HoldUp Problems

1
Topic 3

• Hold-Up Problems

2
Building Contract

• Suppose you have bought a piece of land and
  engage a contractor to build your house.
• Concerns
• might spend too much money and end up with house
  dont like
• timely completion
• contractor may quit halfway

3
Contractor Worries

• May build specified house but customer wont pay
  up
• Dismiss contractor in middle of project and hire
  someone else
• Choose expensive kitchen and bathroom fixtures
  and raise costs

4
Ideal World

• Specify each of these concerns and negotiate over
  them -- impose large penalties if obligations not
  fulfilled
• contract would describe house in detail right
  down to fixtures
• specify how price changes if request changes or
  if price of materials happened to change
• completion date specified maybe with provisions
  for contractor illness or bad weather

5
Worked Example

• Importance of Contractual Commitments

6
Difficulties in Contracting

• Bounded rationality
• Problems in verification
• Ex post renegotiation (imperfect commitment)

7
Bounded Rationality

• Unforeseen circumstances
• e.g., town planning restrictions that alter house
  design
• Costly calculations
• Complexity

8
Verification

• Important contract outcomes may be observable to
  all parties.
• However, they might not be verifiable by a third
  party (e.g., a court)
• Example promises to an individual student
  regarding what will be in an exam

9
Ex Post Renegotiation

• Parties may mutually agree to changing contract
  terms later on to avoid inefficiencies
• Example
• Department store contracts with knitter for
  10,000 jumpers
• Worth 20 but costs knitter 10
• Agree to a price of 15 per jumper

10
Incentive to Renegotiate

• Suppose that knitter gets another order for
  20,000 shirts
• Worth 15 to new buyer and costs 5 per unit
• Knitter cant produce both jumpers and shirts
  (insufficient capacity)
• Efficiency requires changing to shirts (value
  created is 200,000 rather than 100,000)

11
Actual Renegotiation

• Is this just tough?
• No, by breaking the contract 100,000 in
  additional value is created.
• Stipulated damages the knitter can break the
  contract and pay the department store 50,000 in
  compensation for lost profits plus an additional
  amount.
• Hard to agree in advance on damages

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Problems with Renegotiation

• Renegotiation reduces the commitment value of
  contracting
• dieting example
• repayment of debts and taxes
• Denver rehabilitation clinic

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Another example

• Stock options to motivate managers
• work to make sure price is high in the future
• but if market price is never likely to reach
  exercise price this is no motivation
• Suppose there is a crash
• all of sudden managers not motivated
• better to issue new options
• but if managers forecast this, then wont try
  hard enough to keep market price high

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Non-contractible and contractible actions

• Some actions are contractible
• observable and verifiable effort
• quantity produced
• timeliness
• Some are not
• investment levels
• effort
• quality

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Summary

• Sources of contractual incompleteness
• Complexity
• Non-verifiable actions
• Renegotiation
• Consequences of contractual incompleteness
• Potential for hold-up
• Non-cooperative actions -gt outcome not value
  maximising
• Lost trades
• Insufficient investment
• Ultimate issue a lack of commitment

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Commitment Issues

• In negotiations, cannot specify penalties or
  price changes contingent on different
  non-contractible actions
• These actions may influence ex post negotiations
• Parties look forward to outcome of those
  negotiations before choosing non-contractible
  action
• Creates inefficiencies (not value maximising)

17
Mini-cases

• Examples of Hold-Up

18
IBM and IS

• 1970 IBM wanted to contract for specialised
  integrated circuits for a product to be marketed
  in 1972. Not available at time. Approached
  International Systems (IS) to make the BR1
• Quality was critical, but by mid-1974 IBM
  detected problems
• IBM IS not maintaining dedicated line
• IS IBM had bad testing procedures
• Eventually, gave up relationship IBM could not
  prove IS at fault

19
Crime Syndicates

• New York crime syndicate wanted to develop gaming
  in Las Vegas. Hired Bugsy Siegal to do this
  (site selection and marketing)
• Siegal kept on asking for more funds. New York
  had to continue support or stop construction.
• Sank 50m into Flamingo casino before confirming
  embezzlement

20
Fuel and raw materials

• Many plants locate close to raw material
  suppliers
• Efficient save transportation costs
• But leaves them beholden to those suppliers
• Bauxite suppliers to aluminum smelter or gas or
  coal suppliers to electric power
• Result very complex contracts and exclusivity
  arrangements

21
Relationship-Specific Assets

• Common element in these stories investments to
  be made in relationship-specific assets (assets
  have zero value outside of relationship)
• Having made investments, then face subsequent
  contracting with limited bargaining power
• If investment not contractible, then may be
  deterred from investing

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Case Analysis
23
Forms of Asset Specificity

• Site specificity
• Where to build plant
• Physical asset specificity
• Tailored mould for glass manufacture
• Dedicated assets
• ISs assembly line
• Human asset specificity
• Learning a companys procedures

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Fundamental Transformation

• When make relationship-specific investments
• transform large numbers bargaining situation into
  small numbers (bilateral monopoly) situation
• vulnerable to post-contractual opportunism
• investment may be held-up by other party who
  tries to negotiate a greater share of the surplus

25
Case Taco Bell

• Late 1980s and early 1990s, Taco Bell wanted to
  increase number of outlets (including Taco Bell
  Express)
• Existing franchisees feared this strategy would
  cut into their own business
• Were they being held-up?

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Benefits to Taco Bell

• If Taco Bell sold franchises through an up-front
  fee, it would optimally give each an exclusive
  territory as this would maximise that payment
  (maybe use an auction in each location).
  Franchisees pay for monopoly.
• But, in reality, franchisees pay a percentage of
  sales revenue to Taco Bell.

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Fundamental Tacosformation

• Ex post interests of Taco Bell and franchisees
  different
• Adding outlets hurts franchisees
• But this gives Taco Bell more visibility and
  creates locational convenience increasing total
  market demand
• Franchisees find it costly to terminate
  relationship with Taco Bell because of built-up
  human capital

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Transaction Costs

• Hold-up problems caused by contractual
  incompleteness represent transaction costs
• efficient outcomes may not result because of a
  fear of not receiving an adequate return on
  investment
• What organisational structures can mitigate such
  costs?

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Remedies

• Non-contractual commitments
• Change of ownership vertical integration
• next topic
• Reputation for trust
• implicit or relational contracting

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Non-contractual Commitments

• Burn bridges
• Apples inflexible manufacturing plant for Mac
• Increase competition
• Second sourcing by Intel
• Detroit and auto-suppliers
• Increased bargaining power
• Bulk buying
• Unions

31
Floating Power Plants

• Power plants once built become site specific
• Contracts with government potential for hold-up
• 1990s Designed new power plants on floating
  barges no longer site specific
• Can also be assembled off site