Contracts as entry deterrence

Contracts in Organizations and between them

Term Paper (Advanced seminar), 2009

11 Pages, Grade: 1,3



Contracts between buyers and sellers can have social welfare decreasing effects. They prevent entry of entrants with lower production costs than the incumbent, even though they not always prevent it entirely. The buyers may be better of accepting a contract, when the price and liquidated damages specified in it generate higher surplus for the buyer than with­out a contract. However, the contracts are disadvantageous for other society members. Free­rider problems occur, too. New financial means (options) may diminish the negative effects of contracts. In considering contracts’ implications entirely, also their duration is important.[I]

1 The basics

The paper from Aghion and Bolton (1987) investigates whether contracts between buyers and sellers deter entry and whether they are suboptimal from a welfare point of view. The hypotheses are that contracts between buyers and sellers will be signed for entry- prevention purposes. The main reason for signing exclusive contracts is to extract some of the surplus an entrant would get if he entered the seller's market.

Many economists pointed out that contracts between buyers and sellers in intermedi­ate-good industries may have significant entry prevention effects and that such contracts may be bad from a welfare point of view. But it is also a widespread opinion among antitrust practitioners that contracts between buyers and sellers are socially efficient. The buyer is better off when there is entry and he (she) tends to reject exclusive dealing contracts that reduce the likelihood of entry unless the seller compensates him (her) by offering an advan­tageous deal.

If a buyer signs an exclusive contract with a seller and then trades with an entrant, he has to pay damages to the seller (liquidated damages). The damage acts as an entrance fee

that has to be paid by the entrant to the seller. The entrance price is set like a monopoly sets its price when unable to observe the willingness to pay of the customers. In fact, the seller and the buyer form a monopoly towards the potential entrant. These kinds of contracts pro­duce a social cost, as entry is blocked because the contract imposes an entry cost on poten­tial competitors: an entrant must either wait until contracts expire, or induce the customers to break their contract with the incumbent by paying the liquidated damages.

In economics, a mutually advantageous trade is assured by the longest possible con­tract. There is a distinction between the nominal length of the contract (the length that is specified in the contract) and the effective length of the contract (the actual length that the parties expect the relationship to last at the time of signing). As an implicit measure of the effective length of the contract, liquidated damages have to be considered.

1.1 Optimal Contracts between One Buyer and an Incumbent Seller

In the model used in the paper, the incumbent makes a contract offer. By signing a contract, the incumbent and the buyer form a coalition which acts like a non-discriminating monopolist with respect to the entrant. As the incumbent and the buyer can only act as a non-discrimination monopolist, the contract introduces social costs, as the entrants with lower, but not low enough, production costs in comparison with the incumbent are deterred from entering the market. The contracts have to be of infinite length, as otherwise the entrant could enter when the period of contract has extended and no fee has to be paid any more. A simple contract is optimal for the incumbent (he sets the price the buyer has to pay and the liquidated damages).

1.2 The theoretical approach

In the two-period model, one single producer supplies one unit to a buyer. The reserva­tion price of the buyer is P = 1, the seller’s unit cost is set at[illustration not visible in this excerpt]The entrant’s unit cost of production is unknown and assumed to be uniformly distributed in the form of [illustration not visible in this excerpt]. Without a contract, the resulting price after entry will be the Bertrand equilibrium price [illustration not visible in this excerpt] . As the potential entrant makes zero profits without entry, his production costs have to be lower or equal[illustration not visible in this excerpt] Hence, the probability of entry is given by[illustration not visible in this excerpt]

illustration not visible in this excerpt

As for the timing of the model, in the first period, the seller and the buyer negotiate a contract. Then, entry may take place and in the second period there is trade and production. It is assumed that ce cannot be observed by the buyer or the seller, but the distribution is known to the latter. Hence, contracts cannot be based on [illustration not visible in this excerpt].

Without entry, the buyer’s expected payoff is Payoff[illustration not visible in this excerpt] Without entry, the seller sets the price at 1 and the buyer gets no payoff. However, if there is entry, the price equals [illustration not visible in this excerpt] Therefore, a contract has to bring the buyer at least an expected payoff Of 1/4.

