The problem of adaptation
The example above illustrates how the risk of post-contractual opportunistic behaviour affects ex ante incentives to invest in welfare-enhancing specific assets. It is easy to show how, in a world of complete contracts, a penalty like p° = ˆ30 000 incurred by the renegotiating party, may align parties’ incentives to invest efficiently after the contract has been signed.
This may suggest to rational parties that they should determine ex ante, even in an incomplete contracts framework in which investments are not contractible, a very detailed contract at least in terms of pricing, exclusive clauses and breach penalties. However, writing a contract with verifiable fixed prices and/or breach penalties may generate a ‘double hazard problem’ since the potential victim of hold-up might be induced to underinvest after he/she has received a powerful safeguard. A fixed contract price may thus prevent renegotiation even in those cases in which it might be efficient for parties to renegotiate in order to adapt to new unforeseen circumstances. Two well-known examples of the inefficiency associated with fix-price contracts are given by Fisher Body v. General Motors (Klein et al., 1978; Klein, 1996) and Alcoa v. Essex (Speidel, 1981; Goldberg, 1985; Klein, 1996):1. Fisher Body v. General Motors Fisher Body was an automobile body supplier. In order to produce the automobile bodies, Fisher Body had to make specific investments in stamping machines and dies. Due to the high degree of unverifiability on the nature of specific investments, any contract signed by Fisher Body was potentially vulnerable to a counterpart’s hold-up. In 1919, Fisher Body signed a long-term contract with General Motors (GM) for the supply of closed-metal autobodies, containing several provisions aimed at protecting Fisher Body against a possible GM hold-up. A first safeguard was given by an exclusivity clause which obliged GM to buy all of its closed-metal autobodies from Fisher.
Moreover, the contract defined a pricing formula for autobodies based on a cost-plus rule for which the final price was determined by labour and transportation costs plus a mark-up to cover capital costs. Two other contractual clauses (‘most-favoured nation’ and ‘meeting com- petition’5) were aimed at preventing Fisher Body from exploiting its contractual power against GM. Between 1919 and 1924, however, the market registered a huge and unforeseen change in demand: wooden bodies were rapidly replaced by metal autobodies. This exogenous change in automobile bodies contrasted with the original pricing provisions agreed upon by the parties, which revealed that prices for metal bodies were too high. According to the traditional interpretation of this case, Fisher Body refused to renegotiate the pricing formula or to satisfy GM’s request to locate Fisher plants next to GM ones, so as to at least reduce transportation costs. The refusal to renegotiate by the ex ante most vulnerable party corresponds to a hold-up behaviour induced by rigid contractual clauses rather than by contractual incompleteness. In this case, contractual rigidity impeded the efficient ex post renegotiation of contractual terms which would have led to adaptation to new unforeseen contingencies.2. Alcoa v. Essex6 Essex was an aluminium cable manufacturer while Alcoa was an aluminium facility producer. In order to allow shipments of processed aluminium from Alcoa to Essex in molten form and thereby reduce production costs, Essex located its plant next to Alcoa’s plants. This site specificity increased Essex’s dependency on Alcoa’s ex post hold-up. In order to protect Essex from Alcoa’s post-contractual opportunism, Essex entered into a long-term contract with Alcoa, specifying predetermined price formula and output rates for Alcoa’s processing of alumina into aluminium for Essex. The pricing formula linked the price for Essex to a wholesale price index for industrial commodities.
However, after the 1973 crude oil supply crisis, electricity costs (which represented the most important non-labour cost in aluminium production) began to rise much more rapidly than the wholesale price index. As a consequence, the price at which Essex was receiving aluminium from Alcoa was set at a net cost of less than one-half of the contemporary market price of aluminium. This unforeseeable change in electricity costs resulted in turn in an unexpected gain for Essex at the expense of Alcoa. As Klein (1996) points out ‘the enforcement by Essex of the literal terms of this imperfect contract can be considered a hold-up since it can be assumed to be contrary to the original intent of the contractual understanding’.In both cases, Fisher Body v. General Motors and Alcoa/Essex, the ex ante potential victim of hold-up, after obtaining exclusivity clauses and fix-price contracts as safeguards against renegotiation, became itself the opportunistic party as some unforeseen exogenous change in market dynamics transferred to that party all the ex post bargaining power at the renegotiation stage.
The two examples above illustrate the tradeoff between opportunism and adaptation and outline how the pursuit of efficiency in an incomplete contracts framework always requires a complex governance structure which assigns to the most vulnerable party ex ante appropriate safeguards against opportunism without incurring the opposite risk of shifting contractual dependency on to the counterpart, when unanticipated changes in market conditions affect parties’ ex post incentives to fulfil contractual obligations.