Relationship specific investment refers to assets whose value depends on a particular buyer-seller relationship, making the investments less valuable outside of that relationship. This phenomenon is particularly relevant in hold-up problems between firms. Hold-up problems arise when one party makes an investment specific to its trading partner before contract terms are set, leaving it vulnerable to exploitation. Relationship specific investments are crucial in such scenarios as they create dependencies and bargaining power imbalances. This article will examine the importance of relationship specific investments in hold-up problems through concepts like asset specificity, incomplete contracts, and ex-post bargaining power. By understanding these dynamics, firms can design better strategies and contracts to manage hold-up risks from relationship specific investments.
Asset specificity increases dependence and lock-in effects
Relationship specific investments create asset specificity, which refers to assets that have significantly lower value when deployed outside a particular relationship. For example, a manufacturer investing in custom machinery that can only produce parts for one specific customer faces asset specificity. This specialized asset has low value for other purposes, locking the manufacturer into that customer relationship. The higher the asset specificity, the more the investing firm depends on its partner to profit from the investment. This dependence gives the trading partner power during ex-post bargaining. The investing firm cannot easily walk away or find other buyers without incurring a big loss on its relationship specific investment.
Incomplete contracting leaves firms vulnerable to hold-up
Complete, contingent contracts covering all future scenarios are often impractical. Complex relationship specific investments take place under conditions of contractual incompleteness. The investing firm cannot specify terms for all possible contingencies down the line. This inability to write complete contracts ex-ante makes firms vulnerable to hold-up ex-post. After relationship specific investments are sunk, the trading partner can exploit dependencies to negotiate more favorable terms like lower prices. The investing firm earns low returns on investments that cannot be easily redeployed outside the relationship. Advanced contractual designs like option contracts can partially address this hold-up problem.
Relationship investments shift bargaining power to partners
Relationship specific investments hand over bargaining power to trading partners in ex-post negotiations. Since the investor faces switching costs and lower outside options, the partner can make aggressive asks without fear of dissolving the relationship. Knowing this, the investing firm earns low returns on such capital expenditures. This acts as a disincentive to invest in specialized assets in the first place. Businesses must weigh the efficiency benefits of relationship specific investments against the cost of ceding power to partners. Ownership and control rights over assets can somewhat redress bargaining power imbalances arising from relationship investments.
Careful contracting needed to protect relationship investments
Firms making relationship specific investments must take steps to protect their interests against hold-up hazards. Long-term contracts, financial hostages, information disclosure, and staged investments are some strategies to prevent underinvestment. Contracts can specify buyout prices, grant oversight rights, and institute revenue sharing rules. However, too much rigidity also undermines efficiency benefits. Ultimately, businesses must judge each context and strike the right balance between safeguarding relationship specific investments and preserving flexibility.
Relationship specific investments create dependencies and bargaining power shifts that leave the investing firm vulnerable to hold-up problems with incomplete contracting. By appreciating concepts like asset specificity and ex-post negotiations, businesses can better manage the risks from relationship specific investments.