The purpose of this newspaper is to examining the ideas of hold-up and how power performs an important role in how the problem of hold-up is fixed. And also look at possible strategies or solutions for the buying company to avoid hold-up.
This newspaper will examine the work of Klein and Chang & Ive in answering the idea of hold-up in the supply chain and also will study the pre-contractual and post-contractual issues leading to hold-up. The first area of the assignment talks about how idea of incomplete contracts led to problem of hold-up in case there is the overall Motors and the Fisher's case.
In the next area of the assignment, is about how other factors like property specificity and lock-in causes hold-up problems post contractual in reference point with the building projects. Also look at the case of hold-up in the IT industry in regards to the Display - Apple clash.
And finally critically analyzing the different instances and conclude by deriving a strategy or mechanism to avoid or minimising the chance of hold-up's for buying organisations.
Hold-up is a situation where there are two functions (say, buyer and company) and one get together must make specific purchases for the trade. In case the investment is specific and then that customer, then your supplier is vulnerable to hold-up and on the visa-versa, if the merchandise designed is specific to the natural material possessed by the dealer then the buyer is bound to have higher risk of hold-up (Klien, 1996). The party with the higher power seeks to attain the quasi-rents. Hold-up on the trades cost economics is the situation of short-sightedness.
Hold-ups may appear under various situations both pre-contractually and post-contractually. As described by Williamson (Williamson, 1985), maybe it's Opportunistic behavior of distributor pre-contractually or Klein's theory of uncertainty in the market condition or the problem of moral hazard or bad behaviour by the customer that leads to the hold-up situation.
As explained by Klein, "the buyer/supplier discord can be scheduled to unanticipated occurrences that occur during their contractual term; like reduced/increased cost or demand, which plainly puts one get together with the bigger bargaining power and so changing the power dynamics in the partnership. The party with the bigger power tries to breach the agreement or be opportunistic in order to attain the quasi-rents. " (Klien, 1996)
Williamson's concept of feasible foresight/farsightedness could be a possible solution for the buying organisations to avoid or negate the problem of hold-up. People are boundedly rational and developing a myopic view is a challenge. Klein looks at the role of agreements in solving the situation of hold-up and says the assessment of self-enforcing range of the contract and an improved written agreement can avoid the problem.
"The means of solving or considering the situation of hold-up has been around the primary of business deal cost economics. There have been situations where both functions know that there surely is a possibility in hold-up in future but considering the cost and time involved with defining every single contingency in the contract is not possible" (Fares, 2006).
Below I am talking about a few instances where hold-up was noticeable and what corrective actions were considered under different circumstances.
There have been numerous cases of hold-up mentioned in the transfer cost economics and the the one which is most discussed is the General-Motor and the Fisher's Circumstance. In this task, I will be discussing three different circumstances focusing on contractual issues, moral risk, asset specificity and the problems as time passes in Hold-up.
"It has been the most spoke about case in economics with regards to the issue of hold-up. The bottom line is, it is just a case where both functions signed a deal in 1919 for the way to obtain automobile systems by Fisher to Basic Motors. Fisher, the manufacturer or supplier in this case were required to make specific investment funds in stamping machines and dies for Standard Motors. This was a permanent contract(on the ten yr period) and also Basic Motors set a price formula, Fisher's Adjustable cost plus 17. 5%(to cover the administrative centre and overheads). Ideally Basic Motors(henceforth GM) designed the contract in such a way they can develop a hold-up over Fisher. GM possessed even threatened to reduce the demand if Fisher did not drop on price, which means that the investment made by Fisher wouldn't normally be proficiently used.
But what really occurred was not expected by both the parties. Up till 1919, almost all of the cars had wooden physiques but there was a huge surge in demand for steal body automobiles in 1919 which lead to a huge rise in demand for Fisher's products. GM got no other company to displace with and even doing this would lead to a higher switching cost. This may also be a issue of myopic view by GM, who view the purchase price in a permanent perspective and disregarded the market probable/demand. The unanticipated upsurge in demand gave Fisher the higher side and used the contractual conditions to its strength in achieving the quasi-rents. They relocated farther from GM location and created the extra-income through the formulation established by GM in cost determination. Fisher found that the deal was above the self-enforcing range and is at a favourable position for it to gain out off of the contract if it breaches the deal. This provided as an incentive to Fisher.
