Exclusion by a manufacturer without a first-mover advantage

Transcription

1 Exclusion by a manufacturer without a first-mover advantage Bo Shen Jan, 2014 Abstract The existing literature on naked exclusion argues that exclusive contracts can be used by an incumbent firm to anti-competitively exclude a more efficient rival from entry. This paper shows that a dominant manufacturer is able to use exclusive contracts with retailers to foreclose its rival, even though it does not enjoy any first-mover advantage. The rival manufacturer is assumed to also be able to make exclusive deals with retailers. Due to a contracting externality a- mong retailers, equilibria with exclusion arise in which one of the manufacturers monopolizes the market. The dominant firm, with a supra-demand advantage, monopolizes at a lower cost and within a wider range. Exclusion is easier to sustain as upstream competition becomes stronger and as the number of competing retailers becomes smaller. JEL classification: L11; L12; L42 Keywords: Exclusive dealing; First-mover advantage; Foreclosure I would like to thank Julian Wright for his helpful suggestions and comments. I also thank all the participants in the applied IO reading group in National University of Singapore. Department of Economics, National University of Singapore, shenbopku@gmail.com.

2 1 Introduction Exclusive dealing is often used by firms in vertical relations, as a practice to anticompetitively exclude or foreclose other competitors. It has been a controversial issue in antitrust history for a long time, whether a dominant firm is able to use exclusive contracts with its buyers for foreclosure motivation. Most of the existing literature on exclusive dealing focuses on naked exclusion, in the case of which exclusion arises even though there is no efficiency gain. These papers rely on a crucial assumption of firms first mover advantages. The incumbent firm which enjoys a first-mover advantage, will use exclusive deals to sign up all buyers or competing downstream sellers, so that a more efficient firm is foreclosed from entry. However, in real world antitrust cases, the first-mover advantage rarely exists. When a firm is making exclusive offers, rival firms are already present in the market and can make similar exclusive deals as well. Thus a few interesting questions arise: whether exclusion still occurs even though manufacturers do not have any first-mover advantages? Is it possible for a small firm to exclude a larger rival through exclusive deals, if both firms are able make exclusive deals at the same time? This paper tries to fill in the gap of the naked exclusion literature by studying the effect of exclusive dealing in a framework where no first-mover advantages are observed. Exclusive dealing has raised a particular concern from antitrust authorities due to its anti-competitive effects. A dominant firm might use exclusive contracts to maintain its monopoly position by fully excluding other competitors. Thus exclusive dealing will harm consumers by raising the final prices. Earlier antitrust cases regarding to exclusive dealing mostly belong to manufacturing industries. 1 Recently, there are several exclusive dealing cases challenged by Federal Trand Commission (FTC) in US. For example, IDEXX is a company manufacturing point-of-care (POC) diagnostic products used by veterinarians and it has maintained the market share of 70% in the market for POC diagnostic products for at least five years. As one of 1 For example, Standard Fashion Co.v. Magrane-Houston Co., 258 U.S. 346, 1922, Standard Oil Co. of California v.u.s., 337 U.S. 1949, U.S.v.United Shoe Machinery Corporation, 347, U.S.521,

3 the four recent exclusive dealing cases of FTC, IDEXX was accused by achieving and maintaining its dominant market share through exclusive contracts with distributors whose combined sales of POC diagnostic products in the US accounted for 85% of the market. The FTC further alleged that the exclusive contracts prohibited IDEXX s distributors from carrying the POC diagnostic products by other rivals and thus foreclosed IDEXX s rivals from distribution. There are many other recent antitrust cases involving exclusive dealing. 2 Clearly, all these exclusive dealing cases above do not fit in the existing models on naked exclusion, which assume the existence of the firstmover advantage of the incumbent firm. These cases illustrate a situation in which exclusion arises with one firm monopolizes (or nearly monopolizes), while other firms are already in the market and can also make similar exclusive deals. Therefore, no firms are making entry decision and no first-mover advantage exists, Another interesting and well-known antitrust case is between Coke and Pepsi, two world s largest firms in soft drink market. Coke and Pepsi have been engaged in intense competition for more than twenty years. Coke was accused by Pepsi of abusing its dominance power to monopolize the soft drink market through exclusive deals to drink service distributors in US. Alleging that Coke controlled over 90% of the fountain-dispensed soft drink market, Pepsi claimed that Coke used its supra market power to soften competition and control prices. Recently, both companies are competing in the battle for exclusive contracts on college campuses. Though Pepsi once accused Coke of using exclusive contracts to limit competition, it does act as a local monopolist of serving soft drinks in certain regional areas. Pepsi won the exclusive beverage contracts against Coke at University of Arkansas in May Pepsi also signed a $20.75 million agreement with the City University of New York, by exclusively providing soft drinks in the campus for 10 years. The contract started from July 1, In the battle against Coke, which enjoys a dominant market position with a larger market share, Pepsi is also able to profitably use exclusive 2 For example, Graco used exclusive distribution contracts and loyalty discount programme in the market for fast-set equipment (FSE) products; PoolCorp, a large wholesale distributor, sought exclusivity from a group of manufacturers in pool products in the swimming pool industry; McWane also foreclosed the main competitor Star and Sigma Corporation (Sigma) from entry or expansion, in the market of ductile iron pipe fittings (DIPF). 2

