The Effect Of Partial Ownership On Hold-up Problem

As the central problem of incomplete contracting theory, the hold-up problem has always drawn much intention of economists. Due to the uncertainty, bounded rationality, information asymmetry and many other factors, the two transacting parties are not able to consider all the events that could happen in the future. Even they could, it is not reasonable or much too expensive to write down all these events and their solutions in the contract. Therefore, the contract is always incomplete, which creates room for renegotiation. For example, one party may take advantage of the flaws or rigidity of the contract and refuse to follow the items or explain them in another way in order to get more rent to maximize his own profit.One of the reasons that hold-up problem happens in the economic activities is asset specificity. If one party makes the relationship-specific investment, then the value of alternative use is significantly low or even worthless. In that situation, once the investment is sunk and the two transacting parties are locked-in to a bilateral relationship, the hold-up problem is very likely to happen. After observing his partner’s investment, other party may find excuses to ask for renegotiating the contract like reducing the price or changing the quantity or delaying delivery time. It is hard for the seller to prevent this kind of opportunistic behavior because for him it is better to keep the contract than to terminate it given the cost of the specific investment and the high quasi rent.Considering this, the investor tends to reduce the investment in order to partly alleviate the hold-up problem and reduce his own loss. However, this solution will bring inefficient investment problem caused by hold-up.As for this problem, this paper analyzes the effect of partial ownership on hold-up problem and the internal reasons. The objective of this paper is to see whether or not the partial ownership could solve or alleviate the hold-up problem.I build a model with one upstream firm and one downstream firm. The upstream firm makes specific-relationship investment for the downstream firm. Three different cases are considered in which the upstream firm has different percentage of ownership in the seller. Using the socially optimal investment level as a benchmark, I compare the three different results to find out whether or not partial ownership can be a remedy for hold-up problem. When the buyer and the seller are two separate firms, there exists underinvestment problem because it has to share part of the revenue with his partner.When the buyer has partial ownership of the sellers but he is not able to control the seller, it turns out that the underinvestment problem can be alleviated. Besides, as the level of partial ownership increases, the investment the upstream firm makes increases as well.At last, when the percentage of the partial ownership is high enough to allow the buyer to control the seller, then the underinvestment problem occurs again. However, it is necessary to distinguish the reason of under-investment in the first two cases from that in the third case. The situation in the third case is very different. When partial ownership comes with control right, the hold-up problem transfers to the principal-agent problem. The downstream firm will give the upstream firm a transfer in order to induce him to invest in the downstream firm’s interest. However, the downstream firm is not willing to pay a very high rent to the upstream firm, i.e. much incentive to invest. This leads to the underinvestment. Additionally, since now the downstream firm owns most part of the upstream firm, it also reduce his incentives to encourage the upstream firm because the more the upstream firm invests, the more the downstream firm will cover the cost.