120 • Chapter 3 • The Vertical Boundaries of the Firm

The Fundamental Transformation

The need to create relationship-specific assets transforms the relationship as the
transaction unfolds. Before individuals or firms make relationship-specific invest-
ments, they may have many alternative trading partners and can choose to partner
with those that afford the highest possible profit. But after making relationship-
specific investments, they will have few, if any, alternatives. Their profits will be
determined by bilateral bargaining. In short, once the parties invest in relationship-
specific assets, the relationship changes from a “large numbers” bargaining situa-
tion to a “small numbers” bargaining situation. Williamson refers to this change as
the fundamental transformation.

Rents and Quasi-Rents

The fundamental transformation has significant consequences for the economics of
bargaining between buyer and seller, which in turn affects the costs of arm’s-length
market exchange. To set the stage for our discussion of these costs, we must first define
and explain rent and quasi-rent.
These are hard concepts. To explain them, we will walk through a numerical
example about a hypothetical transaction. Suppose your company contemplates
building a factory to produce cup holders for Ford automobiles. The factory can make
up to 1 million holders per year at an average variable cost of C dollars per unit. You
finance the construction of your factory with a mortgage from a bank that requires an
annual payment of I dollars. The loan payment of I dollars thus represents your (annu-
alized) cost of investment in this plant. Note that this is an unavoidable cost: You have
to make your payment even if you do not do business with Ford.23 Your total cost of
making 1 million cup holders is thus I 1 1,000,000C dollars per year.
You will design and build the factory specifically to produce cup holders for Ford.
Your expectation is that Ford will purchase your holders at a profitable price. But if you
build the factory and do not end up selling cup holders to Ford, you still have a “bail-
out” option: You can sell the holders to jobbers who, after suitably modifying them,
will resell them to other automobile manufacturers. The “market price” you can
expect to get from these jobbers is Pm. If you sell your cup holders to jobbers, you
would thus get total revenue of 1,000,000Pm.
Suppose that Pm . C, so the market price covers your variable cost. Thus, you are
more than willing to sell to the jobbers if you had no other option. Ignoring the investment
cost I for a moment, your profit from selling to the jobbers is 1,000,000(Pm 2 C ). Sup-
pose also that the annual investment cost I . 1,000,000(Pm 2 C ). This implies that even
though you are better off selling to jobbers than not selling at all, you will not recover your
investment cost if you sell only to jobbers. In this sense, a portion of your investment is spe-
cific to your relationship with Ford. In particular, the difference I 2 1,000,000(Pm 2 C )
represents your company’s relationship-specific investment (RSI ).
• The RSI equals the amount of your investment that you cannot recover if your
company does not do business with Ford.
• For example, if I 5 $8,500,000, C 5 $3, and Pm 5 $4, then the RSI is $8,500,000
2 1,000,000(4 2 3) 5 $7,500,000. Of your $8,500,000 investment cost, you lose
$7,500,000 if you do not do business with Ford and sell to jobbers instead.
We can now explain rent and quasi-rent. First, let us explain rent.24 Suppose that
before you take out the loan to invest in the cup holder plant, Ford agreed to buy
 Reasons to “Make” • 121

1 million sets of cup holders per year at a price of P* per unit, where P* . Pm. Thus,
your company expects to receive total revenue of 1,000,000P* from Ford. Suppose
that I , 1,000,000(P* - C ), so that given your expectation of the price Ford will pay,
you should build the plant. Then,
• Your rent is 1,000,000(P* 2 C ) 2 I.
• In words: Your rent is simply the profit you expect to get when you build the
plant, assuming all goes as planned.
Let us now explain quasi-rent. Suppose, after the factory is built, your deal with
Ford falls apart. You should still sell to the jobbers, because 1,000,000(Pm 2 C ) . 0;
that is, sales to jobbers cover your variable costs.
• Your quasi-rent is the difference between the profit you get from selling to Ford
and the profit you get from your next-best option, selling to jobbers. That is, quasi-
rent is [1,000,000(P* 2 C) 2 I ] 2 [1,000,000(Pm 2 C) 2 I ] 5 1,000,000(P* 2 Pm).
• In words: Your quasi-rent is the extra profit that you get if the deal goes ahead as
planned, versus the profit you would get if you had to turn to your next-best
alternative (in our example, selling to jobbers).
It seems clear why the concept of rent is important. Your firm—indeed any firm—
must expect positive rents to induce it to invest in an asset. But why is quasi-rent
important? It turns out that quasi-rent tells us about the possible magnitude of the
holdup problem, a problem that can arise when there are relationship-specific assets.

