Hold-up Problem

In economics, the hold-up problem is a situation where two parties (such as a supplier and a manufacturer or the owner of capital and workers) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits. It has been described as the "most influential work" in recent decades on why firms exist and what determines their boundaries.

For example, imagine a scenario where profit can be made if agents X and Y work together, so they form an agreement to do so, after X buys the necessary equipment. The hold-up problem occurs when X might not be willing to accept that agreement, even though the outcome would be Pareto efficient, because after X buys the necessary equipment, Y would have bargaining power and might decide to demand a larger proportion of the profits than before. The source of Y's power lies in X's investment. Since X is now deeply invested in the project, but Y is not, X stands to lose money, should the deal not be completed, but Y has no such risk. Thus, Y has some bargaining power that did not exist before X's investment. In the extreme, Y could demand 100% of the profits, if X's only alternative is to lose the initial investment entirely.

One way to avoid the hold-up problem is for the firms to merge, a tactic known as vertical integration, or to enter vertical agreements, e.g. an agreement with a non-compete clause.

A hold-up problem inherent in binary software transactions has been proposed as one of the reasons for the success of open source software.