Relationship-specific investments refer to assets that have much higher value when used by specific partners. While they can enable efficiencies, relationship-specific investments also lead to several problems like hold-up, underinvestment and contractual breakdowns. However, through effective information design, governance mechanisms and options to switch partners, the inefficiencies of relationship-specific investments can be alleviated.
Relationship-specific investments lead to hold-up problems and underinvestment
When firms make relationship-specific investments, they become dependent on specific partners and vulnerable to hold-ups wherein their partners exploit the high switching costs to extract concessions. Since firms anticipate the possibility of hold-up, it deters them from making efficient relationship-specific investments, leading to underinvestment problems. The central tradeoff is that while relationship-specific investments can enable efficiencies, the hold-up problem makes firms reluctant to make them.
Well-designed contracts can prevent hold-ups but still leave inefficiencies
In principle, the hold-up problem can be avoided by writing complete contingent contracts covering all future conditions. But it is often impractical or costly to write such complex contracts. Incomplete contracts still leave firms open to hold-ups. Renegotiations to update incomplete contracts are themselves plagued by hold-up dynamics. Thus, while well-designed contracts can reduce inefficiencies, some residual inefficiency typically remains.
Ownership reallocation grants control rights to prevent hold-ups
Granting ownership of relationship-specific assets to one partner can alleviate hold-ups since this firm now has residual control rights over the assets. However, ownership reallocation has its own costs like incorrect incentives and miscoordination between partners. Ownership solutions are also incomplete and some inefficiency remains.
Information design uses randomness to prevent full extraction
Since deterministic investment strategies allow partners to fully extract gains, randomization can prevent full extraction. If the output follows a random distribution, partners cannot claim the entire surplus upfront. But some inefficiency still remains since output is lowered in expectation relative to the deterministic optimum.
Multiple competing partners mitigate hold-up problems
When firms have multiple potential partners to choose from, hold-up problems are reduced. Since firms have the option to switch partners, no single partner can extract the full surplus. This acts as a check against exploitative behavior. However, maintaining multiple partners also has costs which place limits on this solution.
In essence, while a variety of solutions can mitigate the inefficiencies caused by relationship-specific investments, some residual inefficiency remains. There is an irreducible tradeoff between fully solving the hold-up problem and maintaining productive relationship-specific investments.