Why Build a Factory Next to One Customer? Because Afterwards They Own You
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An investment that is only valuable within one relationship hands the other party power once it is made, and anticipating that stops useful investments happening at all.
The situation
One party makes an investment that is worth a great deal inside a particular relationship and very little outside it, such as a plant built beside a single customer's works, tooling made for one buyer's product, or years spent learning one firm's systems. Before the investment, both sides negotiate as equals. After it, the investing party has no alternative use for what they built, so the other side can demand better terms and the investor is better off accepting than walking away. The value created by the investment is captured by whoever did not make it.
The damage it does in advance
The serious cost is not the renegotiation but what never happens:
- •A rational investor anticipates being squeezed afterwards
- •So they invest less than the relationship is worth
- •Or demand guarantees the other side will not give
- •Or decline the arrangement entirely
- •The loss is invisible, since it is an investment not made
- •Both parties end up worse off than if commitment were possible
What firms do about it
The standard responses are all attempts to make commitment credible before the vulnerable investment is made. Long term contracts fix terms in advance, and fail where the future cannot be specified in enough detail. Mutual dependence helps, so each side makes a specialised investment and both are exposed. Hostages work, where a party deposits something it would lose by behaving badly. Reputation substitutes for contract in industries where parties deal repeatedly and information travels. And where none of these is enough, the firms merge, which removes the negotiation entirely by putting both activities under one owner.
Where it shows up outside business
The structure appears wherever somebody commits before terms are settled and recognising it is useful well beyond contracts. An employee who trains extensively in one employer's systems has less bargaining power afterwards than a generalist. A tenant who fits out a shop cannot move it. A country hosting a foreign investor's mine can raise taxes after the shaft is sunk, which is a recurring source of international dispute. A government agreeing a defence contract loses leverage once a supplier is the only one capable of finishing the work. The remedy in each case is to settle the terms before the commitment rather than after it.
Why economists care
The problem supplies one of the leading explanations for why firms exist at all and where their boundaries fall, which is a more fundamental question than it appears. Markets are supposed to be efficient, so an economy of independent contractors trading should outperform large organisations, and it evidently does not. Oliver Williamson and Oliver Hart built accounts in which the answer is exactly this vulnerability, so activities requiring specialised mutual investment are brought inside a firm while others are bought on the market. Both received Nobel Prizes for that line of work, in 2009 and 2016.
The takeaway
An investment valuable only within one relationship leaves the investor with no alternative, so the other party can demand better terms afterwards. Anticipating that, the investment is reduced or never made, which is the real loss. Long contracts, mutual exposure, hostages and reputation are the partial fixes, and merging is the complete one, which is a leading explanation of why firms exist.