Supplier hold-up problem

1
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 suppliers product.
• Once the investment is made, the supply can raise
  its prices.

2
Supplier hold-up problem

• The investment by the buyer costs him 500.
• The gross gain to the buyer is 1500.
• The net gain is 1500-5001000.
• 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
  buyers investment (of 500) is lost to him and
  the supplier loses 1000 worth of previous
  business with him.

3
Holdup payoffs(Buyer, Supplier)
Keep Price
(1000,0)
Keep Supplier
Make investment
Supplier
(250,750)
Raise price
Buyer
Buyer
(-500,-1000)
New Supplier
Dont invest (keep Supplier)
(0,0)
Buyers investment costs 500 only useful for
that supplier. Saves buyer 1500 (net 1000).
Supplier can raise price by 750. Supplier losing
the Buyers business costs him 1000.
4
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 1500-1000500.
• 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
  buyers investment (of 1000) is lost to him and
  the supplier loses 1000 worth of previous
  business with him.

5
Holdup payoffs(Buyer, Supplier)
Keep Price
(1000,0)
(500,0)
Keep Supplier
Make investment
Supplier
(250,750)
(-250,750)
Raise price
Buyer
Buyer
(-500,-1000)
New Supplier
(-1000,-1000)
Dont invest (keep Supplier)
(0,0)
What if investment now costs 1000? Potential
savings 500. What happens? Another reason for a
government to allow Vertical Integration.
6
General payoffs
7
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.

8
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 GMs plants, so that they could profit
  from the transportation costs.
• Solution a merger between GM and Fisher.

9
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.

10
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.
  

11
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.