without such a contract, those agents will be subject to a risk of
post-contractual opportunism and, as a result, a diminished bargaining position.
This will generally reduce their payments and, consequently, lower their
incentives to take actions.
Click on the link here to read about long-term contracts for supplying coal for electricity.
Having demonstrated the consequences of
contractual incompleteness, it is worth considering why it may be difficult to
write complete contracts. In general, there are three broad reasons why
contracts may be incomplete: the complexity of the operating environment, costs
associated with third-party verification and the potential for renegotiation.
Complexity
Perhaps the simplest reason contracts are incomplete
is the costs associated with identifying and negotiating all of the possible
consequences and obligations that might fall on agents under very possible
contingency. Some contingencies may simply not be foreseeable or of sufficiently
small probability that it is not worth negotiating rights and obligations for
that event. Agents may have insufficient experience and not realise that certain
rights and limitations need to be clearly specified. As a result, parties to a
contract may not negotiate some important aspect of their relationship.
Verifiability
There is a sense in which complexity is simply a
difficult fact of the contracting environment and may not lead to hold-up
problems per se. That is, to the extent that it is difficult to forecast
contingencies, it is also difficult to foresee the outcomes of subsequent
negotiations and alter one’s actions to confer a bargaining advantage at that
time. Of greater potential concern in contracting, therefore, are issues of
specification. That is, while the rights and obligations of parties may be
understood by them, it may be difficult for those parties to commit to actions
and rewards because those actions cannot be verified by a third party.
To see this, consider the manager-worker
problem discussed earlier. In that transaction, if the manager could commit to
pay the worker $80 if the skills were acquired, the worker would find it
worthwhile to undertake the investment. However, it may be difficult for a court
or third party to determine whether the skills were actually acquired. If this
is the case, the worker faces a real risk: the manager/firm may hold-up the
worker. They may refuse to employ the worker for a payment of $80. Instead, the
manager may try to negotiate a new payment. For the worker, at that stage, it
may be better to agree to a new round of bargaining than to face unemployment.
As demonstrated earlier, the likely payment
in this eventuality would be $50. If the worker anticipates the possibility of a
new round of negotiations with this outcome, no skills will be acquired. It is
verifiability that makes the initial promise of $80 a credible one. Without
verifiability, the worker faces a real risk of hold-up and the manager acting
self-interestedly has an incentive to re-open negotiations in an opportunistic
manner.
Renegotiation
The above problem of verifiability could be mitigated
if the parties could simply commit not to engage in any further rounds of
negotiation. However, under most legal environments concerning contracts, it is
difficult to see how this could be achieved. For example, while the worker’s
investment in skills may not be verifiable, a court could verify if the agreed
payment is renegotiated. One could imagine the manager committing not to
renegotiate by offering a large sum (say, in the millions of dollars) if any
further negotiations took place. However, this commitment could be undermined as
any new contract could include a term waiving such penalties. If the penalty
were to be paid to a third party, that party could be included in subsequent
negotiations (ie, some reduced payment to them could be negotiated). As a
result, it may be difficult to commit not to renegotiate.
Relationship-Specific Investments
An incomplete contract means that agents must
bear the costs of some action prior to any negotiations over value created
taking place. As a consequence, agents may change their actions and investments
in order to avoid being held up in those latter negotiations. Ultimately, the
reason why this situation may not lead to maximum value created is because of
the relevant agent’s weaker bargaining position in ex post negotiations. If the
agent could recover the costs of the actions in another way, the incomplete
contract problem would be mitigated.
Perhaps the primary reason why an agent has a
poor ex post-bargaining position is a lack of outside options. In many
situations, the actions an agent is considering taking are generate value if the
agent trades with a particular person who may be the only holder of key assets.
As such, any investments are relationship specific.
As examples of these, consider those we
encountered in segment 2. The three examples of relationship-specific
investments were the location decisions of electricity generating plants near to
fuel sources, the choices by movie studios in particular actors for movie
sequels and the specific learning made by scientists in pharmaceutical
companies. Our worker’s choice regarding skill acquisition was relationship
specific because those skills were assumed to be only of use to the firm in
question. All of these investments were potentially desirable because they
improved value created. However, in each case, after the action was taken, the
relevant agent was tied to the relationship. That is, they could not realise any
value from their actions unless they dealt with a particular party.
When an agent considers making a
relationship-specific investment, it is important to realise that a “fundamental
transformation” occurs in terms of their bargaining position with the other
party. While the agent may have many potential agents it can trade with prior to
any investment taking place, after those costs have been reduced, the
negotiating environment turns into a bilateral monopoly. From the agent’s
perspective, while they had many trading partners prior to investing, having
done so they must negotiate with a single agent in order to appropriate some
value.
There are, of course, degrees of specificity
to many actions. For some non-contractible actions, agents may be able to
realise all or some value if they are forced to transact with another party. In
others, the agent has some choice about the degree of specificity. For example,
MBA students who are funded by their employer may choose subjects that would be
more valuable if they were to work for another company having completed the
degree. In such cases, the main transaction cost associated with the potential
for hold-up is not diminished investment but investment of a type that may not
maximise total value created.
Click on the link here to find out about the ownership of domain names on the World Wide Web.
