Question

2 Hold-up problem

Assume that an Indian firm is contacted by a multinational car company to produce brake systems. This requires an initial specific investment of I from the Indian sub- contractor and a variable cost c per braking system. The car company plans to buy n braking systems from the subcontractor at price p per braking system.

a. Looking from now, at what price, p = p0, the Indian subcontractor would break even?

b. Once the specific investment is made, at what minimum price, p1, that the Indian subcontractor will just be willing to produce the braking systems?

c. Which price is higher, p0 or p1? What is their difference?

d. Understanding this potential situation, will the Indian subcontractor make the initial

investment?

e. The difference between p0 and p1 is a measure of the severity of the hold-up problem. If the initial investment increases, will the problem become more severe?

f. Consider an extreme case in which I = 0. Will there still be a hold-up problem?

g. Given some I > 0, will the variable cost, c, affect the severity of the hold-up problem?

h. What can you conclude from this exercise?

Answer 1

a) The breakeven price is one at which investment plus total variable cost is recovered (equal to) by revenue earned. Therefore,

p0*n = I + n*c

p0 = (I + n*c)/n

b) Once the investment is made, the minimum price p1 is equal to variable cost, c

c) p0 is higher, because p1 is just equal to variable cost, whereas at p1 both fixed investment and variable cost are recovered. their difference is

p0 - p1 = (I + n*c)/n - c = I/n   (investment divided by volume)

d) As long as price p is greater than p1, the Indian subcontractor would be willing to make the initial investment.

e) Yes, as the Initial investment increases, the problem becomes more severe, because the difference between p0 and p1 increases .

f) When I = 0, there is no hold up problem, because p0 = p1

g) Hold-up problem does not depend upon c, but on the initial investment and volume. So variable cost does not affect the severity of hold up problem.

h) We can conclude that Initial investment is a critical decision for a business, as determines the economic viability of business.