Mando is Held Up. So are Firms.
- Students will experience hold-up problems in a one-shot game.
- Students will experience hold-up problems in a repeated game.
- Students will experience the market when the product isn’t specialized.
Time needed: 30-45 minutes
Materials Required: None
Hold-up problems occur when firms exert effort for a specific buyer; whether that effort occurs in the form of specialized work such as custom designs or specialized capital investment such as specialized tooling. Because the firm only has one buyer, the buyer can dictate prices after the seller has made an investment. The clip “Mando Faces Hold-Up Problem” from the Mandalorian shows this explicitly. With only a single buyer, Mando has no choice but to accept the offer. The only constraint on the seller is that this is a repeated game, as Mando may not wish to play again.
Before class day, create a class roster randomly assigning each student to a partner. Randomly assign one of the two students in each pair as the buyer and the other as the seller. You might have to make an ad-hoc partner pair during class due to absences, but you should try to keep these to a minimum in order to maximize class time.
After showing the clip and explaining the basic concept of the hold-up problem, reveal partner assignments and who is the buyer and who is the seller. Inform all students that the game works as follows:
- The buyer has a product which they can sell on the market at a price of $10.
- The buyer needs a specialized part from the seller to complete the product; for simplicity assume that there are no other costs associated with producing the $10 product.
- It costs the seller $5 in average fixed cost to produce the product; for simplicity assume there are no marginal costs and they can only produce one part per period.
- The seller has already produced the product at a cost of $5 under the assurance that the buyer would buy it.
- The part is specialized so it provides no value to any other buyer.
Allow the teams to negotiate a price for the product such that each team maximizes their profit. The students will tend to be more kind than the Nash outcome but at least some will result in sellers with negative profits. After the negotiation, discuss with the group what the Nash equilibrium solution should be and what happened.
Reframe the game as a repeated game with multiple periods. In each period, the transaction occurs as in the one-shot game. However, after each period, the seller decides if they are willing to make the investment to make the part for the next period. The instructor should run this game for at least three periods, but it is important to not reveal the number of periods to the class otherwise students will alter their behavior based on the ending period.
In this version of the game, the price of the specialized part should be above the $5 cost in most teams. However, you would still rather be the seller.
In a final version of the game, show the market without specialized parts (no hold-ups). Each seller, as before, can produce a single part for $5 in average fixed cost. However, they can sell it to any buyer in the class. The buyer can then sell as many units as they acquire for $10 each.
In this version of the game, the sellers finally have some bargaining power. Most buyers will sell no products and the majority of the parts will go to a handful of buyers at prices just below $10.
In the modern economy, specialized parts are quite common. Auto manufacturers, computer makers, and small appliance manufacturers all have some specialized parts. Thus solving the hold-up for these companies is important for them to function. There are two solutions: strong contracts or vertical integration. Discuss examples of both with the class. Discussions of Apple’s decision to first outsource and then build much of their specialized supply chain resonates with students as it captures both situations using a familiar firm.