In the paper, the contract is restricted to the simple form c = {P, P0} with P representing the price paid when trading with the incumbent and P0 the price the buyer has to pay if he does not trade with the incumbent, i.e. the liquidated damages. Hence, the surplus to the buyer is if there is no entry (1 - P) and at least (1 - P) if there is entrance and the buyer trades with the entrant. It is assumed that the buyer trades with the entrant in case the sur­pluses are equal. Therefore, the contract is acceptable to the buyer if the expected payoff from the contract is (1 - P) > -[illustration not visible in this excerpt] The entrant’s price therefore has to be P < P - P0, which holds in equilibrium condition. Additionally, the entrant has to make profits, i.e. P - ce > 0. Hence, the probability of entry when there is a contract is [illustration not visible in this excerpt]with the in­cumbent facing the maximization problem of max[illustration not visible in this excerpt] subject to (1 - P) >[illustration not visible in this excerpt] Hence, the optimal contract is given by[illustration not visible in this excerpt] This leads to the expected payoff for the incumbent of[illustration not visible in this excerpt] Without a contract or with a contract completely blocking entry, the payoff is lower[illustration not visible in this excerpt] The buyer is therefore not worse off with a con­tract than without. As the probability of entry is [illustration not visible in this excerpt]there is some entry prevention, but not entirely. If the entrant’s cost is lower than[illustration not visible in this excerpt] it will be profitable for him to enter. Thus, the coalition of the buyer and the incumbent behave as a non-discriminating monopolist with re­spect to the entrant. P0 is set like in the case a monopolist cannot discriminate between buy­ers with different willingness to pay. However, if the costs of the entrant were observable, the coalition could extract the entrant’s entire surplus by setting[illustration not visible in this excerpt] However, even if neither the incumbent nor the buyer has bargaining power, the same result of optimal con­tract occurs. The optimal contract induces social costs, because entrants with ce[illustration not visible in this excerpt] do not enter although their production cost is lower than that of the incumbent.

By establishing the optimal simple contract, both the buyer and the incumbent are bet­ter off than without it. However, they cannot set the fee for entrants dependent on the en­trant’s production cost as the coalition faces revelation of information problems. But, no other contract directly specifying the entrance fee to the entrant could generate a rent higher than [illustration not visible in this excerpt]which is the surplus the simple contract raises from the entrant.

1.3 Asymmetric information about the probability of entry

Now, it is assumed that the incumbent has some private information about the likeli­hood of entry (e.g. special high-tech knowledge difficult to copy). A finite length of a contract would be a signal of the incumbent that entry is unlikely along. The same holds for lower liq­uidated damages. However, it can be better for the incumbent to signal low probability of entry by short contract duration instead of low liquidated damages.

In the theoretical model, either high or low probability of entry is possible. Furthermore, the incumbent alone knows the true possibility of entry. It is also him who offers the contract. Hence, similar problems like the “informed principal problem” arise. The model is alike the one in section 1 with symmetric information, i.e. the entrant’s costs are uniformly distributed among [0,1]. However, now the incumbent’s costs are either [illustration not visible in this excerpt] In the first case, there is high probability of entry [illustration not visible in this excerpt] and with c = k there is low probability, namely [illustration not visible in this excerpt] Furthermore, the buyer’s prior beliefs about the cost of the incumbent are given by[illustration not visible in this excerpt]

The simple contract of the previous case is no longer feasible for the incumbent. In­stead, he would have to form a contract of the form c = {P, Pe,P0} to reach the same out­come. The optimal contract under asymmetric information sets the price the buyer has to pay when no entry happens at P, a second price he has to pay when there is entrance but the buyer trades nevertheless with the incumbent at Pe and finally also liquidated damages P0. If this contract could be implemented, there would be no restrictions on the length of the con­tract. However, the entry-price Pe is not feasible, as entry is hard to define and the contract would stimulate to bribe, either the buyer or the incumbent, depending on whether the en­trance price or the ordinary price is higher. Therefore, a simple contract has to be used. There are some implications on the length of the contract and the fines that have to be used in the asymmetric information scenario.

If the length of the contract is considered, entrance can occur in any period N of the trade and production game. As for the low cost incumbent, he is better off not signing a con­tract and waiting until entry occurs (depending on the difference between high and low costs). However, if N periods are considered, it is the case that a shorter length of contract should be chosen by the low cost incumbent. The seller’s contract offer of the form c = {P, P0} changes the beliefs of the buyer about the costs of the incumbent in the way that [illustration not visible in this excerpt]He will therefore only accept the contract if[illustration not visible in this excerpt] which can be rewritten with the equations about 0 and 0 from above as [illustration not visible in this excerpt] With the simple contract, the probability of entry is given by Pr([illustration not visible in this excerpt] This means that the payoff of the incumbent is given by[illustration not visible in this excerpt]It can be seen that it is more costly for an incumbent facing a high probability of entry to lower P0 than for that one with a low probability (see Figure 1).


[I] See Aghion, Bolton (1987).

Excerpt out of 11 pages


Contracts as entry deterrence
Contracts in Organizations and between them
Otto-von-Guericke-University Magdeburg  (Fakultät für Wirtschaftswissenschaft)
Incentives in Markets and Organizations
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sehr umfassende Recherche, Schwachstelle in der Zitation der Literatur
Contracts, Organizations, entry, deterrence
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Jessica Mohr (Author), 2009, Contracts as entry deterrence, Munich, GRIN Verlag,


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