The Holdup Problem

If an asset was not relationship-specific, the profit the firm could get from using the
asset in its best alternative and its next-best alternative would be the same. Thus, the
associated quasi-rent would be zero. But when a firm invests in a relationship-specific
asset, the quasi-rent must be positive—it will always get more from its best alternative
than from its second-best alternative. If the quasi-rent is large, a firm stands to lose a
lot if it has to turn to its second-best alternative. This opens the possibility that its
trading partner could exploit this large quasi-rent, through holdup.25
• A firm holds up its trading partner by attempting to renegotiate the terms of a deal.
A firm can profit by holding up its trading partner when contracts are incomplete
(thereby permitting breach) and when the deal generates quasi-rents for its trad-
ing partner.
To see how this could happen, let’s return to our example of Ford and your cup
holder company. Ford could reason as follows: You have already sunk your investment
in the plant. Even though Ford “promised” to pay you P* per cup holder, it knows that
you would accept any amount greater than Pm per unit and still sell to it. Thus, Ford
could break the contract and offer you a price between P* and Pm; if you accept this
renegotiation of the deal, Ford would increase its profits.
Could Ford get away with this? After all, didn’t Ford sign a contract with you?
Well, if the contract is incomplete (and thus potentially ambiguous), Ford could assert
that, in one way or another, circumstances have changed and that it is justified break-
ing the contract. It might, for example, claim that increases in the costs of commodity
raw materials will force it to sharply curtail production unless suppliers, such as your-
self, renegotiate their contracts. Or it might claim that the quality of your cup holders
122 • Chapter 3 • The Vertical Boundaries of the Firm

EXAMPLE 3.5 POWER BARGES

How do you deal with trading partners who are nations that lack the infrastructure to build
reluctant to make investments that have a high their own power generation facilities, but have
degree of site specificity? This is the problem sufficient reserves of natural gas, oil, or geo-
that many developing nations face in convinc- thermal energy to fuel the power barges. A few
ing foreign corporations to construct power power barges feature nuclear reactors, requir-
plants. Power plants are usually highly special- ing minimal on-site fueling.
ized assets. Once a firm builds a power plant in During the 1990s, power barges became a
a developing nation, the associated investment popular way of providing energy to developing
undergoes the “fundamental transformation” nations. Companies including Raytheon, West-
and becomes a site-specific asset. If the purchas- inghouse, Smith Cogeneration, and Amfel built
ing government defaults on its payments, the floating power plants for customers such as
manufacturer has few options for recovering its Bangladesh, Ghana, Haiti, Kenya, and Malaysia,
investment. (The firm could route the power to as well intermediaries such as the Power Barge
consumers in other nations, but the defaulting Corporation. There are even a few power barges
government could easily prevent it.) Even in developed nations. For example, Consolidated
though no manufacturer has had to repossess a Edison operates a gas-turbine generator that is
plant, the fear of default has scared them off. housed on a barge in the Gowanus Canal in
As a result, growing economies in developing Brooklyn.
nations may be slowed by power shortages. Power barges are moored on one or more
The solution to the problem is ingenious. barges in safe harbors and “plugged into” land-
Manufacturers have eliminated the geographic based transformers that send electricity to
asset specificity associated with power genera- domestic consumers. If the purchaser defaults,
tion! They do this by building power plants on the manufacturer or intermediary can tow the
floating barges. Floating power plants are not barge(s) away and sell the plant to another
new. Since the 1930s, U.S. Navy battleships customer. Floating power plants can also be
have used their turboelectric motors to pro- assembled off-site and then towed to the pur-
vide emergency power to utilities. The idea of chasing nation. This lowers labor costs because
installing a power plant on a barge deck origi- the manufacturers do not have to pay their
nated with General Electric, which manufac- skilled workers to go to a distant site for a long
tured power barges for use by the U.S. military time. There is one final incentive for floating
during World War II and have been in use ever power plants: an amendment to the 1936 U.S.
since. Recent innovations have reduced the Merchant Marine Act provides substantial
size and increased the reliability of gas turbines, financing advantages for vessels constructed in
making it possible to house large-capacity the United States but documented under the
generators on a small number of barges. This laws of another nation. Floating barges fit this
makes them especially attractive to developing description and enjoy favorable financing.

