The pre contractual and post contractual issues leading to hold up
1. AIM/OBJECTIVE
The purpose of this paper is to examining the concepts of hold-up and how power plays an important role in how the problem of hold-up is resolved. And also look at possible strategies or solutions for the buying organisation to avoid hold-up.
2. METHODOLOGY
This paper will examine the work of Klein and Chang & Ive in answering the concept of hold-up in the supply chain and also will examine the pre-contractual and post-contractual issues leading to hold-up. The first part of the assignment looks at how concept of incomplete contracts led to problem of hold-up in case of the General Motors and the Fisher’s case.
In the second part of the assignment, is about how other factors like asset specificity and lock-in leads to hold-up problems post contractual in reference with the construction projects. Also look at the case of hold-up in the IT industry in regard to the Flash – Apple clash.
And finally critically evaluating the different cases and conclude by deriving a strategy or mechanism in avoiding or minimising the risk of hold-up’s for buying organisations.
3. INTRODUCTION
Hold-up is a situation where there are two parties (say, buyer and supplier) and one party has to make specific investments for the trade. If the investment is specific only to that customer, then the supplier is vulnerable to hold-up and on the visa-versa, if the product designed is specific to the raw material possessed by the supplier then the buyer is bound to have higher risk of hold-up (Klien, 1996). The party with the higher power seeks to achieve the quasi-rents [1] . Hold-up on the transactions cost economics is the problem of short-sightedness.
Hold-ups can occur under various situations both pre-contractually and post-contractually. As explained by Williamson (Williamson, 1985), it could be Opportunistic behaviour of supplier pre-contractually or Klein’s theory of uncertainty in the market condition or the issue of moral hazard or bad behaviour by the buyer that leads to the hold-up situation.
As explained by Klein, “the buyer/supplier conflict can be due to unanticipated events that occur during their contractual term; like reduced/increased cost or demand, which clearly puts one party with the higher bargaining power and thus changing the power dynamics in the relationship. The party with the higher power tries to breach the contract or be opportunistic in order to achieve 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 issue of hold-up. People are boundedly rational and having a myopic view is a problem. Klein looks at the role of contracts in solving the problem of hold-up and says the assessment of self-enforcing range of the contract and a better written contract can avoid the situation.
“The ways of solving or taking into account the problem of hold-up has been in the core of transaction cost economics. There have been occasions where both parties know that there is a possibility in hold-up in future but considering the cost and time involved in defining each and every contingency in the contract is not feasible” (Fares, 2006).
Below I will be discussing a few cases where hold-up was evident and what corrective actions were taken under different circumstances.
4. HOLD – UP: CASE ANALYSIS
There have been numerous cases of hold-up discussed in the transaction cost economics and the one that is most spoken about is the General-Motor and the Fisher’s Case. In this assignment, I will be discussing three different cases focusing on contractual issues, moral hazard, asset specificity and the issues with time in Hold-up.
4.1 General Motor & Fisher’s Case of Incomplete Contracts [2]
“This has been the most spoke about case in economics in relation to the issue of hold-up. In a nutshell, it is a case where both parties signed a contract in 1919 for the supply of automobile bodies by Fisher to General Motors. Fisher, the manufacturer or supplier in this case had to make specific investments in stamping machines and dies for General Motors. This was a long term contract(over a ten year period) and also General Motors set a price formula, Fisher’s Variable cost plus 17.5%(to cover the capital and overheads). Ideally General Motors(henceforth GM) designed the contract in such a way that they can create a hold-up over Fisher. GM had even threatened to reduce the demand if Fisher did not come down on price, which would mean that the investment made by Fisher would not be efficiently used.
