Monday, June 22, 2009

Cashmere Sweaters and the Hold-Up Problem

One of the topics I used to cover in the MBA Managerial Economics course I taught at USF was the hold-up problem. The hold-up problem occurs because of sunk costs. There are a few examples in the literature about the hold-up problem and most of my class discussion was not about how to hold-up your vendors, but rather how to avoid it and the warning signs that you may be in danger of falling into the problem.

Since I am no longer covering this, I thought that I would go over the basics and use the example of Cashmere producers being held up in this economic recession.

Since the manufacturers of cashmere sweaters have incurred a sunk cost of producing those sweaters - transportation costs and other capital costs, the cashmere sweater purchasers have an opportunistic incentive to claim that demand is declining (and it may be), and now ask for the terms of the agreement to be changed. The cashmere manufacturers have an incentive to agree if the new price is above the total of any salvage value of the cashmere sweaters (i.e. what they can sell them to other vendors) plus the variable costs used to make the sweaters. The cashmere sweater producers can walk away and lose their sunk costs - assuming they have another vendor to sell to.

As mentioned in the article, the cashmere producers feel "held-up" by their trading partner. Also as mentioned, one way for them to overcome this problem is to demand payment up front - or at least enough payment to cover the per unit sunk costs of manufacturing - that way if the terms of the deal need to be changed, the cashmere sweater producers can say no, and sell their sweaters to another vendor - if one exists. If not, they can ask for the full payment up-front, but now the cashmere sweater purchaser faces potential hold-up by the cashmere producer - do you see how?

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