Hold-up problem

The hold up problem is a term used in economics to describe a situation where two parties (such as a supplier and a manufacturer) may be able to work most efficiently together, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and reduce their own profits.

For example: Imagine a scenario where there is profit to be made if agents X and Y work together, so they form an agreement to do so after X buys the necessary equipment. The hold-up problem is X might not be willing to take that agreement, even though the outcome would be Pareto efficient, because after A has made that investment, Y would have the power might decide to demand a larger proportion of the profits than before, since X is now deeply invested in the project but Y is not, so Y has some bargaining power that was not there before the investment. Y could potentially demand all of the profits, if X's alternative is to lose the investment entirely.

One way to avoid the hold up problem is for the firms to merge, normally this is known as vertical integration.

See also

• Specific asset
• Vertical monopoly

Reference

• Luis M. B. Cabral: Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000.