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)

Buyer

Supplier

Keep Price

Raise price

Make investment

Don’t invest (keep Supplier) (0,0)

(1000,0)

(250,750)

Buyer

(-500,-1000)

Keep Supplier

New Supplier

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

• 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)

Buyer

Supplier

Keep Price

Raise price

Make investment

Don’t invest (keep Supplier) (0,0)

(1000,0)

(250,750)

Buyer

(-500,-1000)

Keep Supplier

New Supplier

What if investment now costs 1000?Potential savings 500. What happens?Another reason for a government to allow Vertical Integration.

(500,0)

(-250,750)

(-1000,-1000)

General payoffsPayoffs: (Buyer, Supplier)

Buyer

Supplier

Keep Price

Raise price

Make investment

Don’t invest (keep Supplier) (0, 0)

(P - C, 0)

(P - C - R, R)

Buyer

(-C, -B)

Keep Supplier

Change Supplier

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 ex-employees 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.

Why is there hold-up problem?• (a) unforeseeable external factors: global technology

shifts or changes in consumer lifestyles, • (b) lack of trust, difficulty the buyer has in re-assuring

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 can be expensive/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.