Editing Hold-up problem (section)

== Principle ==
In a scenario where two risk-neutral parties S (supplier) and B (Buyer) can make profit by working together, it is efficient to work together as long as the buyers' valuation exceeds the sellers' costs (Schmitz, 2001). When the two parties could agree on a binding contract covering the whole period of the investment and anticipating all possible outcomes and providing protection for both parties in every situation that may arise at the time the investment is made, the parties would have enough confidence to make the investment, and both parties could enjoy high profits. Then, it can be assumed that there are no wealth constraints and there is no private information. According to the [[Coase theorem]], voluntary bargaining results in trade whenever it is efficient.<ref>Schmitz, P.W. (2001). The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory. ''Bulletin of Economic Research, 1''(53), 1-17. Retrieved from http://mpra.ub.uni-muenchen.de/12562/2/MPRA_paper_12562.pdf</ref> However, making such a contract is often not possible for these four reasons:

* Unforeseeable external factors
* Lack of trust
* Quality problems
* [[Asymmetric information]]

The initial contract can cover only short-term situations. Eventually, renegotiation is needed, which provides an opportunity for e.g. S to hold up B. As S knows that the investment is a significant cost to B and tries to use this as leverage to negotiate an increase in its prices. In that case, S has more bargaining power, compared to B, and tries to use it to its own advantage. The source of power lies in the investment of B. For B it is hard to find out whether or not the raise in prices is reasonable. In an extreme case, S could demand 100% of the profits if the only alternative to B is to lose the entire initial investment. Even if the outcome would be [[Pareto efficient]], B might not accept the agreement. If the renegotiations turn out to be unsuccessful both parties are worse off: B has made an investment that goes to waste, and S lost a customer.

Inefficiency is caused by the hold-up problem when B is reluctant to make the investment ex ante from the fear that S uses its extra bargaining power to its own advantage. In that case the supplier is 'holding up' the buyer.<ref>Balkenborg, D., Kaplan, T.R., & Miller, T. (2010). A simple economic teaching experiment on the hold-up problem. ''MPRA Paper No. 24772''. Retrieved from http://mpra.ub.uni-muenchen.de/24772/1/MPRA_paper_24772.pdf</ref>