Both the get-togethers new that the contract had not been completely perfect and believed that the contact was ideal designed to minimize the probability of hold-up. GM had only two options available to resolve the challenge, first to terminate the agreement and find a fresh supplier. This might mean that the huge market demand can't be satisfied and the turning cost becomes high. The second being, renegotiating with Fisher and offer a lump amount payment to keep carefully the contract jogging. Without question, GM possessed to stay for the option two as the time span was very limited and GM didn't have much of an option in suppliers then. Thus the challenge of imperfect or incomplete contracting resulting in hold-up is apparent in this case.
In this circumstance, to avoid the ex-poste issue of contracting, GM should have got the farsightedness view towards contract and identified a contingency plan in case there's a drastic change on the market condition to renegotiate the deal and derive at a fresh price. This may have saved quite a lot of time and resources. It will not be just from the purchase price point view but should be considered a all natural view of the deal. They must have defined the self-enforcing range so that they do not need to be amended frequently. They were right in defining the power relationship pre-contractually but underestimated on the post-contractual drift in vitality. Also GM should have had better incentive plans in place so that the supplier does not think about breaching certain incompleteness of the agreement" (Klien, 1996).
The second is an instance with multiple levels of hold-up ranging from small to large in the money mixed up in dispute. This is a case in the development project with three different variables (uncertainty/unanticipated situations in the job, lock-in situation and the amount of money mixed up in dispute) of hold-ups determined. In the building specific project a fresh form of advantage specificity was revealed, process specificity" (Chen-Yu Chang, 2007).
"The route tunnel project is a build-own-operate-transfer job for creating a tunnel for railway network. Both French and the British governments honored the job to Eurotunnel, to construct and operate the tunnel for 55 years(which after expansion is 99 yr job). Eurotunnel in-turn sublet the building to a ten member consortium called Transmanche-Link. The job was at the design stage when TML was allocated and the changes that that they had to make in the job had to adhere to safety guidelines of the intergovernmental commission payment" (Chen-Yu Chang, 2007).
The project started under huge pressure and Eurotunnel, offered out the task to TML under two deals: "cost-plus contract for tunnelling and lump-sum contract for installing out and terminals" (Chen-Yu Chang, 2007). Two events which were ungovernable uncertainty that occurred in the first stage where, the conditions for the land, which TML expected it to be better but was in a much worse condition and the delays in putting your signature on of the Anglo-French channel treaty delayed the beginning of the structure. Although the amount of money under dispute had not been a large amount at this time TML were required to go for an extension in the task time and there were no concessions made on the cost overruns.
The second round of dispute was on the cost overruns that have been outstanding from the prior dispute. By this time around both were in a lock-in situation as over 850 million loan has been slow of the bank. Due to the delays caused earlier, there is a step go up in the cost which needed the agreement to be re-valued and the new focus on cost for the project was placed but TML were required to bear a higher percentage of the price overruns.
The third dispute was a sizable amount of cash involved, where in fact the requirements of intergovernmental commission rate and railway companies induced a huge rise in cost on the tools. TML offered this additional cost to the service provider Eurotunnel. By this time Eurotunnel was in a lock-in situation with TML and possessed to stay for the needs of TML. Thus TML benefitted out of the incomplete long-term deal signed.
"The 3rd case has ended property rights concern in IT industry. IT and Software industry is prone to hold-up problem. For example, developing an online site/company basing it on a specific software firm/application that your company does not have property rights is known as equivalent to creating a house without owing the land. For just about any changes that have to be made on the internet, they want the original inventor/vendor, which makes it dependant or held-up by owner.
Flash is an identical kind of software or program, where in fact the products built on Display are at risky of endure. As a result of this, flash is recently been targeted by firms like Apple and Yahoo, in updating them with a much better source. Apple because of its new product iPad, had a need to make heavy investment in the ecosystem. Possessed it used Flash, Apple's ability to achieve rents from the investment would have been held-up by Adobe. Flash is a more sealed software and will not discuss exclusive information with its clients. It has been a hindrance to many firms and firms are looking for a much start source software and websites to build up their products.