But what really happened was not expected by both the parties. Up till 1919, most of the cars had wooden bodies but there was a huge rise in demand for steal body cars in 1919 which lead to a huge rise in demand for Fisher’s products. GM had no other supplier to replace with and even doing so would lead to a high switching cost. This could also be a problem of myopic view by GM, who view the price in a long term perspective and ignored the market potential/demand. The unanticipated increase in demand gave Fisher the upper hand and used the contractual terms to its strength in attaining the quasi-rents. They moved farther from GM location and created the extra-income through the formula set by GM in price determination. Fisher found that the contract was over the self-enforcing range and was in a favourable position for it to profit out off the contract if it breaches the contract. This provided as an incentive to Fisher.
Both the parties new that the contract was not completely perfect and believed that the contact was optimal designed to minimize the probability of hold-up. GM had only two options available to resolve the problem, first to terminate the contract and find a new supplier. This would mean that the huge market demand cannot be satisfied and the switching cost becomes very high. The second being, renegotiating with Fisher and provide a lump sum payment to keep the contract running. Without question, GM had to settle for the option two as the time span was very limited and GM did not have much of an option in suppliers then. Thus the problem of imperfect or incomplete contracting leading to hold-up is evident in this case.
In this case, to prevent the ex-poste problem of contracting, GM should have had the farsightedness view towards contract and defined a contingency plan in case there is a drastic change in the market condition to renegotiate the contract and derive at a new price. This could have saved quite a lot of time and resources. It should not be just from the price point view but should be a holistic view of the contract. They should have defined the self-enforcing range so that they need not be amended frequently. They were right in defining the power relation pre-contractually but underestimated on the post-contractual drift in power. Also GM should have had better incentive plans in place so that the supplier does not think about breaching certain incompleteness of the contract” (Klien, 1996).
Asset / Process Specificity & Lock-In Situation In Construction Projects [3]
The second is a case with multiple levels of hold-up ranging from small to large in the money involved in the dispute. This is a case in the construction project with three different parameters (uncertainty/unanticipated events in the project, lock-in situation and the amount of money involved in the dispute) of hold-ups identified. In the construction specific project a new form of asset specificity was identified, process specificity” (Chen-Yu Chang, 2007).
“The channel tunnel project is a build-own-operate-transfer project for creating a tunnel for railway network. Both the French and the British governments awarded the project to Eurotunnel, to build and operate the tunnel for 55 years(which after extension is 99 year project). Eurotunnel in-turn sublet the construction to a ten member consortium called Transmanche-Link [4] . The project was at the design stage when TML was assigned and the changes that they had to make in the project had to comply with safety rules of the intergovernmental commission” (Chen-Yu Chang, 2007).
The project started under huge pressure and Eurotunnel, gave out the project to TML under two contracts: “cost-plus contract for tunnelling and lump-sum contract for fitting out and terminals” (Chen-Yu Chang, 2007). Two events that 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 signing of the Anglo-French channel treaty delayed the start of the construction. Although the money under dispute was not a large sum at this stage TML had to go for an extension in the project time and there were no concessions made on the cost overruns.
The second round of dispute was on the cost overruns which were outstanding from the previous dispute. By this time both were in a lock-in situation as over ?850 million loan has been drawn out of the bank. Due to the delays caused earlier, there was a step rise in the cost which needed the contract to be re-valued and the new target cost for the project was set but TML had to bear a higher percentage of the cost overruns.
The third dispute was a large sum of money involved, where the requirements of intergovernmental commission and railway companies induced a huge rise in cost on the equipments. TML passed on this added cost to the contractor Eurotunnel. By this time Eurotunnel was in a lock-in situation with TML and had to settle for the needs of TML. Thus TML benefitted out of the incomplete long-term contract signed.
4.3 Flash – Apple War
“The third case is over property rights issue in IT industry. IT and Software industry is prone to hold-up problem. For example, developing an internet page/company basing it on a particular software firm/application which the company doesn’t have property rights is considered equivalent to building a house without owing the land. For any changes that have to be made on the internet, they need the original creator/vendor, which makes it dependant or held-up by the vendor.
