Holdups and Overinvestment in Physical Capital Markets

Abstract

Firms in many situations must make investment decisions long before they meet with new capital suppliers. In addition, most physical capital is specific to a task or location, thus implying potentially important switching costs in case negotiations between a firm and a supplier break down. The present paper analyzes the implications of these frictions. The sequentiality of investment makes it impossible to write binding ex-ante contracts. Together with the rents arising from switching costs, this implies a holdup problem. In partial equilibrium, firms react strategically by overinvesting so as to reduce their marginal productivity and thus the price of capital they negotiate with their suppliers upon matching. In general equilibrium, the holdup problem interacts with externalities from switching costs, resulting in inefficient allocations. In a more general macroeconomic context, the holdup problem in physical capital markets interacts with holdup problems in labor markets that typically lead to underinvestment. As long as capital and labor are complements, this presents the firm with a trade-off between overinvestment and overemployment that neutralizes, at least partially, the distortionary effects of each of the two holdup problems.