The concern in the IT sector could be reduced by making an obvious contract stating the near future maintenance and upgrading of the software and also define an interval when the agreement will be re-valued or re-negotiated" (Michael Schwartz, 2010).
After taking a look at the three above conditions some of the prevention options a buying organisation could adopt are the following. It isn't always possible for a buying organisations to adopt these is all the situations.
Figure 1: Contractual Process
The above picture depicts the procedure of contracting that the buyer could you to look at to avoid or minimize the risk of hold-up in a relationship. The first rung on the ladder for the customer is to decide on the investment and make a cost-benefit evaluation of the investment. Some of the basic questions like is the investment really needed, is it worth getting into the relationship & most importantly prior to the investment decision is the analysis of the buyer-supplier electricity relationship. The customer before getting into deal specific investment in romance, has to examine the power dynamics and foresee the possibility of transfer in power post investment. If it discovers itself in a weaker position, certain contractual terms could be put into protect its revenue from the investment. Defining the relationship also clears the fear of buyer dropping into a lock-in situation with the company. As Williamson says, purchasers need to have the farsighted take on the agreements than putting your signature on a deal and taking care of the challenge later, and then recognise that they have to settle for the next most suitable choice.
Then is the writing of contracts. As we've seen from the above circumstance illustrations, it is clear that all the contingencies can't be on paper in the contract as identifying them is an extended process and can be an expensive process too. To make an effective agreement, we're able to use both Klein and Williamson's concept in design a agreement that includes a self-enforcing range but also possessed the farsightedness view of the job and identifying opportunistic characteristics of the company. And yes it is important at this time to define the house rights of the merchandise or the procedure that the distributor is making with the specific investment made. It is also important to identify the bonuses that the dealer gets for on-time conclusion of the job and within the budget fixed. This incentive should be made as a nice-looking offer to the company so the threat of opportunistic behavior by the supplier can be minimised.
The next thing is usually that the distributor makes the investment and the customer needs to forget the spend in order that they do not go increased of the planned budget. The situation in conflicts and lock-in has generally in most occasion been because of the excessive spends and buyer possessed always been to get partially payed for the problems of the distributor as a result of sunk cost or switching cost for the buyer if he previously to change the dealer during conflict. The agreement should be defined in such a way that over a specific period of time and cost, the deal will be re-opened for negotiations and a performance review been conducted on the dealer.
The fourth and fifth steps are with regards to the renegotiation of the contracts. During the agreement stage, the period of time of re-negotiation or re-evaluation of the merchandise should also be described. Even in a long-term agreement when the price is set on certain parameters, it is better to re-examine the conditions over time or after certain unanticipated incidents like financial meltdown or sudden climb popular to keep a contractual balance and stop one party from benefiting from the deal.
The last step is the obligations for the trade and the buyer's need to be careful here not to delay the obligations as this may lead to issue and the supplier taking arbitration actions to court. This could also lead to bad reputation and destruction the image of the customer on the market.
Again, Power relationships play an important role for the buyer organisation in determining their contractual terms with the dealer. Vitality is the universal term in economics and failing woefully to understand it could be costly for organisations. From your case information above it is clear that being over-optimistic in design the deals have made some companies in burning off their vitality post-contractually. Hold-ups are credited to unexpected incidents or sometime a deliberate process due to the insufficient time or resources available. There has been no specific method or tool to negate the hold-up issue and depending on the situation the activities are taken. Nonetheless it is very important to buyers to pre-empt the situation and be ready to tackle the situation.
Thus I conclude by expressing that in real life all the situations are possible, information asymmetry, opportunistic behavior supplier, moral hazard behaviour of buyers, lock-in situation, imperfect contracting and hold-ups are the evident final result and one needs to craft a well designed deal to evade the situation.
They buyer's need to keep in mind this assertion of "why accept a silver when you can go for the gold"