Hold-up problem

In economics, the hold-up problem (or commitment 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:

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 thereby 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.

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.

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 not often possible for these reasons:

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 percent 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.

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