"In economics, the hold-up problem is a situation where two parties (such as a supplier and a manufacturer) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.
For example: Imagine a scenario where profit can 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 occurs when X might not be willing to accept that agreement, even though the outcome would be Pareto efficient, because after X buys the necessary equipment, Y would have bargaining power and might decide to demand a larger proportion of the profits than before. The source of Y's power lies in X's investment. Since X is now deeply invested in the project, but Y is not, X stands to lose money, should the deal not be completed, but Y has no such risk. Thus, Y has some bargaining power that did not exist before X's investment. In the extreme, Y could demand 100% of the profits, if X's only alternative is to lose the initial investment entirely.
One way to avoid the hold-up problem is for the firms to merge, a tactic known as vertical integration, or to enter vertical agreements, e.g. an agreement with a non-compete clause."
Discuss (Austrian analysis, sources on it, solutions etc.)
Make the contract in advance. Problem solved.
Also interesting:
http://mises.org/rothbard/mes/chap5b.asp#9._Pricing_Theory_Bargaining
9. Pricing and the Theory of Bargaining
We have seen that, for all goods, total receipts to sellers will tend to equal total payments to factors, and this equality will be established in the evenly rotating economy. In the ERE, inter est income will be earned at the same uniform rate by capitalists throughout the economy. The remainder of income from produc tion and sale to consumers will be earned by the owners of the original factors: land and labor.
Our next task will be to analyze the determination of the prices of factor services and the determination of the interest rate, as they tend to be approached in the economy and would be reached in the ERE. Until now, discussion has centered on the capital-goods structure, treated as ifit were in one composite stage of production. Clearly, there are numerous stages, but we have seen above that earnings in production ultimately resolve themselves, and certainly do so in the ERE, into the earnings of the original factors: land and labor. Later on, we shall expand the analysis to include the case of many stages in the production process, and we shall defend this type of temporal analysis of production against the very fashionable current view that production is “timeless” under modern conditions and that the original-factor analysis might have been useful for the primitive era but not for a modern economy. As a corollary to this, we shall develop further an analy sis of the nature of capital and time in the production process.
What will be the process of pricing productive factors in a world of purely specific factors? We have been assuming that only services and not whole goods can be acquired. In the case of labor this is true because of the nature of the free society; in the case of land and capital goods, we are assuming that the capi talist product-owners hire or rent rather than own any of the productive factors outright. In our example above, the 95 ounces went to all the factor-owners jointly. By whatprinciples can we determine how the joint income is allocated to the various indi vidual factor services? If all the factors are purely specific, we can resort to what is usually called the theory of bargaining. We are in a very analogous situation to the two-person barter of chapter 2. For what we have is not relatively determinate prices, or proportions, but exchange ratios with wide zones between the “marginal pairs” of prices. The maximum price of one is widely separated from the minimum price of the other.
In the present case, we have, say, 12 labor and land factors, each of which is indispensable to the production of the good. None of the factors, furthermore, can be used anywhere else, in any other line of production. The question for these factor-owners to solve is the proportionate share of each in the total joint in come. Each factor-owner’s maximum goal is something slightly less than 100 percent of the income from the consumers. What the final decision will be cannot be indicated by praxeology. There is, for all practical purposes, no theory of bargaining; all that can be said is that since the owner of each factor wants to participate and earn some income, all will most likely arrive at some sort of voluntary contractual arrangement. This will be a formal type of partnership agreement if the factors jointly own the product; or it will be the implicit result if a pure capitalist purchases the services of the factors.
