The Problem of the Hold Up Problem: Outside Options, Irreversible Investments and Entry Deterrence
Abstract: Standard literature on incomplete contracts has focused on the hold-up problem that arises in the absence of ex-post verifiability. Investment in specific assets may expose investors to the risk of opportunistic behaviour by contractual counterparts, who may impose a renegotiation of the terms contracted upon (the so-called hold-up problem). Under this framework, contractual parties maintain strong incentives to under-invest in asset specificity due to the risk of counterpart’s opportunistic behaviour, the potential quasi-rents which might be generated by specific investments are almost completely dissipated. In this paper we argue that the hold-up problem is rather weakly founded. While it is generally assumed that the opportunistic agent is always able to impose a take-it-or leave-it offer to counterpart, we argue that the threat of quitting the contract is far to be credible under standard assumptions. As long as exit is costly a rational opportunistic agent will always be specific to some extent to the contract and will never quit the relationship. As a result, in our view, hold-up is effective only when outside options are binding and opportunist’s quasi-rents are null. This implies in turn that the hold-up problem raises in context of asymmetric information over parties’ outside options. This conclusion sheds new lights over the informational setting surrounding incomplete contracts and the hold-up problem.