4 contracts to downstream distributors so that Coke is excluded in some regions. In this case, Pepsi as a smaller firm, also monopolizes through exclusive contracts. This result can not be explained by the existing models on naked exclusion. In contrast to the naked exclusion literature which relies on the key assumption of the first-mover advantage, the paper aims to restudy the effect of exclusive dealing in a framework where no first-mover advantage is present. In a model with two manufacturers offering differentiated products to downstream retailers, we show that exclusion occurs even though both firms are present in the market and are able to make exclusive offers to retailers. As two competing manufacturers are making linear pricing contracts, equilibria with exclusion arise in which one of the manufacturers monopolizes the market, when upstream competition is strong and dominant firm s demand advantage is small. Due to a contracting externality among retailers, a retailer always finds it more profitable to remain as the single seller of the manufacturer s products, whenever it receives similar exclusive offers from both manufacturers. Therefore, in order to fully exclude the rival and maintain the monopoly position, the manufacturer must make sufficiently high exclusive offers so that it is able to induce all retailers to sign up exclusively. Given the high offers made by a manufacturer, the rival is not profitable to compete by attracting either both retailer or only one. As the dominant firm s demand advantage becomes strong enough, exclusion only occurs where the small firm is foreclosed. Due to supra demand advantage, the dominant firm is able to monopolize at a lower cost and within a wider range. This model can be used to explain most of the exclusive dealing cases on antitrust history, where no first-mover advantage is observed. It can also be applied to the case of Coke and Pepsi and explains why Pepsi monopolizes in certain local regions, despite its weaker market dominance as compared to Coke. The exclusion results are robust to discriminatory exclusive offers, Nash bargaining between parties and multiple competing retailers. Discriminatory offers will not change the outcome since the contracting externality between retailers still exists. In order to monopolize and foreclose the rival, a manufacturer must sign up all retailers using a high amount of compensations. Discriminatory offers can not increase man- 3

5 ufacturer s profit since the rival is always ready to attract the retailer which receives a lower offer. As Nash bargaining occurs between parties who seek to maximize the channel profit, the exclusion mechanism still holds. Exclusion outcome also exists when there are multiple competing retailers, though it will become harder for a manufacturer to monopolize as the number of retailers increases. Sequential offers and two-part tariff contracts might change the exclusion mechanism. When the manufacturers can make exclusive offers sequentially, multiple exclusion equilibria will be eliminated. The manufacturer who makes offers first is able to sign up all retailers, ending up as a monopolist. This result is consistent with the existing literature on naked exclusion, where first-mover advantages exist. When the manufacturers can offer two-part tariff contracts, multiple equilibria will be also e- liminated since there is no longer any contracting externality between retailers. Since the manufacturer is always able to extract sellers surplus (gross of the exclusive compensations), sellers participation decision no longer depends on others choice. Thus competition between manufacturers occurs in the battle of using exclusive deals. The dominant manufacturer who earns a higher monopoly profit is able to sign up all the retailers and it eventually excludes the rival. Therefore, without first-mover advantages, the contracting externality between retailers is the main reason why multiple exclusion outcomes occur. This paper belongs to the literature of exclusive dealing. Exclusive dealing has been studied since 1950s, the traditional concern of which is anticompetitive because it will be used by an incumbent firm to deter efficient entry and thereby reduce social welfare. Chicago School (Posner, 1976; Bork, 1978) challenges this argument by claiming that rational firms would not engage in the practice of using exclusive contracts for anticompetitive reasons, because the joint profit of the contracting parties will not increase using exclusive contracts. Thus foreclosure would occur only when there exists some efficiency gain from exclusive dealing. The idea of Chicago School was later challenged by several papers on naked exclusion, where exclusion arises even though there is no efficiency gain associated with it. Rasmusen, Ramseyer and Wiley (1991) and Segal and Whinston (2000) argue that 4

