Ownership, Incentives, and the Hold-Up Problem

Abstract

Vertical integration is often proposed as a way to resolve hold-up problems in connection with specific investments. However, decision-makers are generally compensated based on divisional (not firm-wide) profit. Hence, hold-up problems are bound to resurface in integrated firms. This paper develops a model where managers benefit from investment returns via compensation (incentives) and private benefits of control ("empire benefits"), and they negotiate the terms of trade under asymmetric information using a sealed-bid mechanism. The model predicts that: (a) incentives are lower-powered; (b) capital investments are higher; and (c) bargaining is "more cooperative" in vertically integrated firms. Lower-powered incentives make managers value empire benefits relatively more, resulting in less aggressive bargaining and improved trading and investment efficiency. Thus, vertical integration indeed alleviates hold-up problems even in the absence of firm-wide profit sharing. Moreover, rather than reflecting commitment problems, lower-powered incentives under integration may in fact be value-enhancing.

Keywords: Holdup problem, Vertical Integration, Incentives, Bargaining

JEL Classification: D23, D82, L22, M40, M41, M46, G34