Hold Up Problem

19253 words 78 pages
BENJAMIN KLEIN University of California, Los Angeles

After working well for more than 5 years, the Fisher Body–General Motors (GM) contract for the supply of automobile bodies broke down when GM’s demand for Fisher’s bodies unexpectedly increased dramatically. This pushed the imperfect contractual arrangement between the parties outside the self-enforcing range and led Fisher to take advantage of the fact that GM was contractually obligated to purchase bodies on a cost-plus basis. Fisher increased its short-term profit by failing to make the investments required by GM in a plant located near GM production facilities in Flint, Michigan. Vertical integration, with an associated
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In particular, examining the operation of the Fisher-GM contract helps us to understand why transactors may choose what appear to be obviously imperfect contract terms, the conditions under which such imperfect contracts are likely to break down, and the advantages of vertical integration under these circumstances. The answers to these questions rest on the role transactors assign to contract terms. Transactors choose the imperfect contract terms that govern their relationship based on the expected effectiveness of the terms in supporting self-enforcement of the underlying contractual understanding. It is only when market conditions develop unexpectedly, as they did in the Fisher Body–GM case, that the relationship moves outside the ‘‘selfenforcing range’’ defined by these imperfect contract terms and the transactors’ reputational capital. When this occurs, one transactor will find it profitable to use the court to take advantage of the imperfect, legally enforceable contract terms in order to violate the intent of the contractual understanding. The Fisher Body–GM case not only provides a useful illustration of these economic forces but also illuminates the economic advantages of vertical integration, namely, the increased flexibility transactors gain from not having to use a rigid long-term contract to supplement their limited reputational


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