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. Free-rider problems occur, too. New financial means (options) may diminish the negative effects of contracts. In considering contracts’ implications entirely, also their duration is important.
Table of Contents
1 The basics
1.1 Optimal Contracts between One Buyer and an Incumbent Seller
1.2 The theoretical approach
1.3 Asymmetric information about the probability of entry
1.4 Optimal contracts with several buyers
1.5 Provisional conclusion
2 Profiting from induced changes in competitor’s market values
2.1 Entry with a passive incumbent
2.2 Entry with entry deterrence by the incumbent
3 Time
4 Conclusion
Research Objectives and Topics
This paper examines the economic implications of contracts, specifically their role as barriers to market entry, and analyzes how different contractual structures and market conditions influence competitive dynamics and social welfare.
- Theoretical analysis of contract-based entry deterrence strategies.
- Impact of asymmetric information on contractual outcomes and signaling.
- Effects of cross-trading and secondary financial impacts on business competition.
- Role of contract duration and time-dependent renegotiation in market efficiency.
Excerpt from the Book
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 c = 1/2. The entrant’s unit cost of production is unknown and assumed to be uniformly distributed in the form of ce ∈ [0,1]. Without a contract, the resulting price after entry will be the Bertrand equilibrium price P = max{1/2, ce}. As the potential entrant makes zero profits without entry, his production costs have to be lower or equal 1/2. Hence, the probability of entry is given by φ = Pr(ce ≤ 1/2) = 1/2.
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 ce.
Without entry, the buyer’s expected payoff is Payoff = (1 - φ) * 0 + φ * 1/2 = 1/4. Without entry, the seller sets the price at 1 and the buyer gets no payoff. However, if there is entry, the price equals 1/2. Therefore, a contract has to bring the buyer at least an expected payoff of 1/4.
Summary of Chapters
1 The basics: Introduces the foundational concepts of exclusive contracts and their potential to serve as entry barriers that may reduce social welfare.
1.1 Optimal Contracts between One Buyer and an Incumbent Seller: Examines how an incumbent uses simple contract structures to deter entrants with lower production costs.
1.2 The theoretical approach: Defines the mathematical model used to assess buyer payoffs, entrant costs, and the resulting probability of market entry.
1.3 Asymmetric information about the probability of entry: Analyzes how an incumbent's private information regarding the likelihood of entry influences the design of optimal, signaling-based contracts.
1.4 Optimal contracts with several buyers: Extends the model to include multiple buyers, highlighting how individual contracts can create negative externalities and affect overall market competition.
1.5 Provisional conclusion: Summarizes the implications of entry-deterring contracts, noting their potential for social inefficiency and their reliance on individual business circumstances.
2 Profiting from induced changes in competitor’s market values: Explores how cross-trading and securities holdings influence the probability of entry for potential competitors.
2.1 Entry with a passive incumbent: Discusses how an entrant's potential trading profits can affect their entry decision when dealing with a passive incumbent.
2.2 Entry with entry deterrence by the incumbent: Investigates how an incumbent can use financial commitments to strategically deter entry in the presence of cross-trading opportunities.
3 Time: Discusses the critical role of contract duration and renegotiation processes in maintaining market efficiency and investment incentives.
4 Conclusion: Evaluates the limitations of the presented theoretical models and suggests areas for future research regarding timing and financial market implications.
Keywords
Contracts, Entry deterrence, Social welfare, Asymmetric information, Liquidated damages, Incumbent, Entrant, Cross-trading, Market value, Bertrand equilibrium, Monopoly, Signaling, Contract duration, Investment incentives, Competition policy
Frequently Asked Questions
What is the core focus of this research paper?
The paper primarily examines how exclusive contracts are used as strategic tools to deter entry into a market and whether these practices lead to socially suboptimal outcomes.
What are the primary thematic areas explored?
The main themes include entry deterrence mechanisms, the impact of asymmetric information on contract design, the role of financial impacts like cross-trading on competition, and the importance of contract duration.
What is the ultimate research objective?
The objective is to theoretically model and assess the implications of contract-based entry prevention on market efficiency, buyer payoffs, and the behavior of incumbents and entrants.
Which scientific methods are applied in the paper?
The paper utilizes formal economic modeling, specifically game-theoretic two-period frameworks, to analyze equilibrium conditions under both symmetric and asymmetric information.
What content is addressed in the main sections?
The main sections cover the basics of entry-deterring contracts, the impact of private information on these contracts, multi-buyer scenarios, and the secondary effects of financial market interactions on business decisions.
Which keywords best characterize the study?
Key terms include entry deterrence, asymmetric information, liquidated damages, social welfare, and cross-trading.
How does the paper differentiate between nominal and effective contract length?
It distinguishes between the duration explicitly stated in the contract and the actual duration parties expect, noting that liquidated damages often serve as an implicit measure of this relationship's true length.
What role does cross-trading play in the model by Hansen and Lott?
Cross-trading creates financial incentives that can smooth the probability of entry; an entrant's profit-seeking behavior regarding the incumbent's stock value can significantly alter traditional entry predictions.
Why does the author argue that simple contracts are optimal in the presented models?
Simple contracts—defining a price and liquidated damages—are optimal because they effectively extract surplus from the entrant while remaining feasible for the incumbent under informational constraints.
- Citation du texte
- Jessica Mohr (Auteur), 2009, Contracts as entry deterrence, Munich, GRIN Verlag, https://www.grin.com/document/127109