fails to meet promised specifications and that it must be compensated for this lower
quality with lower prices.
Unless you want to fight Ford in court for breach of contract (itself a potentially
expensive move), you are better off accepting Ford’s revised offer than not accepting
it. By reneging on the original contract, Ford has “held you up” and has transferred
some of your quasi-rent to itself. To illustrate this concretely, suppose P* 5 $12 per
unit, Pm 5 $4 per unit, C 5 $3 per unit, and I 5 $8,500,000.
• At the original expected price of $12 per unit, your rent is (12 2 3)1,000,000 2
8,500,000 5 $500,000 per year.
• Your quasi-rent is (12 2 4)1,000,000 5 $8,000,000 per year.
 Reasons to “Make” • 123

• If Ford renegotiates the contract down to $8 per unit, Ford will increase its profits
by $4 million per year and it will have transferred half of your quasi-rents to itself.
Note that after the holdup has occurred, you realize that you are getting a profit
of (8 2 3)1,000,000 2 8,500,000 5 2$3,500,000. You are losing money on your invest-
ment in the factory! This tells us that if, instead of trusting Ford, you had anticipated
the prospect of holdup, then you would not have made the investment to begin with.
This situation is especially problematic because your rent was small but your quasi-rent
was large. When Ford holds you up and extracts a portion of your quasi-rent, you end
up with losses that dwarf the expected profits. This example shows why we talk about
the holdup problem in the context of vertical integration. If you are afraid of being held
up, you might be reluctant to invest in relationship-specific assets in the first place,
forcing Ford either to find another supplier of cup holders or to make them itself.

Holdup and Ex Post Cooperation

Economist Oliver Hart, whose “property rights theory of the firm” we will encounter
in the next chapter, recently offered a theory of holdup that does not require ex ante
noncontractible investments made at the start of a trading relationship.26 Suppose
instead that a relationship between a buyer and seller is enhanced through ex post
cooperation as the relationship unfolds. For example, they may share information
about quality control, identify potential new markets, or lobby governments. As the
trading relationship unfolds, conditions may change in ways that advantages one firm
more than another—demand may be higher than expected or costs may drop. Most
of the time the buyer and seller will continue to cooperate, but sometimes conditions
are so volatile that one firm gains a huge advantage or disadvantage not necessarily at
the expense of the other. In these situations, the firm that is relatively worse off may
threaten to withhold cooperation unless the contract is renegotiated so as to get a
share of the spoils (or pass on some of its losses). In order to force renegotiation, the
firms may even withdraw cooperation. This is a form of holdup that as Hart describes,
“transforms a friendly relationship into a hostile one.” The end result could be the
breakdown of cooperation and reduced profitability for both firms.

The Holdup Problem and Transactions Costs

The holdup problem raises the cost of transacting arm’s-length market exchanges in
four ways. It can lead to:
1. More difficult contract negotiations and more frequent renegotiations
2. Investments to improve ex post bargaining positions
3. Distrust
4. Reduced ex ante investment in relationship-specific investments and/or reduced
ex post cooperation.

Contract Negotiation and Renegotiation

When trading partners anticipate the possibility of holdup, initial contract nego-
tiations are likely to be time consuming and costly as each side seeks to put
safeguards into the contract. As circumstances change in unanticipated ways, the
temptation for a party to hold up its trading partner is likely to lead to frequent
renegotiations and additional costs. In addition, renegotiations are likely to be
associated with delays or disruptions, raising production costs and impeding
delivery of products to customers.