Hold Up Problem

Topics: General Motors, Contract, Contractual term Pages: 53 (19239 words) Published: February 24, 2012
BENJAMIN KLEIN University of California, Los Angeles

After working well for more than 5 years, the Fisher Body–General Motors (GM) contract for the supply of automobile bodies broke down when GM’s demand for Fisher’s bodies unexpectedly increased dramatically. This pushed the imperfect contractual arrangement between the parties outside the self-enforcing range and led Fisher to take advantage of the fact that GM was contractually obligated to purchase bodies on a cost-plus basis. Fisher increased its short-term profit by failing to make the investments required by GM in a plant located near GM production facilities in Flint, Michigan. Vertical integration, with an associated side payment from GM to Fisher, was the way in which this contractual hold-up problem was solved. This examination of the Fisher-GM case illustrates the role of vertical integration in avoiding the rigidity costs of long-term contracts.

I. Introduction

damentally changed the way we look at economic institutions. Coase recognized that one must compare the costs of transacting to explain the boundaries of the firm. Without transaction costs, the organization of economic exchange is indeterminate. This forced economists to focus on the costs and benefits of transacting under alternative institutional arrangements. Benjamin Klein, Robert Crawford, and Armen Alchian expanded upon this insight by emphasizing the role of specific investments as a determinant of economic organization.2 The presence of transactor-specific investments, we claimed, created a potential hold-up problem that increased market contracting costs and, therefore, the incentive for vertical integration. Our analysis of the contractual relationship between Fisher Body and General Motors (GM) provided a concrete example of this mechanism. It illustrated the * Professor of Economics, University of California, Los Angeles. I am indebted to Ryan Sullivan and Joshua Wright for superb research assistance and to Scott Masten for extensive comments on an earlier draft. 1 R. H. Coase, The Nature of the Firm, 4 Economica (n.s.) 386 (1937). 2 Benjamin Klein, Robert G. Crawford, & Armen A. Alchian, Vertical Integration, Appropriable Rents and the Competitive Contracting Process, 21 J. Law & Econ. 297 (1978). [Journal of Law and Economics, vol. XLIII (April 2000)] © 2000 by The University of Chicago. All rights reserved. 0022-2186/2000/4301-0005$01.50

Ronald Coase’s landmark contribution in The Nature of the Firm fun1



the journal of law and economics

problems that arise when transactors use imperfect long-term contracts to solve hold-up problems created by specific investments and also illuminated the economic motivation for GM’s use of vertical integration. The FisherGM case has been cited by numerous researchers, and many studies have since empirically documented the relationship between vertical integration and specific investments in widely varying circumstances.3 Coase rejects this idea that specific investments are a determinant of vertical integration. He claims that hold-up problems created by the presence of specific investments normally can be handled satisfactorily with longterm contracts without requiring vertical integration. He also specifically rejects the view that the Fisher-GM case involved hold-up behavior.4 Coase claims that my description of the Fisher-GM case, which has become an accepted element of transaction cost theory, does not reflect what actually occurred. In what follows, I first reexamine in detail the operation of the longterm contract entered into by Fisher Body and GM in 1919. Contrary to Coase and to the two other papers by Robert Freeland5 and by Ramon Casadesus-Masanell and Daniel Spulber 6 included in this issue, the facts of the Fisher-GM case are shown to be fully consistent with the hold-up description provided in Klein, Crawford, and Alchian. The evidence unambiguously...
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