The Hold-up Problem in the Presence of Free Trade Agreement Negotiations

Abstract

This paper examines how the underinvestment that results from the hold-up problem is affected when there is some probability of reaching a free trade agreement (FTA). This paper examines the canonical domestic hold-up problem in an international context. It considers an input supplier undertaking one-sided cost-reducing relationship-specific investment to produce an input for a final-good producer. Once the FTA is reached, both the final-good producer and input supplier face foreign competition. This study finds that it is possible for the presence of FTA negotiations to either aggravate or alleviate the domestic hold-up problem. The total effect of the presence of FTA negotiations on ex-ante investment incentives can be decomposed into an “output competitive effect” and an “input substitution effect”. Both effects can be further decomposed into a “strategic effect” and a “cost effect”. The fundamental driving forces behind the “strategic effect” and “cost effect” are the characteristics of the cost function for the non-standardised input, the characteristics of the final-good’s demand function, and the relative efficiency of the two final-good producers in the two countries. In addition, the probability of reaching the FTA serves as an “intensifier” of the aggravation or alleviation. The modification cost of the foreign input serves as a “protector” for the domestic non-standardised input against competition from the cheaper foreign substitutes.