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October 24, 2019

Hold-up Problem Has Clean Solution Based on Applied Information Design

Noelle Wiker

If every possible factor in an investment could be written into a contract then most arrangements between buyers and sellers would move along without a hitch. That’s not the case, though, as the ubiquitous hold-up problem illustrates. However, new research suggests that information control could mitigate the hold-up problem.

The study, Information Control in the Hold-up Problem, conducted by researchers at the Tepper School of Business at Carnegie Mellon University and Nanyang Technological University in Singapore was recently published by RAND Journal of Economics.

Anh Nguyen, Assistant Professor of Economics at the Tepper School who coauthored the paper, became interested in exploring solutions to the hold-up problem while researching Medicare. “Medicare is trying to save costs, but it relies a lot on information that is submitted from the hospital to Medicare,” said Nguyen. “So the question is, ‘Is there a way for Medicare to audit the hospital so that it is incentivized to save costs for Medicare?’” 

Simply put, the hold-up problem arises when a potential investor anticipates that the other party will alter the relationship after a contract is signed due to an imbalance of information and so decides against signing the contract in the first place. Between two individuals it’s a frustrating game of chicken. But between two firms, it blocks market flow. 

Previous literature has suggested that the hold-up problem can only be remedied by making overly complex arrangements in the relationship between seller and buyer. The study, however, discovered that there is a distinction between the asymmetric information that generates an ex-ante investment incentive—in other words, potential returns for the buyer—and the asymmetric information that causes ex-post inefficiency. Instead, the theoretical research found that by introducing applied information design, the solution was very simple: information control can always improve welfare gain. 

Nguyen believes that such a clean theoretical solution can be applied in empirical settings, such as between Medicare and a hospital. 

“I think this will apply across any situation in which you have firm-to-firm business where some part of the relationship isn't contractible,” said Nguyen. “This could become standard practice in any kind of dispute.”