Chapter 11: Holdups

Overview

Trust none. For oaths are straws, men’s faiths are wafer-cakes . . .

Shakespeare, Henry V^[1]

You’re waiting in the hospital while your husband undergoes open-heart surgery. The operation has been scheduled for about a month. A doctor leaves the operating room and approaches you. He says you must pay $500,000 to have the operation completed. If the hospital doesn’t get the money, then the doctors will stop working, and your husband will die. You ask why they need the extra money, and the doctor responds that they don’t really need the extra money so much as want it. The hospital found out that you were rich and figured that you would pay another $500,000 to keep your husband alive.

You just experienced the “holdup problem.” By going to the hospital, you made yourself artificially vulnerable to its doctors. Because you had a month to schedule the operation, you could easily have found other doctors who would have charged you less. Once the operation started, however, you became dependent on the doctors you selected, and they acquired an artificial monopoly over you. The doctors exploited your dependence by demanding extra money.

Imagine, instead, that there is only one doctor in the world who can perform your husband’s operation, and she charges $1 million. This doctor is not holding you up, because she has a real monopoly that you couldn’t have scheduled around. She didn’t trick you into dependence; rather, her unique skills make her your only salvation.

The famous legal case of Alaska Packers’ Assn. v. Domenico^[2] also illustrates the holdup problem. A boat owner hired fishermen to catch salmon in Alaska. The fishermen were hired in San Francisco and agreed to work for a specific wage. When the boat arrived in Alaskan waters, however, the fishermen announced they would not work unless they received a substantial wage increase. The boat owner was in a difficult situation because it would have been very challenging for him to get new fishermen on such short notice. The boat owner agreed to the wage increase, but when the boat returned to port, he refused to pay the extra money. The fishermen sued but lost. The court held that the fishermen improperly tried to take advantage of the boat owner’s short-term dependence upon them.

Figure 45 illustrates a generalized holdup game. In this game Player One can hire one of three people to complete a task. Once someone has been hired, however, only he can finish the job. From the viewpoint at the beginning of the game, three people could finish. Once Player One picks someone, however, he becomes dependent upon his hire, for it is now too late to pick someone else. Figure 46 shows another game where you are dependent upon someone, but there is no holdup. In this game person A is always the only person who can complete the job. Thus, you do not become more dependent upon person A after hiring her. In Figure 45 the act of hiring person A gives her considerable power over you, while in Figure 46 person A always has this power.

Figure 45

Figure 46

You should minimize holdup problems by avoiding dependence on those who could exploit you. For example, imagine that you are considering building a factory to produce widgets. After building the factory you will still need sprockets to manufacture widgets, and only one company produces sprockets. After the factory’s completion, therefore, you will be dependent upon this sole sprocket supplier, and it will be able to charge you extremely high prices. To avoid this potential holdup problem, before building the factory you should enter into a long-term contract with the sprocket provider to ensure that it never charges too much.

Second sourcing also mitigates holdup problems. If in the previous example you ensured that at least two firms could sell you sprockets, then neither would have a monopoly. Perhaps before you build the factory, you could convince another supplier to start making sprockets so that you would never be dependent upon just one firm.

^[1]Browning (1989), 236.

^[2]117 F. 99 (9th Cir. 1902). See Posner (1998), 110–111 for a full discussion of this case.