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.

Overview

Level

Any level

Prerequisite knowledge

None

Suitable modules

Any

Intended learning outcomes

Origin of the hold-up problem.
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 Part 1 payoffs and 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.

	Topics in Economic Classroom Experiments

Auctions	Wallet Game Twenty-Pound Auction Private-Value Auctions

Markets	Pit Market

Public Economics	Public Goods Insurance

Industrial Organization	Bertrand Competition Network Externalities Price Discrimination Hold-Up Problem Lemons
Macroeconomics and Finance	Currency Attack Being Warren Buffett Call Options Bank Runs: Diamond Dybvig Model Money: Kiyotaki-Wright Model
Game Theory	Guessing Game Prisoner's dilemma Coordination game Chicken Battle of the sexes Stag hunt Matching pennies Ultimatum Game Rock, Paper, Scissors Dictator game Sports Draft
Individual Decisions	Search Monty Hall

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