Question

Topic: The Hold-up Problem

Based on chap. 5. What is the hold-up problem?

Delta State University has recently hired you to suggest situations where the problem may arise. Share one of your "findings" with the class and suggest ways the parties involved may prevent/reduce this hold-up situation.

Answer 1

The hold up problem is a situation where to 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 thus reduce their own profits.

The hold-up problem is central to the theory of incomplete contracts, The hold up problem results from situations where it is diffcult to write complete contracts. 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.  

The one of the main prevention method for the underinvestment problem due to the hold-up problem is, if parties are able to write a simple option contracts. Renegotiation and experimentation reduces the effectiveness of the option contract.