Essays on the Holdup Problem and on the Value of Legal Advice

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This project will investigate the implication of the holdup problem in a dynamic environment. The holdup problem exists when an economic agent makes specific investments, such as workers' acquiring firm-specific skills, or business partners adapting their product lines and processes to the needs of their partners. Parties making such investments are often at the risk of expropriation by their partners since these investments are worth little without their partners. Protecting the investors from the risk of holdup has been a prominent rationale for various organization and contractual arrangements, including vertical integration, reorganization of asset ownership. Most of these theories rest on a very static assumption about the investments, which is often unrealistic. The current project reexamines the holdup problem with a model that permits a more realistic investment dynamics. The research so far reveals that, in many plausible circumstances, the holdup problem need not entail inefficiencies, thus calling into question the reliance on the holdup problem as a rationale for contracts and organizations. In other cases, inefficiencies would result from the holdup problem, but organizational responses necessary to alleviate inefficiencies differ markedly from those prescribed by the existing theories. The project will thus investigate organizational/contractual treatment of inefficiencies, and will in the process explore implications on such long-standing issues as the role of asset ownership in the performance of firms, the effect of exclusivity agreements and other trade contracts in protecting specific investments, and the optimal legal rule for protecting entitlements and compensating their breach (i.e., the issue of the liability rule vs. the property rule).