2 Hold-up problem
Assume that an Indian firm is contacted by a multinational car company to produce brake systems. This requires an initial specific investment of I from the Indian sub- contractor and a variable cost c per braking system. The car company plans to buy n braking systems from the subcontractor at price p per braking system.
- Looking from now, at what price, p = p0, the Indian subcontractor would break even?
- Once the specific investment is made, at what minimum price, p1, that the Indian subcontractor will just be willing to produce the braking systems?
- Which price is higher, p0 or p1? What is their difference?
- Understanding this potential situation, will the Indian subcontractor make the initial
- The difference between p0 and p1 is a measure of the severity of the hold-up problem. If the initial investment increases, will the problem become more severe?
- Consider an extreme case in which I = 0. Will there still be a hold-up problem?
- Given some I > 0, will the variable cost, c, affect the severity of the hold-up problem?
- What can you conclude from this exercise?