6 exclusive contracts can inefficiently deter entry in the presence of scale economies and multiple buyers. By signing the exclusive contracts with the incumbent firm, a buyer makes it harder for the entrant to achieve the minimum efficient scale and makes it less profitable for the entrant to enter. A buyer s decision of signing up the exclusive contracts imposes a negative externality on other buyers, which makes exclusion easier to occur. Therefore, exclusion occurs due to coordination failure among buyers. Simpson and Wickelgren (2007) consider the case where buyers who sign the exclusive contracts are able to breach, and they find out that entry is the unique equilibrium. However, these papers consider exclusive contracts between firms and buyers who are all independent final consumers, while most of the exclusive dealing cases in reality are observed between manufacturers and downstream competing retailers. Later studies relax the assumption by considering downstream competition between buyers. Fumagalli and Motta (2006) show that when buyers are homogeneous Bertrand competitors, there always exists a single free buyer who wants to buy from an efficient entrant at a lower price, which makes it difficult for the incumbent to exclude. Thus downstream price competition ensures that exclusion never arises. This studied is further extended by others to consider the framework with imperfect competition either at upstream level or at downstream level. Simpson and Wickelgren (2007), Abito and Wright (2008), Kitamura(2010) study naked exclusion under imperfect downstream competition. Gratz and Reisinger (2013) further shows that exclusive dealing can be pro-competitive when downstream buyers can breach. Wright (2008) analyzes the entry deterrence decision of an incumbent under imperfect upstream competition. However, all these models rely on the key assumption that the incumbent firm has a first-mover advantage by offering exclusive contracts to deter entry and the entrant, even if more efficient, is not able to make exclusive deals. Getting rid of the first-mover advantage assumption, this study analyzes a more realistic setting where two active firms in the market are competing through exclusive deals. Following Wright (2008), this paper studies a model with imperfect upstream competition and it is assumed that firms have asymmetric demand rather than different cost structures. 5

7 This paper is closely related to DeGraba (2013), who formally models competition between a dominant input supplier and a small rival by making sales to downstream competing firms. DeGraba (2013) argues that the exclusion mechanism depends crucially on input suppliers imposing price discrimination to buyers for different consumer segments. This paper does not rely on the assumption of price discrimination. Moreover, the exclusion outcome in this paper is mainly due to the contracting externality among retailers, which differs from DeGraba (2013). Furthermore, this paper can also explain when and how a small manufacturer is able to monopolize, the result of which has not be explained by others yet. The rest of the paper proceeds as follows. Section 2 sets up the basic model. Section 3 analyzes the model under linear pricing contracts. A linear demand function is further used to illustrate the main equilibrium results. The exclusive dealing case of Coke and Pepsi is further analyzed to explain the main findings of the model. Section 4 considers several possible extensions: discriminatory offers, sequential offers, Nash bargaining between parties, two-part tariff contracts and multiple competing retailers. Section 5 briefly concludes the paper. 2 The Model In the basic model, there are two upstream firms or manufacturers, which are denoted as M 1 and M 2. Both manufacturers are already present in the market and thus no firm is subject to making entry decision. Therefore, no first-mover advantages are assumed in this model. The two manufacturers are producing differentiated products with the same marginal cost of production c. Two manufacturers are asymmetric with M 1 being the dominant firm. The asymmetry means being the dominant manufacturer, M 1 enjoys a (weakly) larger demand when the prices for both products are the same. 3 The demand dominance becomes stronger as M 1 s advantage goes larger. Both M 1 and M 2 sell their products through two downstream firms or retailers, which are denoted as R 1 and R 2. Retailers buy product(s) from manufacturer(s) and then make 3 The logic also applies to the special case where two firms are identical. We will mention this case in the later section. 6

8 sales to final consumers. Two retailers are identical and they compete in prices. Thus Bertrand competition occurs at downstream level. To study the effect of exclusive dealing, we assume both manufacturers are able to make exclusive offers to retailers in exchange for their commitment of not purchasing from the rival manufacturer. We construct a five-stage game, with the timing as follows: Stage 1 Both manufacturers simultaneously make non-discriminatory exclusive offers to the retailers. 4 The exclusive offers involve some fixed compensations or lump-sum payments x i, where x i is the offer made by M i to both retailers. Here the exclusivity means if a retailer accepts the exclusive offer from one manufacturer, it commits to buy products only from the signed manufacturer but not from the rival manufacturer in the later stage. If a retailer does not accept any exclusive offers, it is free to buy products from either manufacturer. Stage 2 Given the exclusive offers made by two manufacturers, retailers simultaneously decide whether to accept an offer or not. If they do, by the property of exclusivity, they can at most accept one offer. Stage 3 Observing retailers decision, two manufacturers make pricing contracts to the retailer(s). For the contracts in detail, we consider linear pricing contracts in this basic model. 5 The contract offers are assumed to be private so that the retailer does not observe the contract made to the rival retailer. Stage 4 Both retailers decide which contract(s) to accept, if any. If a retailer has already signed exclusively with a manufacturer, it is not allowed to accept the contract from the rival manufacturer. For a free retailer, it can accept both offers, if profitable. Moreover, we need to further make the assumption of the retailers beliefs about the offer made to its rival. Following Abito and Wright (2008), we assume that retailers hold symmetric beliefs about the contracts 4 In the basic model, we only focus on simultaneous and non-discriminatory offers. Sequential and discriminatory offers will be studied later. We find that discriminatory offers will have exactly the same effects as non-discriminatory offers. Sequential offers will artificially result in first-mover advantage of one firm, which parallels to the existing literature on naked exclusion. 5 We will also study other types of contracts in the later sections. 7

