Investigation of Information Control and Reputation as Informal Controls Against Hold-Ups

Abstract

Interfirm relationships can be successful but are also fraught with problems. We study how to encourage one party, herein the seller, to make a cooperative relation-specific investment that will increase the joint surplus. The seller, fearing he will be held up by the buyer, typically refrains from investing or attempts to protect himself with costly protection mechanisms such as vertical integration. We present two informal protection mechanisms that originate with the seller and the buyer, respectively. We propose that information control by the seller and buyer reputation for fairness can separately or simultaneously help reduce the risk that the seller will be worse off after the investment than before and, accordingly, encourage seller investment. To test the related hypotheses, we conduct two experiments and find that information control in the form of aggregated seller investment and production costs reduces the transparency of the seller’s cost information sufficiently to encourage seller investment and to increase offers of self-interested buyers. Additionally, we find that a fair purchasing strategy can signal the buyer’s intention to not appropriate the surplus created by the seller’s investment, thereby also encouraging the seller to invest in the relation-specific asset. Furthermore, we show that this increased investment efficiency is mitigated by the sellers’ expectations about the trade offers buyers will make ex post.