Bidding on a Missile Program Merowak Missiles is proposing to develop its next generation Democratizer Offensive Weapon System II (DOWS II) for the US military. It expects to have to sink $1 billion into R&D and design, spend $0.5 billion building the

Question

tools and production facility that are unique to DOWS II production. It houses these in standard factory floor space that costs $1 million. Each missile has a marginal cost of $2,000 . The Pentagon is considering ordering 1 million of these missiles. Merowak fears that the Pentagon will ask for a lower price after only half the missiles are produced. How could it keep itself from being victim of holdup?

Answer 1

Bidding on a price per missile with such high relationship-specific fixed costs leaves Merowak vulnerable to holdup because these costs would be sunk at the time production commences. The common strategy is to separate the contract for the relationship-specific asset from the use of the asset. In this case, Merowak can seek three contracts: 1) an R&D contract for $1 billion to develop the missile, 2) a construction contract to produce the unique tools, and 3) a production contract per missile. That way Merowak does not have to include the average fixed costs of the first two into the price of each missile. Of course, this leaves the Pentagon vulnerable to holdup because it could squander the first $1 billion and not develop the missile.