9 offered to the rival: whenever a retailer receives an off-equilibrium offer from a manufacturer, it also believes the rival retailer receives the same offer from the manufacturer. Stage 5 Both retailers set retail prices simultaneously to the consumers and the market clears. The profits for all parties are realized. Before analyzing the equilibrium in the basic model, we make some general assumptions on demand functions and firms profits. Let the demand for M i s products be D i (p i, p j ), where p i and p j are the prices for the products of M i and M j. Due to demand asymmetry, M 1 faces a (weakly) higher demand given the same prices, D 1 (p, p) D 2 (p, p). 6 And the demand is strictly higher when two manufacturers are not identical. The demand functions are assumed to be parameterized by γ between 0 and 1, where γ measures the upstream competition level or production differentiation between the two products by manufacturers. A higher γ suggests stronger upstream competition or weaker product differentiation. When γ 1, upstream firms become Bertrand competitors, while γ 0 upstream firms become local monopolists. If M i acts as the monopolist manufacturer, it will charge the monopoly price p M i and enjoys a monopoly profit of Π M i = (p M i c)d i (p M i, ). If each manufacturer only sells products through one retailer and thus duopoly competition occurs, it is assumed that M i earns a profit of Π i while the retailer buying from M i earns a profit of π i. Clearly, the profits depend on upstream competition level, firms demand asymmetry as well as the pricing contracts between retailers and manufacturers. Given the definition of γ, we further make two assumptions on the profit functions: A1: The monopoly profits Π M i (i=1,2) do not depend on γ. A2: When two channels are competing, firms profits Π i and π i (i=1,2) are continuous and decreasing in γ. When a manufacturer becomes a monopolist, the demand for its products in the absence of the rival s products is independent of product differentiation level. Thus the monopoly profit does not depend γ. Particularly, monopoly is a special case 6 Thus this model also captures the case where two manufacturers are exactly symmetric. 8

10 where γ = 0. When both manufacturers are competing with their brands, as product differentiation becomes smaller, stronger inter-brand competition will drive prices down and thus lower the profits for all parties. The two assumptions hold for a class of general demand functions, such as linear, Hotelling, CES demand functions. Due to demand advantage, the profits generated for the dominant manufacturer are (weakly) higher than its rival, Π M 1 Π M 2, Π 1 Π 2, π 1 π 2, and the inequality holds strictly if two manufacturers are not the same. All the profits are assumed to be positive. 7 For the equilibrium analysis, we use the concept of sub-game perfect equilibrium. To avoid the open-set problems in defining equilibria, we use the tie-breaking rule that when the retailers are indifferent between signing an exclusive contract and remaining free, they will sign. Moreover, when the retailers are indifferent between signing up with either manufacturer, they are free to sign up with either manufacturer. In this case, we assume the retailers choice that makes the equilibrium well-defined will be selected. 3 Linear Wholesale Prices We first analyze the basic model in which both manufacturers make linear pricing contracts to the retailers. Clearly the equilibrium outcomes depend on retailers decision of whether to accept any exclusive offer. Before analyzing the possible equilibria, first we want to argue that there will be no free retailers in stage three. In other words, both retailers will accept an exclusive offer in the second stage. The result is given by Lemma 1. 8 Lemma 1. In equilibrium, both retailers will sign an exclusive offer in the second stage and there will be no free retailers in stage three. 7 It suggests that in the case of duopoly competition, even the small manufacturer is able to make positive sales and thus earns a positive profit. We rule out the case where the small manufacturer can not profitably make sales under competition, the case of which is not quite interesting. 8 All proofs are relegated to the Appendix. 9

