Publication: RAND Journal of Economics
Publication Date: 22-MAR-07
Delivery: Immediate Online Access
Author: de Meza, David ; Selvaggi, Mariano

Article Excerpt
Exclusive contracts prohibit one or both parties from trading with anyone else. Contrary to earlier findings, we show that investments that are specific to the contracting parties may be encouraged by exclusivity. Results depend on the nature of investments and the bargaining solution. The major part of the analysis shows that exclusivity deals designed to "assure" the supply of essential inputs promote investment. Infinite penalties for breach, even if ex post renegotiable, may result in excessive investment, in which case a positive but finite damage payment yields the first-best outcome.

1. Introduction

* A burgeoning literature examines how to mitigate hold-up problems. Less attention has been paid to why firms deliberately increase their vulnerability to ex post expropriation. That, after all, is the consequence of exclusive-dealing contracts so frequently adopted when legal. (1) There is no real paradox, though. Exclusivity redistributes bargaining power by prohibiting trade with third parties, so if one party to the contract is more exposed to hold up, the other is less so. Relationship-specific investment may therefore increase. In fact, with sufficient complementarity, both parties may invest more.

All this is denied by an influential article by Segal and Whinston (2000). They find that contractually locking parties together is "neutral" with respect to investment in the relationship. Although any reasonable bargaining model implies that an exclusive-dealing contract enhances the unrestricted party's bargaining power, this does not affect incentives if, as in Segal and Whinston's model, the payoff rises by the same amount whether or not investment is undertaken. Segal and Whinston assume that agents' bargaining payoffs are linear combinations of their marginal contributions to each possible coalition; a generalization of the Shapley value of cooperative game theory. (2) Suppose there are two potential buyers of a seller's good. Exclusivity then eliminates the surplus created by a coalition of the seller and the excluded buyer. As nothing changes in a coalition that includes the contracted buyer, exclusivity leaves marginal investment incentives unaffected--Segal and Whinston's irrelevance result. (3)

As a first indication that this finding does not extend to other reasonable bargaining models, suppose a buyer desires a unit of an input available in generic form from a competitive industry at price equal to production cost c. The buyer values the good at v > c. A seller is able to tailor the good to the buyer's requirements. The modified good is no more costly to produce and boosts the buyer's valuation to v + [DELTA], where [DELTA] > 0. For this benefit to be realized, prior to production, both the buyer and the seller must each make an unverifiable investment of i, where i < 0.5[DELTA]. Buyer investment could be the time and effort to inform the seller of what is needed to enhance value, adapting plant to use the modified input or advertising a superior final product.

If both investments are undertaken but the good is not yet produced, there is a surplus of v + [DELTA] - c to divide. The buyer could purchase a generic good on the competitive market, so has outside option v - c. For the seller, the best alternative is to produce for the market, in which case she obtains zero surplus. At this point, a binding price may be negotiated. The bargaining is a Rubinstein-type alternating-offer game with outside options. As the interval between rounds shrinks to zero, the buyer's outside option binds if v - c > 0.5(v + [DELTA] - c), that is, if v - c > [DELTA]. In such a case, the tailored good is sold for c + [DELTA], and the buyer's gross surplus is v - c irrespective of investment. Hence, the only equilibrium is that neither party invests.

Now suppose there is a prior exclusive-dealing contract that forbids the buyer acquiring the good from any but the specified seller. Delivery remains noncontractible, though. The buyer's outside option vanishes and the surplus is now split equally between the parties. Consequently, both buyer and seller investing is an equilibrium if 0.5(v + [DELTA] - c) - 0.5(v - c) - i > 0, that is, if 0.5[DELTA] > i. Thus, exclusivity elicits investment if and only if it is efficient to invest. (4) As the informal literature argues, the seller, who directly benefits from the exclusive clause, invests more. So too does the buyer, despite being restricted by the clause. In the end, both parties are better off. The arrangement resembles a franchise contract where, as Klein and Saft (1985) document, it is common that the franchisee (the buyer) must obtain inputs from the franchisor (the seller) rather than from the open market. The usual explanation for this practice is quality control. Our analysis suggests that investment incentives might be to the fore. (5)

A more important application may be to employment contracts. Even in the absence of statutory employment protection, firms typically constrain themselves from replacing workers at will. When an employer offers a long-term contract to an employee, in effect, it becomes an exclusive supplier. The example just analyzed indicates that, as a result, both sides may invest more in the partnership.

The remainder of this article does not invoke a competitive sector and the outside-option principle. Like Segal and Whinston (2000), we model explicitly the ex post bargaining between all potential traders, namely the seller of a unit good and two potential buyers, one of which has a stochastic investment opportunity. The resolution of the uncertainty determines which buyer values the input most but, as resale is possible, an exclusive contract does not hamper ex post efficiency. Crucially, in the event of resale, the bargained price is increasing in investment because the threat point is higher. This creates a positive private marginal return from investment, which counteracts the hold-up problem arising when the contracted party is the efficient user. Even without complementarity, the protected party may invest more. In fact, overinvestment is possible, though this can be corrected by suitable penalties for breach of contract.

This model supports informal arguments suggesting a strong link between exclusionary provisions and the beneficiary's investment incentive (e.g., Klein, Crawford, and Alchian, 1978; Klein, 1988; Frasco, 1991). The findings extend to alternative bargaining settings (see de Meza and Selvaggi, 2004). The irrelevance result of Segal and Whinston (2000) appears to be a special case. The appropriate specification of the bargaining model is a matter of debate, but our formulation seems reasonable in many settings. Moreover, with no contract in place, Segal and Whinston's framework implies that firms that do not trade nevertheless obtain positive payoffs from those that do. Such payments are not obviously observed in practice and are not implied by the noncooperative circulating-offer bargaining model of our article.

Apart from Segal and Whinston (2000), the formal literature on exclusive dealing is mostly concerned with free-riding problems arising from investment spillovers. For instance, a manufacturer may grant a retailer an exclusive dealership to encourage presale services or advertising that would otherwise benefit all retailers carrying the brand (as in Mathewson and Winter, 1994). Investments of this kind are evidently not entirely relationship specific. The issue is whether investments that benefit only the two contracting parties are encouraged by an exclusivity provision.

Attempts to curb free riding in the context of technological externalities also underlie the exclusionary provisions analyzed by Mathewson and Winter (1987), Marvel (1982), Besanko and Perry (1993), Masten and Snyder (1993) and Bernheim and Whinston (1998). Motta (2004) reviews these arguments. Using a rather different set-up, McAffe and Schwartz (1994) also conclude that, in multilateral contexts, exclusivity can protect customers from ex post opportunism. However, their result stems from the assumption that downstream firms produce (perfect or imperfect) substitute products, which, in the absence of exclusive dealing, leads to negative pecuniary externalities between them. We assume, on the contrary, that downstream firms do not compete on the product market.

When option contracts are feasible but fail to...



NOTE: All illustrations and photos have been removed from this article.



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