Economic Classroom Experiments/Hold-Up Problem

A buyer is unwilling to make an investment that would be useful only in conjunction with a single supplier because of a fear that the supplier will demand a share of the profits from the investment.

Level
Any level

Prerequisite knowledge
None

Suitable modules
Any

Intended learning outcomes

 * 1) Origin of the hold-up problem.
 * 2) Vertical integration as a solution to the hold-up problem.

Computerized Version
There is a computerized version of this experiment available on the Exeter games site.

You may find the sample instructions helpful. There are also extended form diagrams for the [[media:HoldUpPart1Payoffs.jpg|Part 1 payoffs]] and [[media:HoldUpPart2Payoffs.jpg|Part 2 payoffs]].

Abstract
Students play together in pairs as a buyer and a supplier who are engaged in an ongoing business relationship. The buyer has an opportunity to invest in some specialist equipment that will increase his/her profits but only if the relationship continues with the same supplier. If the investment is made, the supplier, in turn, has an opportunity to take a share of the increased profits by raising his/her prices. If the supplier raises prices, the buyer can either accept the situation or change suppliers but the latter action damages both parties: the buyer has made a wasted investment and the supplier loses the buyer's business.

The hold-up problem arises when the buyer is reluctant to make the investment because of a fear that the supplier will exploit the extra bargaining power.

Discussion of Likely Results
If the investment is not made, the utility payoffs are 0 to both buyer and supplier. If the buyer makes an investment of V and gains increased profits of P, the payoffs are P-V to the buyer and 0 to the supplier, provided the supplier does not raise prices. If the supplier raises prices by R, the payoffs are now P-V-R to the buyer and R to the supplier, provided the buyer does not change suppliers. If the buyer changes suppliers, the payoffs are -V to the buyer and -B to the supplier, where B is an amount reflecting the loss of business.

Students play two consecutive games which differ only in the cost to the buyer of the investment. In both games, P is £1500, R is £750 and B is £1000. In the first game V is £500 whereas in the second game it is £1000. In the first game, if the buyer makes the investment and allows the supplier to raise prices, both parties benefit, with payoffs of £250 to the buyer and £750 to the supplier. In the second game in the same scenario, the payoff to the buyer is £-250, so the buyer should not make the investment.