11 Lemma 1 shows that neither retailer finds it profitable to reject the exclusive offer in the second stage and both will sign exclusively with one manufacturer. The intuition is as follows: suppose one retailer sells only one product (say product 1), the other retailer will never want to carry both products. By carrying both brands, intra-brand competition drives the price of good 1 down to retailers marginal cost, and the demand as well as the profit for the other brand also become lower, due to inter-brand competition and substitutability of the two products. By selling both products, the retailer earns zero profit from good 1 while the profit for good 2 is also smaller. Thus the retailer finds it more profitable to only sell the other brand. In this sense, the free retailer can never be worse-off signing the exclusive contract in the second stage, obtaining the same profit from selling good 2 together with a non-negative compensation from the manufacturer. Therefore, due to Bertrand competition at downstream level, no retailers gain any benefits as being free, though both products are available. The effects of inter-brand and intra-brand competition will make both retailers sign an exclusive contract in the second stage. Following Lemma 1, in order to analyze the equilibria, we only need to study the possible cases where different decisions are made by retailers of signing up exclusively with one manufacturer. Given the exclusive offers made by the manufacturers (which are x 1 and x 2 respectively), retailers incentive compatibility constraints or decision rules are given below: 1. If x 1 x 2 + π 2, both retailers sign exclusively with M 1 ; 2. If x 1 + π 1 > x 2 > x 1 π 2, one retailer signs with M 1 while the other signs with M 2 ; 3. If x 2 x 1 + π 1, both retailers sign exclusively with M 2. Intuitively, when the exclusive offer from one manufacturer is sufficiently high as compared to the rival s offer, the higher offer will attract both retailers, making the corresponding manufacturer a monopolist. When two exclusive offers are close to each other, only one retailer will sign up with each manufacturer, since the retailer is 10

12 able to earn some positive profit being the single seller of one product. Therefore, the contracting externality between retailers exists, whenever the exclusive offers from two manufacturers are sufficiently close to each other. Based on retailers decision rules, we are able to study the equilibria in this model. According to the existing literature on naked exclusion, different types of equilibria exist. 9 In this paper where there are no first-mover advantages and no entry decision of either manufacturer, we are also interested in exclusion equilibria or monopoly equilibria where one manufacturer fully excludes the rival and monopolizes the market. 10 Since both manufacturers are able to make exclusive offers simultaneously, we might expect to have two possible monopoly equilibria where one of the manufacturers monopolizes. Now we study the conditions under which each type of monopoly equilibrium exists. 3.1 Dominant firm monopoly equilibrium We first study the equilibrium in which the dominant manufacturer monopolizes. 11 Whenever the dominant manufacturer monopolizes, it signs up both retailers using exclusive deals. By charging a common price equal to the monopoly price p M 1, it extracts all the profit (gross of the exclusive deals) and earns a monopoly profit of Π M 1 (gross of the exclusive deals). In equilibrium, retailers incentive compatibility constraints must be satisfied, x 1 π 2 + x 2. Clearly, the exclusive offer by M 1 must be sufficiently high so that M 2 does not want to compete and no retailer wants to deviate by being the single seller of M 2 s product. Given M 1 s offer x 1, due to the contracting externality between retailers, there are 9 Particularly, two possible equilibria are of interest: exclusion equilibria and entry equilibria. 10 There also exists another type of equilibria: market sharing equilibria, in which two manufacturers are sharing the market. Such equilibria exist only when upstream competition is not strong and firms demand asymmetry is small. However, such equilibria might not always exist for general demand functions. For example, under linear demand function, such equilibria never exist, regardless of upstream competition level and firms demand asymmetry. It is also one of the reasons why we mainly focus on the monopoly equilibria. 11 We call this type of equilibrium as dominant firm monopoly equilibrium, while the other monopoly equilibrium as small firm monopoly equilibrium. 11

13 two possible strategies for M 2 to avoid foreclosure: by offering x 1 + π 1, M 2 induces both retailers to sign and earns a monopoly profit of Π M 2 ; by offering x 1 π 2, it induces exactly one retailer to sign and earns a profit of Π 2. In order to fully exclude M 2, the offer made by M 1 must be sufficiently high enough so that neither strategy is profitable for M 2. Therefore, the lowest offer that M 1 makes for exclusion takes the following form: 12 x e 1 = max{ 1 2 ΠM 2 π 1, Π 2 + π 2 }. Given the above offer, M 2 never finds it profitable to compete. In equilibrium, M 2 simply makes the offer such that the retailers are indifferent, which suggests x 2 = x e 1 π 2. As a result, M 1 ends up as the monopolist and earns a net profit of Π e 1 = Π M 1 2x e 1. To support the result as an equilibrium, two conditions must be satisfied. First, M 1 s profit should be non-negative, which suggests Π e 1 0. Second, there should also be no incentive for M 1 to deviate given M 2 s offer. M 1 can possibly deviate by lowing the offer so that it induces one retailer to sign and earns a profit of Π 1. Such deviation is not profitable if Π M 1 2x e 1 Π 1 max{0, x 2 π 1 }. The two conditions hold if upstream competition is strong enough. The following proposition summarizes the result: Proposition 1. There exists a dominant firm monopoly equilibrium, when upstream competition is strong. In order to fully exclude the rival, the dominant manufacturer must offer a sufficiently high amount of exclusive deals such that both retailers want to sign up 12 And it is also the equilibrium offer if such equilibrium exists, since there is no incentive for M 1 to further raise the offer. 12

