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Hold-up, Asset Ownership, and Reference Points

By Harvard Law School Program on Corporate Governance

On March 17, I presented my paper titled Hold-up, Asset Ownership, and Reference Points in the Law, Economics, and Organization Seminar here at the Law School.

This paper studies two parties who desire a smooth trading relationship under conditions of value and cost uncertainty. The existing literature in this area has found that trading relationships become problematic in situations where the gains from trade are unevenly divided under an existing contract. Under these situations, one party will engage in costly opportunistic or non-cooperative behavior in order to renege on or renegotiate the contract. However, the existing literature does not explain why the parties cannot negotiate around the costs of opportunism.

I show that there is a range of self-enforcing prices, which depend on the state of the world, such that, if the long-term contract price lies in this range, hold-up is avoided; while if it lies outside this range hold up occurs. Under this formulation, a contract fixing price works well in normal times since there is nothing to argue about. However, when value or cost is exceptional, one party will deviate from the contract and hold up the other party, causing deadweight losses as parties withhold cooperation. I show that contract indexation can help by making it more likely that price remains within the ?self-enforcing? range. In addition, a judicious allocation of asset ownership increases efficiency to the extent that it raises the correlation between parties? outside options and their value inside the relationship, since this reduces the likelihood of hold-up.

In contrast to much of the literature, the driving force in this model is payoff uncertainty rather than non-contractible investments. One notable benefit of the approach used in this paper is that I am able to formalize hold-up costs by introducing behavioral features. The analysis provides useful insights into the empirical contracting and the vertical integration literature.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on March 26, 2008 (boomark / email).