Hold-up problem

Assume that an Indian firm is contacted by a multinational car company to produce brake systems. This requires an initial specific investment of I from the Indian sub- contractor and a variable cost c per braking system. The car company plans to buy n braking systems from the subcontractor at price p per braking system.

a. Looking from now, at what price, p = p0, the Indian subcontractor would break even?

b. Once the specific investment is made, at what minimum price, p1, that the Indian subcontractor will just be willing to produce the braking systems?

c. Which price is higher, p0 or p1? What is their difference?

d. Understanding this potential situation, will the Indian subcontractor make the initial investment?

e. The difference between p0 and p1 is a measure of the severity of the hold-up problem. If the initial investment increases, will the problem become more severe?

f. Consider an extreme case in which I = 0. Will there still be a hold-up problem?

g. Given some I > 0, will the variable cost, c, affect the severity of the hold-up problem?

h. What can you conclude from this exercise?