14 exclusively and the rival firm is not able to profitably compete. Such offer must make sure that the profit earned by the rival of attracting either both retailers or a single retailer is non-positive. With sufficiently strong upstream competition, it is more profitable to attract both retailers as the monopoly profit is higher than the profit earned under competition. Thus the equilibrium offer is made such that the rival is not able to profitably attract both retailers. As the profit earned by a retailer being a single seller of the rival manufacturer s products is low, the retailer has less incentive to reject the exclusive offers. Moreover, as the profit of the dominant manufacturer under competition is also small, the manufacturer finds it more profitable to monopolize through exclusive deals and is more willing to make aggressive offers. 3.2 Small firm monopoly equilibrium Similarly, we study the small firm monopoly equilibrium. Suppose such equilibrium exists, the equilibrium offer of M 2 must be x e 2 = max{ 1 2 ΠM 1 π 2, Π 1 + π 1 }. Clearly, non-negative profit condition and no deviation condition should also hold for M 2, which suggests Π M 2 2x e 2 max{0, Π 2 max{0, x 1 π 2 }}, where x 1 = x e 2 π 1. Similar as Proposition 1, a small firm monopoly equilibrium also exists under strong competition and small demand asymmetry. Proposition 2. There exists a small firm monopoly equilibrium, when upstream competition is strong and the demand asymmetry is small. The intuition for exclusion is quite similar as the case where the dominant firm monopolizes. The exclusive offers from the small manufacturer must high enough so that both retailers are willing to sign up and the dominant manufacturer is not able to compete. Due to demand asymmetry between two firms, the small manufacturer has disadvantages against the rival over market share and profit. In order to prevent the 13

15 rival from competing and earning a positive profit, the monopoly profit earned by the small manufacturer must be large enough. It suggests that the demand asymmetry should be so small that the small manufacturer is able to gain similar profits as the rival does under monopoly position. 3.3 Monopoly equilibria Following Proposition 1 and Proposition 2, the conditions under which different types of monopoly equilibria exist are summarized as follows: Proposition 3. When two asymmetric manufacturers make simultaneous and nondiscriminatory exclusive offers and pricing contracts are linear, different types of monopoly equilibria exist, which depend on upstream competition level and firms demand asymmetry: 1. both dominant firm monopoly equilibrium and small firm monopoly equilibrium exist, when upstream competition is strong and firms demand asymmetry is small; 2. only dominant firm monopoly equilibrium exists, when upstream competition is strong and the dominant manufacturer s demand advantage is strong. Proposition 3 summarizes the equilibrium outcomes in the basic model. When upstream competition is strong and firms demand asymmetry is small, there exist multiple exclusion equilibria in which one of the manufacturers monopolizes. Exclusion occurs as either manufacturer has the ability and incentive to use exclusive deals for enjoying the monopoly position. When upstream competition becomes weaker, the profit earned by a retailer as the single seller of one product increases, which weakens the incentive of a retailer to buy exclusively from the monopolist. Therefore, it makes either manufacturer harder to fully sign up both retailers. Moreover, as the profit earned by a manufacturer increases under competition, it also becomes less attractive for a manufacturer to remain as a monopolist, in the situation of which a high amount of exclusive costs must be dissipated. As a result, a manufacturer s ability and incentive for exclusion shrink, as competition becomes stronger. 14

16 The following corollary is used to explain the special case where two manufacturers are exactly identical. In the extreme case without demand asymmetry, two symmetric exclusion equilibria arise where one of the manufacturers monopolizes. This occurs as upstream competition is sufficiently strong. Corollary 1. When two symmetric manufacturers are making simultaneous and nondiscriminatory exclusive offers and pricing contracts are linear, there exist two symmetric exclusion equilibria in which one of the manufacturers monopolizes, when upstream competition is strong. When demand asymmetry exists, it seems quite surprising that even the small manufacturer is also able to monopolize. One might possibly argue that due to the demand advantage, the dominant manufacturer can at least match the offers made by the rival so that it is able to steal downstream buyers, preventing from the rival monopolizing. However, this logic does not work due to the contracting externality between buyers. A buyer earns nothing (gross of exclusive offers) by competing with the other retailer on the same brand due to Bertrand competition at downstream level, while it makes a positive profit as being the single seller of one brand. Therefore, whenever the exclusive offers from both manufacturers are similar, either retailer finds it more profitable to remain as a single seller which prevents the intra-brand competition. By exactly matching the offer by the small manufacturer in equilibrium, the dominant manufacturer is not able to attract both retailers but only one and it will end up making a loss. Therefore, even though demand advantage exists, the dominant manufacturer is not able to profitably compete, if the rival tries to lobby the retailers using aggressive strategies. Therefore, the battle between the two manufacturers is more like one anti-coordination game. There never exists a situation where both players compete aggressively. Multiple equilibria arise due to coordination failures between manufacturers. Though multiple monopoly equilibria occur, the dominant manufacturer which enjoys a demand advantage monopolizes at a lower cost and thus earns a higher profit than the rival. This is quite intuitive due to two effects: first, the exclusive 15

