Academic journal article Economic Inquiry

Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships

Academic journal article Economic Inquiry

Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships

Article excerpt

One of my most enjoyable intellectual experiences was working with Armen Alchian on the Klein, Crawford and Alchian [1978] hold-up paper. In this paper I extend the basic framework presented in that paper, pointing out what I now consider to be its shortcomings and providing insights into the nature of hold-ups and the form of contracts chosen by transactors to avoid hold-ups. The major analytical extension entails combining hold-up analysis with my work on private enforcement. Because private enforcement capital is limited and written contract terms are necessarily imperfect, transactors must optimally combine court-enforced written terms together with privately enforced unwritten terms to define what I call the self-enforcing range of their contractual relationship. Hold-ups occur when unanticipated events place the contractual relationship outside the self-enforcing range. This probabilistic framework, where transactors enter contractual relationships knowing that a hold-up may take place (but believing that the expected gains from trade outweigh the expected rent-dissipating costs associated with the hold-up risk), is shown to have important implications for understanding the structure of contracts adopted by transactors in the marketplace.

I. WHY DO HOLD-UPS OCCUR?

I begin with a simple example that illustrates the basic economic forces involved in a hold-up. Assume that a builder constructs a house on a piece of land the builder does not own but, rather, only leases short-term. After the initial land lease expires, the landowner could hold up the builder by raising the land rent to reflect the costs of moving the house to another lot. This example illustrates all the hold-up factors emphasized in Klein, Crawford and Alchian - (a) the builder has made an investment that is highly specific to a particular piece of land and (b) the landowner has taken advantage of the incompleteness of the contract that governs the relationship (in particular, the fact that the lease does not cover future years) to (c) expropriate the quasi-rents on the builder's specific investment. The obvious question is why anything like this would ever occur; that is, why would someone be so naive as to build a house on land for which they had only a short-term lease?

Our primary goal in Klein, Crawford and Alchian was not to explain the existence of hold-ups, but rather the institutions adopted by transactors to avoid hold-ups. For example, we would expect that builders, anticipating a potential hold-up problem, would decide to purchase the land or at least to sign a long-term ground lease before starting construction. However, we do present some examples in the paper of hold-ups that actually occurred. The implicit reason we give for the occurrence of these hold-ups is transactor ignorance. Apparently, transactors are not always smart enough to choose the contractual arrangement that would eliminate the hold-up problem.

Oliver Williamson provides a similar, but much more explicit answer to the question of why hold-ups occur. When defining "opportunism" he states:

By opportunism I mean self-interest seeking with guile. This includes but is scarcely limited to more blatant forms, such as lying, stealing and cheating. Opportunism more often involves subtle forms of deceit. ...More generally, opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, obfuscate, or otherwise confuse.(1)

For example, the hold-up may have occurred in our illustrative house construction example because the landowner deceived the builder with a low up-front land rental price and vague promises about the future.

Relying on the ability of one transactor to take advantage of the naivete or ignorance of another transactor is a highly unsatisfactory way to explain the incidence of hold-ups. Simple examples of deception, such as a builder constructing a house on land that is only rented short-term, rarely, if ever, occur. …

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