In Chapter 5 Of Managerial Economics, Froeb Discussed 864043

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 means that when parties make an agreement, they join together to complete an endeavor of mutual interest. The challenge with long-term contracts is that not all potential problems can be anticipated at the outset. Since the parties' interests are intertwined, they will seek to make adjustments and accommodations to serve their mutual interests, provided that the return on their invested activities justifies such adjustments. Froeb illustrates this idea with the example of marriage as a contract, emphasizing the relational and ongoing nature of mutual commitments.

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

Review of Scenarios for Post-Investment Holdup

The following are three scenarios for analysis to determine which, if any, illustrate post-investment holdup:

Scenario 1:

A firm hired a highly qualified chief financial officer (CFO) at an annual salary of $250,000. After six months, the CFO resigned to join another firm.

Scenario 2:

The company has an exclusive contract to assemble automobile seats for luxury models. Nearly all materials are imported, with over half from China. When tariffs increased costs by 25%, the company informed its customers that the higher costs would be passed on, which they reluctantly accepted.

Scenario 3:

During pursuing an MBA, you were asked to serve as interim director after the previous director left. You served for 13 months until your company was acquired, and your position was abolished.

Analysis

Among these scenarios, Scenario 1 is the clearest example of post-investment holdup. This situation involves a fundamental issue related to sunk costs and changing circumstances post-investment, which aligns with the concept of holdup. The CFO’s employment represents a specific investment that the firm made in human capital. Once hired, the firm’s investment in the CFO was largely sunk after six months, yet the CFO’s departure signifies a post-investment holdup, especially if the firm cannot recover the direct costs tied to hiring and onboarding the CFO and if the departure leads to a loss of potential future benefits. The fact that the CFO leaves shortly after being hired exemplifies the problem where investments made by one party are exploited by the other after the investment is sunk, leading to potential inefficiencies and lost resources.

Scenario 2 primarily involves contractual adjustments due to external cost shocks, such as tariffs, which affected the costs of imported parts. It does not exemplify post-investment holdup, as the firm’s initial investments and contractual agreements are sustained, and the increase in costs is passed on to customers, not exploiting a sunk cost after a specific or particular investment by either party.

Scenario 3 involves employment during the pursuit of an MBA, with the eventual abolition of the position following acquisition. Although this may seem related to employment contracts and organizational change, it does not clearly reflect post-investment holdup in the classical sense. The employment here was likely not a specific sunk investment that could be exploited post-commitment, but rather a temporary arrangement during educational advancement, with the eventual termination due to external corporate decisions.

Definitions and Contextual Explanation

Sunk (or stranded) cost:

A sunk cost is an expenditure that has already been made and cannot be recovered. In the context of Scenario 1, the costs associated with recruiting, onboarding, and training the CFO are largely sunk after six months. These costs include recruitment expenses, onboarding costs, and possibly training or orientation expenses. Once incurred, these costs cannot be recovered regardless of whether the CFO stays or leaves.

Contract:

A contract is a legally binding agreement between two or more parties that stipulates their rights and obligations. In Scenario 2, the firm has a contract to supply automobile seats, and the agreement includes passing on increased costs due to tariffs. The contract specifies terms under which the firm supplies the seats, including how to handle price increases, reflecting ongoing mutual obligations.

Was the contract breached?

In Scenario 2, the contract was not breached; rather, external events (tariffs) increased costs, and the firm responded by informing customers of the need to pass through these costs. In Scenario 3, no breach is indicated, as the employment was terminated due to company acquisition and organizational restructuring, which are common in mergers and acquisitions.

Damages:

Damages refer to the financial or economic losses resulting from a breach of contract or other misconduct. For Scenario 1, damages could include the costs of recruiting and onboarding the CFO, as well as potential lost opportunities due to the CFO’s departure. If legally challenged, damages might include compensation for the sunk costs and any breach-related losses. In Scenario 2, damages relate to the firm's increased costs, which are passed onto customers, and hence, there are no damages in the legal sense. In Scenario 3, damages are less direct but could include the loss of position and potential career advancement opportunities for the individual involved.

Conclusion

In summary, Scenario 1 clearly exemplifies post-investment holdup because the firm made a specific investment in hiring a CFO that was exploited when the CFO left shortly afterward. This case illustrates how sunk costs and future uncertainty can lead to inefficient bargaining and exploitation after investments are made. Scenario 2 does not exemplify holdup, as the contractual adjustments are reactions to external shocks, not opportunistic exploitation of sunk investments. Scenario 3 involves employment during educational pursuits and organizational restructuring, which does not straightforwardly fit the classic model of post-investment holdup. Understanding these distinctions is critical for firms to develop strategies that mitigate holdup risks and ensure that investments are protected or appropriately managed.

References

• Froeb, L. M. (2018). Managerial Economics: A Problem Solving Approach. Cengage.
• Williamson, O. E. (1985). The Economic Institutions of Capitalism. Free Press.
• Hart, O. (1995). Firms, Contracts, and Financial Structure. Oxford University Press.
• Barzel, Y. (1982). Measurement Cost and the Organization of Markets. The Journal of Law & Economics, 25(1), 27-48.
• Alchian, A. A., & Demsetz, H. (1972). Production, Information Costs, and Economic Organization. The American Economic Review, 62(5), 777-795.
• Milgrom, P., & Roberts, J. (1992). Economics, Organization and Management. Prentice Hall.
• Grossman, S. J., & Hart, O. D. (1986). The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration. The Journal of Political Economy, 94(4), 691-719.
• Klein, B., Crawford, R. A., & Alchian, A. A. (1978). Vertical Integration, Appropriable Rents, and Competitive Contracting. The Journal of Law & Economics, 21(2), 297-326.
• Laffont, J.-J., & Tirole, J. (1993). A Theory of Incentives in Procurement and Regulation. The MIT Press.
• Buchanan, J. M. (1969). Cost and Choice: An Inquiry in Economic Theory. University of Chicago Press.