17 offers that the dominant manufacturer needs to make in order for exclusion is lower than its rival s. Second, as a monopolist, the dominant manufacturer earns a higher monopoly profit than the rival s. Therefore, the dominant manufacture captures a higher profit (net of exclusive offers) than the small firm. The following corollary summarizes the findings: Corollary 2. Whenever multiple monopoly equilibria exist, the dominant manufacturer monopolizes at a lower cost and earns a higher profit than its rival. As the demand asymmetry becomes larger so that the profit earned by the dominant firm is strictly higher than the rival s profit, the small firm is no longer able to profitably exclude the rival from competing. Therefore, the exclusion outcome will not arise in which the small firm monopolizes. As long as upstream competition is strong, the dominant firm is still able to monopolize. However, due to the strategic effects, pure strategy equilibria may not always exist, as the monopolist (particularly the dominant firm), might want to deviate by lowering the exclusive offers in order to give up its monopoly position, when the rival s offers are sufficiently high. This strategy might be profitable if the profit earned by the deviated firm under competition is not too small. For general demand functions, we might have the case where small firm monopoly equilibrium exists while dominant firm monopoly does not. 13 However, if we impose some conditions on the relative division of channel profits between the retailer and manufacturer, we can show that the dominant firm monopoly equilibrium always exists whenever the small firm monopoly equilibrium exists. The following assumption is a sufficient condition: A3: The profits earned by the contracting retailer and manufacturer under competition satisfy π i Π i 1, i = 1, 2. 2 A3 implies the relative profit of the contracting and manufacturer is not too small (at least half). Due to the market power of setting prices to affect retailers pricing decision, the manufacturer has a better chance of earning higher profits than the rival. The exclusion mechanism requires the existence of the contracting externality. A3 13 Although the dominant firm is also able to monopolizes due to its demand advantage, it might want to deviate by only attracting one retailer, given the rival s offers are sufficiently high. 16

18 further strengthens this contracting externality: being a single seller of one product, a retailer needs to earn a positive profit and this profit is not so small as compared to the profit earned by the manufacturer. It also suggests that the profit earned by a manufacturer is bounded above. This assumption is satisfied under both linear demand and Hotelling demand functions. Given A3, the following corollary holds: Corollary 3. If A3 holds, the dominant firm always monopolizes within a wider range. If the relative profit between the contracting retailer and the manufacturer is not too small, the dominant firm monopoly equilibrium always exists whenever the small firm monopoly equilibrium exists. Clearly, if small firm monopoly equilibrium exists, the dominant firm is also able to monopolize due to its demand advantage, as predicted by Corollary 2. The equilibrium outcome will break down only when the dominant firm finds it more profitable to deviate by selling to a single retailer under competition, if the rival s offer is sufficiently high. This type of deviation occurs if the manufacturer is able to earn a relatively high profit under competition. As long as a manufacturer does not earn a large proportion of the channel profit under competition, this type of deviation will be eliminated. Thus A3 is a sufficient condition for avoiding such possible deviation. Therefore, the dominant firm monopoly equilibrium can always be sustained, if the small firm monopoly equilibrium occurs. 3.4 Linear demand illustration Now we use the linear demand function as an example to further illustrate how different degrees of upstream competition and demand asymmetry affect equilibrium outcomes. Let D i (p i, p j ) be the demand function for M i, 14 which is given by 1 p 1 if 0 < p β 1 γ θ+p 2, γ 1 γθ p D 1 (p 1, p 2 ) = 1 +γp 2 γ θ+p if 2 < p β(1 γ 2 ) γ 1 < 1 γθ + γp 2, 0 if p 1 1 θγ + γp 2, 14 The demand function is derived from the quadratic utility function U(q 1, q 2 ) = q 1 + θq 2 β(q 2 1 +q2 2 +2γq1q2) 2. 17