Solving Hold-Up Problems
When contracts are incomplete and do not
cover the costly actions of key decision-makers, there is potential for hold-up.
In some circumstances, this potential may not be realised. For instance, an
investment that is not relationship specific may take place regardless of
whether a return on the investment is guaranteed by the contract terms or not.
In other circumstances, however, the investment may not take place or may be
made in an inefficient way. This is because the investor may choose to avoid the
hold-up problem or expend resources in minimising it. Ultimately, the end result
is that valuable trading opportunities may not be realised.
There is a sense in which hold-up problems
are a necessary part of business life. Nonetheless, awareness of them could
improve contractual terms that are negotiated ex ante. For example, a franchisee
of a fast food outlet may be concerned about stories that franchisers were
allowing further franchises in a location that had proved to be highly
profitable. The solution to this may be to explicitly include a term in the
franchise agreement restricting the franchiser's ability to expand the number of
franchises or, alternatively, to stipulate damages that could be paid to the
franchisee if such an expansion took place.
However, awareness of potential hold-up may
not always suggest a contractual solution, especially where renegotiations were
possible. Consequently, parties may look for ways to substitute for the
commitment value that a contract might otherwise give.
Ownership changes (integration)
Changes in ownership (ie, vertical or horizontal integration) – by increasing
the added value of the asset owner – may be such a mechanism. When an agent owns
key assets, that agent has a better bargaining position in any subsequent
negotiations. If ownership of a key asset is given to the agent that is most
likely to be subject to hold-up (that is, to agents who are making important
investment or effort choices), then value created will be higher.
Reputation
Developing a reputation for not holding up
agents may improve incentives over the long run. That is, an on-going
relationship may resolve some hold-up problems by allowing the hold-up itself to
be punished. However, this relies on co-operation being sustained despite the prisoners'
dilemma nature of the once off hold-up problem. Agents will have to be
patient in order for a relationship to avoid hold-up issues.
Increased bargaining power
One direct means of mitigating hold-up problems is to
find a way of improving the bargaining power of the player making the
investment. An improvement in bargaining power will mean that that player would
expect to appropriate more value in negotiations after the investment takes
place. For instance, if a worker appropriated 80 rather than 50 percent of the
bargaining surplus, this may have given them a sufficient return to acquire
skills regardless of whether there was an explicit contract or not.
Collective or group bargaining is another way
of improving the added values of investors. When a group of workers forms a
union, their average added value is increased because when there is a breakdown
in bargaining, all workers leave the firm. Hence, unions may be desirable
organisations when a firm wishes to encourage workers to make
relationship-specific investments. For example, the incentive of a worker to
relocate in a “company town” may be greater if that company has a strong union
that would protect workers from downward wage pressure after they have moved.
Competition and substitutes
Another way of increasing a payoff is to reduce the
added value of others. If a player taking a non-contractible action has many
substitute players whom they could transact with, this improves their bargaining
position. They can use competition among those players to increase their
expected outcome. In a sense, if there is sufficient competition, this can
substitute for contractual commitments on price. This allows the player to
capture more value and justify bearing the costs of any non-contractible
actions. In our earlier manager-worker example, if the worker’s skills were of
value to other employers, the worker could use competition among them to prevent
excessive hold-up. In many respects, this is just another way of saying that the
worker’s investment is not specific to a particular firm.
Another example of this comes from the licensing
of new technology. Sometimes patent holders, as well as producing a new product
innovation themselves, licence the rights to sell the product to another
manufacturer. This practice is called “second sourcing”. This practice may be
seen as strange as the patent holder is effectively giving up its monopoly
rights to the new technology. However, this is exactly the goal because it wants
to convince users to make their own complementary investments that enhance the
innovative value. For example, a computer-chip manufacturer may second source so
as to encourage the development of software for that chip. The idea is that by
creating competition, the patent holder reduces the possibility that it may hold
up the investments made by complementors.
A final way in which hold-up problems can be
mitigated is if one player reduces their relative added value by making it
costly to break existing arrangements. This can be achieved if that player cuts
off their own outside options; that is, they burn their bridges. If this occurs,
then that player will find it more difficult to hold up other players who may be
making non-contractible investments. Their reduced bargaining position
necessarily enhances the bargaining position of the investor after they have
made any investments.
An example of burning bridges occurred in
1984 when Apple built a plant for its new Macintosh computer. Despite the
general uncertainty over the nature of information technology, Apple built and
publicly announced that the Macintosh plant would be highly specialised to that
product and would not be sufficiently flexible to produce any other type of
computer. While such inflexibility may often be seen as a weakness, in this case
it could also be viewed as a commitment to users and complementors. The
inflexible plant meant that Apple would face less incentive to discontinue the
Macintosh line in the future. This sent a signal to users and complementors that
they could invest in Macintosh with less risk of those investments becoming
worthless in the future.
Topic Summary
-
In many transactions, an agent making important investments and bearing significant sunk costs may be subject to hold-up.
-
The hold-up problem arises when contracts are difficult to write and enforce and when agents face a potentially weak bargaining position in on-going negotiations.
-
There are various alternative means that can be employed to avoid the hold-up problem including changes in ownership, reputation, increased bargaining power, the use of competition or the use of commitments.