In Chapter 5 Of Managerial Economics, Froeb Discussed Post I

In Chapter 5 Ofmanagerial Economics Froeb Discussed Post Investment H

In Chapter 5 of Managerial Economics, Froeb discussed post-investment holdup as a sunk cost problem associated with contract-specific fixed investments. The modern theory of contracts is sometimes called the theory of joining wills, which simply means when parties make an agreement they are joining together to complete an endeavor of mutual interest. The problem with all contracts that endure over time is that not all potential challenges can be anticipated. The idea of joining wills is that parties will attempt to seek accommodations to advance their mutual interest, so long as the return on the invested activity pays off. Froeb illustrates the idea by the example of marriage as a contract.

Sources: Luke M. Froeb. 2018. Managerial Economics: A Problem Solving Approach (5th ed.). p. 59. Cengage.

Review the three scenarios to analyze post-investment holdup

The three scenarios are:

1. A firm hires a highly qualified CFO, who leaves after six months to join another firm.
2. The company has an exclusive contract to assemble automobile seats, with imported parts from China, which increased costs due to tariffs.
3. You serve as an interim director after your company’s director leaves; your position is later abolished after acquisition.

Analysis of Scenarios for Post-Investment Holdup

Scenario 1: CFO resignation

This scenario involves a costly recruitment process and investment in hiring a highly qualified Chief Financial Officer (CFO). The firm invested time and resources in recruiting an expert, which constitutes a sunk cost once the CFO leaves. Here, the contractual relationship was that of employment, which is typically not a long-term binding contract but rather an at-will employment agreement. The employment relationship was not legally breached by the CFO leaving, but from the company's perspective, there may be elements of post-investment holdup if the CFO's departure occurs after significant firm-specific investment in training or relationship-building. The damages include the costs associated with hiring and training the CFO, who then leaves prematurely. This scenario does not exemplify classic post-investment holdup, as there was no explicit contractual breach or ex-post bargaining problem that resulted from sunk investments beyond normal employment risks.

Scenario 2: Automobile seat assembly contract with tariffs

This scenario involves a long-term, exclusive contract for assembly services, with supply chain investments that include importing parts. Once the tariffs increased costs by 25%, the company faced a situation of increased input costs. The contractual obligation was to supply seats, and the company attempted to pass additional costs onto customers. The supplier of parts, however, did not have a direct contractual relationship with the automaker, and the holistic contract may involve specific investments in supply chain or manufacturing processes. If the supplier or automaker had invested in specific assets for producing these seats, and then external shocks (tariffs) altered the costs, it could lead to a holdup problem if either party seeks to renegotiate or alter the contract after the sunk costs of specific investments have been made. The breach here mainly concerns the change in costs and the passing on of increased tariffs, which was communicated and accepted by customers; thus, this scenario does not directly exemplify post-investment holdup but rather a contractual response to external costs. Damages would be the additional costs due to tariffs, passed onto customers, and possibly lost profit if the parties cannot agree on sharing costs appropriately.

Scenario 3: Serving as interim director

In this scenario, you took on a temporary managerial role, with an implicit understanding that you could apply for a full-time position later. The firm invested in your time and effort, which represents human capital investments. Your tenure lasted 13 months until the company was acquired and your position was eliminated. The focus here is whether the company’s decision to abolish your position after the acquisition constitutes a form of holdup. Since your initial agreement was not a formal, binding contract with specific compensation, but rather an implied agreement for future employment, this case resembles a partial post-investment scenario. The sunk costs are the efforts and resources you invested during your tenure. When the acquisition led to the abolishment of your role, the company did not breach an explicit contractual obligation; however, the situation echoes post-investment holdup if the company benefitted from your efforts but then retracted employment opportunities without compensation or prior guarantee. Damages could include lost wages and the value of your human capital development during that period.

Conclusion

Among the three scenarios, the third scenario most clearly demonstrates the concept of post-investment holdup, where the firm benefits from an employee’s human capital investment and then terminates employment after acquisition. The first scenario relates to employment risk rather than holdup over specific investments, while the second involves cost increases and contractual responses to external shocks but does not fit the classic model of post-investment holdup. Recognizing the nuances of each scenario illustrates how post-investment holdup can manifest in various contractual and economic contexts, emphasizing the importance of careful contract design to address potential holdup problems (Froeb, 2018; Williamson, 1985; Klein, Crawford & Alchian, 1978). Effective contractual arrangements, including safeguards and investment-specific considerations, are crucial to mitigate holdup risks and align incentives between parties.

References

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