Two-sided hold-up

In the investment's chapter, we talk about the problem of post-investment hold-up.  After a firm makes sunk-cost investments, it becomes vulnerable to post-investment hold up by its trading partners.  A variety of solutions are available to address the problem of hold-up, including litigation.

The antitrust laws have been moving recently to address the problem of hold-up by adopting rules that shift bargaining power from innovators (who develop intellectual property that is implemented in a standard, like 4G LTE) to implementors (who license patents necessary to use the standard).

In this paper, two economists point out that the problem is really two-sided,

Concerns expressed regarding the potential for patent hold-up are generally one-sided, focusing on the incentives of the implementers of the technology while generally ignoring the incentives of innovators to create the technology in the first place. 7 Such analysis takes the level of innovation as given, so that the only possible harm to competition is through the implementer’s decision to invest. The underlying incentive problem, however, is two-sided because an innovator’s incentives to engage in significant R&D may also be distorted by well-intentioned actions taken to correct the potential hold-up problem.

But one of the hold-up problems--the innovator's--is relatively easy to solve, via negotiations that occur prior to the implementer’s investment in the standard.  In contrast, negotiations always occur after the innovator’s investment in R&D is sunk.  Consequently, shifting bargaining power to the implementor exacerbates the risk of under-investment:

The reason is that innovators and implementers can and do bargain prior to the implementer’s adoption of and investment in a standard and courts impose such “hypothetical” bargaining when determining royalties. Therefore, the implementer’s efficient investment, which benefits both parties, is an essential part of these deliberations. However, bargaining does not occur prior to the innovator’s investment in R&D. In fact, all such “ex ante” bargaining occurs after these investments are sunk. Curtailing injunctive relief and basing royalties on the smallest salable component both pose the risk of under-rewarding innovators for their investments. This is likely to retard innovation, reduce incentives to participate in standards, and reduce economic welfare