Economists have always been very unhappy about bargaining situations of this kind, since economic analysis is estopped from saying anything more of note. We must not pursue the temptation, however, to condemn such situations as in some way “ex ploitative” or bad, and thereby convert barrenness for economic analysis into tragedy for the economy. Whatever agreement is arrived at by the various individuals will be beneficial to every one of them; otherwise, he would not have so agreed.[27]
It is generally assumed that, in the jockeying for proportionate shares, labor factors have less “bargaining power” than land fac tors. The only meaning that can be seen in the term “bargaining power” here is that some factor-owners might have minimum reservation prices for their factors, below which they would not be entered in production. In that case, these factors would at leasthave to receive the minimum, while factors with no minimum, with no reservation price, would work even at an income of only slightly more than zero. Now it should be evident that the owner of every labor factor has some minimum selling price, a price below which he will not work. In our case, where we are assuming (as we shall see, quite unrealistically) that every factor is specific, it is true that no laborer would be able to earn a return in any other type of work. But he could always enjoy leisure, and this sets a minimum supply price for labor service. On the other hand, the use of land sacrifices no leisure. Except in rare cases where the owner enjoys a valuable esthetic pleasure from contemplating a stretch of his own land not in use, there is no revenue that the land can bring him except a monetary return in production. Therefore, land has no reservation price, and the landowner would have to accept a return of almost zero rather than allow his land to be idle. The bargaining power of the owner of labor, therefore, is almost always superior to that of the owner of land.
In the real world, labor, as will be seen below, is uniquely the nonspecific factor, so that the theory of bargaining could never apply to labor incomes.[28]
Thus, when two or more factors are specific to a given line of production, there is nothing that economic analysis can say further about the allocation of the joint income from their prod uct; it is a matter of voluntary bargaining between them. Bar gaining and indeterminate pricing also take place even between two or more nonspecific factors in the rare case where the pro portions in which these factors must be used are identical in each employment. In such cases, also, there is no determinate pricing for any of the factors separately, and the result must be settled by mutual bargaining.
Suppose, for example, that a certain machine, containing two necessary parts, can be used in several fields of production. The two parts, however, must always be combined in use in a certain fixed proportion. Suppose that two (or more) individuals owned these two parts, i.e., two different individuals produced the differ ent parts by their labor and land. The combined machine will be sold to, or used in, that line of production where it will yield the highest monetary income. But the price that will be estab lished for that machine will necessarily be a cumulative price so far as the two factors—the two parts—are concerned. The price of each part and the allocation of the income to the two owners must be decided by a process of bargaining. Economics cannot here determine separate prices. This is true because the propor tions between the two are always the same, even though the combined product can be used in several different ways.[29]
Not only is bargaining theory rarely applicable in the real world, but zones of indeterminacy between valuations, and there fore zones of indeterminacy in pricing, tend to dwindle radically in importance as the economy evolves from barter to an advanced monetary economy. The greater the number and variety of goods available, and the greater the number of people with differing valuations, the more negligible will zones of indeterminacy be come.[30]
At this point, we may introduce another rare, explicitly empirical, element into our discussion: that on this earth, labor has been a far scarcer factor than land. As in the case of Crusoe, so in the case of a modern economy, men have been able to choose which land to use in various occupations, and which to leave idle, and have found themselves with idle “no-rent” land, i.e., land yield ing no income. Of course, as an economy advances, and popula tion and utilization of resources grow, there is a tendency for this superfluity of land to diminish (barring discoveries of new, fertile lands).
The state is not the enemy. The idea of the state is.
How about X enters into a binding contract with Y before he buys the equipment? A clause would stipulate penalties for Y if it later reneges on the terms. X uses the penalties to recoup its investment. Incentives aligned, everyone happy.
If this is a problem, then you've got yourself a much larger problem. Taken to the extreme, this "problem" gets to the core of every exchange. X agrees to trade his apple for Y's orange. X hands the apple first. "Since X is now deeply invested in the project, but Y is not, X stands to lose money, should the deal not be completed, but Y has no such risk. Thus, Y has some bargaining power that did not exist before X's investment. In the extreme, Y could demand 100% of the profits, if X's only alternative is to lose the initial investment entirely."
[EDIT: Previous post appeared as I was writing mine. Sorry for the repeat answer.]
Z.