Supplier hold-up problem
• If one company is supplying another company a
good used in production (such as a supplier of
coal to an electric company), then the supplier
can hold-up the buyer company.
• This works if the buyer company decides to
make an investment to adjust its products to
make better use of the supplier’s product.
• Once the investment is made, the supply can
raise its prices.
Supplier hold-up problem
•
•
•
•
•
The investment by the buyer costs him 500.
The gross gain to the buyer is 1500.
The net gain is 1500-500=1000.
The supplier can raise the price by 750
This would reduce the net gain of the buyer by
750 to 250.
• If the buyer switches to a new supplier, the
buyer’s investment (of 500) is lost to him and the
supplier loses 1000 worth of previous business
with him.
Holdup payoffs:(Buyer, Supplier)
Keep Price
Make investment
Supplier
Raise price
Buyer
Don’t invest
(keep Supplier)
(1000,0)
Keep
Supplier (250,750)
Buyer
New
(-500,-1000)
Supplier
(0,0)
Buyer’s investment costs 500 – only useful for that supplier.
Saves buyer 1500 (net 1000).
Supplier can raise price by 750.
Supplier losing the Buyer’s business costs him 1000.
Supplier hold-up problem
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•
•
•
•
Now the investment is 1000 (instead of 500).
The gross gain to the buyer remains 1500.
The net gain changes to 1500-1000=500.
The supplier can still raise the price by 750
This would reduce the net gain of the buyer by
750 to -250. (rather than +250)
• If the buyer switches to a new supplier, the
buyer’s investment (of 1000) is lost to him and
the supplier loses 1000 worth of previous
business with him.
Holdup payoffs:(Buyer, Supplier)
Keep Price
Make investment
Supplier
Raise price
Buyer
Don’t invest
(keep Supplier)
(1000,0) (500,0)
Keep
Supplier (250,750)
(-250,750)
Buyer
New
(-500,-1000)
Supplier
(-1000,-1000)
(0,0)
What if investment now costs 1000?
Potential savings 500. What happens?
Another reason for a government to allow Vertical Integration.
General payoffs
Payoffs: (Buyer, Supplier)
Keep Price
Make investment
Supplier
Buyer
Don’t invest
(keep Supplier)
Raise price
(P - C, 0)
Keep
Supplier (P - C - R, R)
Buyer
Change (-C, -B)
Supplier
(0, 0)
Buyer’s investment costs C – only useful for that supplier.
Increases buyer’s profits by P (net P - V).
Supplier can raise price by R.
Loss of business costs supplier B.
Example: Soviet Military
• State forced to buy arms from specific manufactures.
• Arms manufacturers were able to cut costs by substituting
goods of inferior quality.
• The state attempted to counter this by employing a small
army of inspectors.
• Many items: tanks. Expensive to monitor during production.
• Inferior quality was readily observable once delivered.
• A compromise reached: the inspectors overlooked shortfalls
in quantity and late deliveries, in return for improvements in
quality;
• More efficient outcome because lowest quality items cost
more to produce than they were worth to the army.
Example: Fischer Body.
• GM signed a contract with Fisher Body to
provide it with closed metal bodies.
• Early 1920s: unexpected increase in demand.
• The contract was cost-plus: GM pays 17% over
and above any non-capital costs.
• Fisher had incentive to build new plants further
away from GM’s plants, so that they could profit
from the transportation costs.
• Solution: a merger between GM and Fisher.
Training and Skills Shortages
• New employees require training before they are fully productive.
• Training may be firm specific or more general.
• If the employee pays for the training (reduced wages), the firm has
an incentive to offering them a different contract on less favourable
terms; the company may also cherry-pick the best workers: workers
can be exploited.
• More difficult to recruit.
• If company pays, workers can threaten to leave and work for a
competitor. The company may counter this by making exemployees sign a contract that they will not work for a direct
competitor for a certain period of time. The contract may or may not
be enforceable.
• Both cases, there is a disincentive to make investment in skills (in
particular general skills) which would benefit both parties.
Other Hold-ups
• Standards in IT.
– A standard may form before a license
agreement.
– The patent holder can hold up the adopters.
• Car body design.
– Car manufacturers had in-house programming teams.
– They could demand high pay/job security.
– This broke down thanks to software for Hollywood
used to design prototypes and software for
aerodynamics.
Why are there hold-up problems?
• (a) unforeseeable external factors: global
technology shifts or changes in consumer
lifestyles,
• (b) lack of trust, difficulty the buyer has in reassuring the supplier that the money has been
invested properly or indeed that it has been
invested at all,
• (c) asymmetric information, for instance the
supplier may over-estimate the cost of the
investment to the buyer or ascertaining quality at
points of time.
• (d) monitoring quality/effort is difficult.
Contracting around hold-up?
Could the contract could specify that the
work will be done at a fixed price,
thereby eliminating the problem?
• Difficult to write contract that anticipates every
possible situation that may occur during a length
project.
• Loopholes may allow the supplier to default on
the contract in subtle ways or take advantage of
unforeseeable external events.
• Proving quality/effort in court can be difficult.
Avoiding hold up problem
• Mergers
– GM eventually bought Fischer body
• Long-term contracts for workers.
– ROTC requires longer service
• Repeat game
– Reputation
• Behavioral traits
– Ethics/fairness