DP4688 Hold-Up Problems and Firm Formation

Author(s): Hans Gersbach , Hans Haller

Publication Date: October 2004

Keyword(s): hold-up problem , firm formation , reinvestment-proof equilibria , efficient firm structure

JEL(s): D20 , D60 , L20

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP4688.asp

Agents from a homogeneous population organize themselves into productive partnerships and are confronted with a hold-up problem when making relation-specific investments in those partnerships. The problem is mitigated if agents can leave a partnership in which they have invested, bear the costs yet forego the benefits of the investment, join another partnership, invest there anew, and appropriate the surplus created by the new investment. To capture the idea we introduce the notion of reinvestment-proof equilibria in which no agent has an incentive to reinvest or to change his investment in the current firm. We show that the presence of a small inefficient firm causes substantial efficiency gains in all larger firms.