Chapter 14.1: Relationship specific investments
Relationship specific investments are a particular type of sunk cost and can be good or bad depending on the circumstances. Typically these are fixed costs, only useful for the future in the context of maintaining the current relationship.
In romantic relationships the time and effort you invest in each other is a relationship specific investment. These win goodwill with that specific person and apart from any reputation gains have relatively little value outside of the relationship. Of course on the assumption that the relationship is healthy and optimally ought to continue, relationship specific investments are beneficial to both parties.
The same is true for relationships with friends & family and pets. The time you spend with your cat or dog is useful within the context of that particular relationship but doesn’t particularly endure you to other creatures. All the time and effort I spent training my first dog does nothing to improve the behavior of my current golden retriever. She perhaps benefits from my knowledge and experience, in some sense this is a form of learning by doing cost saving gains that I now possess relative to a new dog owner, but the specific lessons, treats, and tricks were lost with the passing of that one.
This looks a bit different in business relationships. Suppose one company adopts specific software that improves compatibility with one specific vendor. Such an investment promotes efficiency so long as that business relationship persists, but might present an obstacle to forging another business relationship instead. Existing infrastructure in place for the benefit of working with a specific supplier creates a relatively high switching cost and might discourage the company from seeking another supplier, even if all things considered it’s better to switch.
An example of this was Apple’s use of Intel processors. The fact that Apple had built its array of Mac’s based around running Intel chips prevented it from switching to in-house chips for many years, until 2020. Eventually in 2023, Apple finally switched over all of its computers to ship with their own Apple silicon chips. This was non-trivial as switching processor chips required substantial investment and development in Apple’s own chips and reworking the line of computers that would operate with them.
While eventually Apple was sufficiently motivated to begin its own in-house production of cpu’s, there are other situations where the presence of a relationship specific investment can lead to worse outcomes.
Suppose a family commissions a local artist to paint their portrait. Both parties agree on the sum and the timeline for the family to sit for the initial sketches. Suppose for example the original purchase price is something like $2500 for the whole deal. The family comes in, the artist begins working on the painting, and later on in the future the artist presents the finished painting.
By this point the artist has made a huge relationship specific investment: They’ve invested time, effort, and materials and have forgone other projects during this time. But the family has only invested at most a few hours, and probably less than that. When it comes time pay up the family could inspect the painting, express disappointment, and claim that they are only willing to pay $1000 for the painting. And the artist would be stuck. Settling aside legalities, this is an example of the hold-up problem: one party has made a relationship specific investment that the other party is exploiting for a better bargaining position.
The artist has a difficult decision to make. Realizing that the painting has significantly less value to any other prospective buyer they can sell the painting to the family for $1000 or they can refuse, and perhaps pursue legal action. But in all likelihood the legal measures necessary to recover the full price of $2500 would involve costs that exceed the marginal benefit ($1500) of a successful case versus simply accepting the now admittedly unfair offer of $1000 and being done with it.
This is the hold-up problem. Basically what has happened is the buyer tries to renegotiate the original terms of the deal on the realization that the seller has made a relationship-specific investment, now a sunk cost, shifting bargaining power in favor of the buyer. This is very undesirable from the perspective of the seller!!!
What can the artist do to prevent these circumstances? Demand a substantial portion of the payment upfront! One key reason why artists and photographers and contractors and many other businesses require a large percentage of the final purchase price in advance is to protect themselves against the hold-up problem. What about us?
Whether you have a business or not, this is something that you can do as well! Requiring some sort of ‘buy-in’ in advance from the other party is a potential way to avoid the hold-up problem and/or to reduce the incentive for them to try to renegotiate the terms later on. This doesn’t have to be a monetary investment; it can be a time investment, or an emotional investment.
The key idea in the context of a relationship it is important to make sure that you’ve got a reasonable level of buy-in from them as well, depending on the specific circumstances. This signals their commitment to the original terms, whatever these might be, and raises the switching costs. In the business sphere this might often involve contracts, in the personal sphere this is often represented by a reasonable level of mutual investments in plans and experiences in order to signal that both parties’ interests are relevant.