Topic 3

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 don’t like timely completion contractor may quit halfway

3. Contractor Worries May build specified house but customer won’t 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 can’t 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

12. Problems with Renegotiation Renegotiation reduces the commitment value of contracting dieting example repayment of debts and taxes Denver rehabilitation clinic

13. 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 won’t try hard enough to keep market price high

14. Non-contractible and contractible actions Some actions are contractible observable and verifiable effort quantity produced timeliness Some are not investment levels effort quality

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

16. 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

22. Case Analysis

23. Forms of Asset Specificity Site specificity Where to build plant Physical asset specificity Tailored mould for glass manufacture Dedicated assets IS’s assembly line Human asset specificity Learning a company’s procedures

24. “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?

26. 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.

27. 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

28. 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?

29. Remedies Non-contractual commitments Change of ownership: vertical integration next topic Reputation for trust implicit or relational contracting

30. Non-contractual Commitments Burn bridges Apple’s 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