The Hold-Up Problem

The essential elements of "the hold up problem" can be illustrated with the following example. A builder constructs a house on land it does not own, but only leases short term. Perhaps the builder believes it has an understanding with the landowner on the future purchase price of the land. However, after the initial land lease expires, the landowner violates the intent of the contractual understanding by threatening to raise the land rent unless the builder agrees to buy the land at an exorbitant price. This simple example illuminates the three factors necessary for the occurrence of a hold up.First of all, the builder's investment must be specific to the particular piece of land. If the house were built on wheels and it were costless to move it to another piece of land, a hold up could not take place. The landowner could not threaten to increase the sale price of the land after the builder made its investment because the builder's entire investment would be costlessly transferable. More generally, if some element of the builder's investment were specific to the particular piece of land and hence non-salvageable, this element would be the maximum amount by which the landowner could increase the price of the land.Secondly, the contract governing the relationship between the landowner and house builder must be incomplete. In this case the land lease did not cover future years. If the land lease had fixed the rent for all future years, the landowner could not engage in this particular hold up.Thirdly, the landowner must find it profitable to engage in a hold-up. Although the presence of an incomplete contract and of specific investments creates an opportunity for the landowner to hold up the builder, the landowner may decide not to take advantage of this opportunity if doing so entails additional costs. For example, the landowner may be planning to transact with the builder in the future. As a result, engaging in a hold-up would jeopardize the landowner's future relationship with the builder and thereby lead to lost expected future profits. A hold up occurs only when a transactor, taking these future effects into account, decides it is wealth-maximizing to take advantage of contractual incompleteness to expropriate the rents on the specific investments made by its transacting partner. Each of these three factors, specific investments, incomplete contracts and the conditions of wealth maximization, are now discussed in turn.