Flash is a similar kind of software or platform, where the products built on Flash are at high risk of hold up. Because of this, flash is recently been targeted by firms like Apple and Google, in replacing them with a better source. Apple for its new product iPad, needed to make heavy investment in the ecosystem. Had it used Flash, Apple’s ability to achieve rents from the investment would have been held-up by Adobe. Flash is a more closed software and does not share exclusive information with its clients. This has been a hindrance to many firms and firms are looking for a much open source software and platforms to develop their products.
The issue in the IT sector could be minimized by making a clear contract stating the future maintenance and updating of the software and also define a period when the contract will be re-valued or re-negotiated” (Michael Schwartz, 2010).
5. CRITICAL EVALUATION
After looking at the three above cases some of the prevention measures that a buying organisation could adopt are as follows. It is not always possible for a buying organisations to adopt these is all the situations.
Figure 1: Contractual Process
The above picture depicts the process of contracting that the buyer could you to adopt to avoid or minimize the risk of hold-up in a relationship. The first step for the buyer is to decide on the investment and make a cost-benefit analysis of the investment. Some of the basic questions like is the investment really needed, is it worth entering into the relationship and most importantly before the investment decision is the analysis of the buyer-supplier power relationship.The buyer before entering into contract specific investment in relationship, has to assess the power dynamics and foresee the possibility of shift in power post investment. If it finds itself in a weaker position, certain contractual terms could be added to protect its profits out of the investment. Defining the relationship also clears the fear of buyer falling into a lock-in situation with the supplier. As Williamson says, buyers need to have the farsighted view on the contracts than signing a contract and taking care of the problem later, only to recognise that they have to settle for the second best option.
Then is the writing of contracts. As we have seen from the above case examples, it is clear that all the contingencies cannot be written down in the contract as identifying them is a lengthy process and is an expensive process too. To make an effective contract, we could use both Klein and Williamson’s concept in design a contract which has a self-enforcing range but also had the farsightedness view of the project and identifying opportunistic nature of the supplier. Also it is important at this stage to define the property rights of the product or the process that the supplier is making with the specific investment made. It is also important to define the incentives that the supplier gets for on-time completion of the project and within the budget fixed. This incentive should be made as an attractive offer to the supplier so that the risk of opportunistic behaviour by the supplier can be minimised.
The next step is that the supplier makes the investment and the buyer needs to overlook the spend so that they do not go excessive of the planned budget. The problem in conflicts and lock-in has in most occasion been due to the excessive spends and buyer had always been to have partially paid for the mistakes of the supplier because of the sunk cost or switching cost for the buyer if he had to change the supplier during conflict. The contract should be defined in such a way that over a specific period of time and cost, the contract will be re-opened for negotiations and a performance review been conducted on the supplier.
The fourth and fifth steps are in relation to the renegotiation of the contracts. During the contract stage, the time period of re-negotiation or re-evaluation of the product should also be defined. Even in a long-term contract when the price is fixed on certain parameters, it is better to re-examine the conditions after a few years or after certain unanticipated events like financial crisis or sudden rise in demand to keep a contractual balance and prevent one party from benefiting from the contract.
The final step is the payments for the trade and the buyer’s need to be careful here not to delay the payments as this could lead to conflict and the supplier taking arbitration actions to court. This could also lead to bad reputation and damage the image of the buyer in the market.
6. CONCLUSION
Again, Power relations play an important role for the buyer organisation in defining their contractual terms with the supplier. Power is the universal term in economics and failing to understand it could be costly for organisations. From the case evidence above it is clear that being over-optimistic in design the contracts have made some companies in losing their power post-contractually. Hold-ups are due to unexpected events or sometime a deliberate process due to the lack of time or resources available. There has been no specific method or tool to negate the hold-up issue and depending on the situation the actions are taken. But it is important for buyers to pre-empt the situation and be ready to tackle the situation.
Thus I conclude by saying that in real world all the situations are possible, information asymmetry, opportunistic behaviour supplier, moral hazard behaviour of buyers, lock-in situation, incomplete contracting and hold-ups are the evident result and one needs to craft a well designed contract to evade the situation.
They buyer’s need to keep in mind this statement of “why settle for a silver when you can go for the gold”
