Suppose that an entrepreneur is deciding whether or not to build a new highspeed railroad on the West Coast. Building the railroad will require an initial sunk cost F. If operated, the new railroad will generate revenue R. Operating the railroad will cost M in fuel and nw in wages, where n is the number of full-time jobs needed to operate the new railroad and w is the career wage per worker. If a rail worker does not work on the new railroad, then he can get a wage of w at some other job. Assume that R > M + F + n
, so it would be profitable to build and operate the new railroad even if rail workers had to be paid somewhat more than the going rate w. The entrepreneur, however, must decide whether to invest the initial sunk cost F before knowing the wages she must pay.
(a) Suppose that if the railroad is built, after F is invested, the local rail workers' union can make a "take it or leave it" wage demand w to the entrepreneur. That is, the entrepreneur can only choose to accept and pay the wage demand w or to shut down. If the railroad shuts down, each worker receives w. Will the railroad be built? Why?
(b) Next suppose that the wage is jointly selected by the union and the entrepreneur, where the union has bargaining weight pU and the entrepreneur has bargaining weight πE = 1 - πU . Use the concept of negotiation equilibrium to state the conditions under which the railroad will be built.
(c) Explain the nature of the hold-up problem in this example. Discuss why the hold-up problem disappears when the entrepreneur has all of the bargaining power. Finally, describe ways in which people try to avoid the hold-up problem in practice.