19 θ p 2 if 0 < p β 2 1 γθ + p 1, θ γ p D 2 (p 2, p 1 ) = 2 +γp 1 if 1 γθ + p β(1 γ 2 ) 1 < p 2 < θ γ + γp 1, 0 if p 2 θ γ + γp 1. The above linear demand function is captured by three parameters: γ is a parameter between 0 and 1, measuring upstream competition level. A larger γ suggests stronger upstream competition. θ is a parameter between 0 and 1, measuring firms demand asymmetry. A larger θ suggests the dominant firm s demand advantage against the rival becomes smaller. β is a positive parameter measuring the market size. A larger β suggests a larger market demand for both firms. The linear demand function satisfies both assumptions A1 and A2. We study how different types of monopoly equilibria arise under different ranges of parameters. 15 below are given to illustrate the case where two firms are asymmetric: Two examples Example 1. Strong competition and small demand asymmetry. Suppose β = 1 400, γ = 0.95 and θ = The corresponding profits are Π M 1 = 100, Π 1 = 20.2, π 1 = 10.1 and Π M 2 = 90.2, Π 2 = 10.2, π 2 = 5.1. There exist multiple monopoly equilibria: 1. Dominant firm monopoly equilibrium: x e 1 = 35, x e 2 = M 1 earns an equilibrium profit of Small firm monopoly equilibrium: x e 2 = 44.9, x e 1 = M 2 earns an equilibrium profit of 0.4. By comparing the two equilibria, the equilibrium offer of M 2 when it monopolizes is larger than that of M 1 when it monopolizes. M 1 earns a higher profit than M 2, whenever they monopolize. 15 The cost c is normalized to zero. 18

20 Example 2. Strong competition and large demand dominance. Suppose β = 1 400, γ = 0.95 and θ = 0.8. The corresponding profits are Π M 1 = 100, Π 1 = 37.4, π 1 = 18.7 and Π M 2 = 64, Π 2 = 1.0, π 2 = 0.5. There exists only the dominant firm monopoly equilibrium. The equilibrium offers are x e 1 = 13.3 and x e 2 = And M 1 earns a profit of The two examples above can be used to illustrate the results from Proposition 3. Multiple monopoly equilibria exist when upstream competition is strong and firms demand asymmetry is small. Due to the demand advantage, the dominant firm incurs a lower cost and is earning a higher profit than the small firm. As the demand asymmetry becomes larger, it is no longer profitable for the small firm to exclude the rival. Thus unique exclusion outcome occurs where the dominant firm monopolizes. The following example considers a special case where two firms are symmetric. Example 3. Symmetric manufacturers (θ = 1). Regardless of the magnitude of β, two symmetric monopoly equilibria exist if and only if γ An Example: Coke and Pepsi The effects of exclusive dealing on exclusion outcome predicted in the basic model can be applied to many antitrust cases involving exclusive dealing. The results from the model can explain why exclusion occurs even though there is no first-mover advantages of firms. It can also explain how the small firm is able to enjoy a monopoly position despite the demand disadvantage. Here we use the well-known antitrust case of Coke and Pepsi as an example, to show how the ideas from the basic model apply. As the two leading companies in soft drink markets, Coke and Pepsi compete with each other intensively by selling soft drink to downstream distributors. As the dominant supplier, Coke enjoys a larger market share than Pepsi for quite a long time. Due to strong upstream competition, Coke is able to monopolize at some local areas using exclusive dealing. As happened in US and EU, Coke was brought to the court by Pepsi, which argued that Coke abused its market power of using exclusive contracts to distributors. This practice was accused to be anti-competitive since it 19

21 prevents the rival Pepsi from selling soft drinks to retailers and thus softens upstream competition. This result can be explained by the model, which predicts that exclusion occurs where the dominant firm monopolizes, when upstream competition is strong. This result fits in the example where exclusion by Coke arises. It can also partly support the outcome why Pepsi won the antitrust case against Coke in Europe, as the exclusive contracts used by Coke have anticompetitive effects. Furthermore, the model can also explain why Pepsi, as a smaller firm, also ends up as a unique soft drink supplier in certain areas (for example, university campuses). As predicted in the model, the equilibrium in which a small firm monopolizes also exists, when upstream competition is sufficiently strong and demand asymmetry is small, the situation of which match the case of Coke and Pepsi. Therefore, as a small supplier, Pepsi is also able to make high exclusive contract offers to downstream retailers so that it can monopolize in certain markets. As long as the compensations to retailers are sufficiently high, Coke will never profitably compete. This is probably why Pepsi spent $20.75 million on the agreement with the City University of New York, so that it could exclusively provide soft drinks in the campus for 10 years. The results of multiple equilibria in this model will also make it less convincing to argue that the monopoly position of Coke in certain regions is due to the abuse of its dominant market power, since Pepsi could also probably make similar exclusive offers. Therefore, the equilibrium multiplicity provides a possible theoretical reason to support the evidence why Pepsi also lost a similar antitrust case with Coke in US. 4 Several Extensions 4.1 Discriminatory offers In the basic model, we assume both manufacturers can only make non-discriminatory exclusive offers, so that neither manufacturer is able to discriminate between two retailers. Now we relax the assumption to allow manufacturers to make discriminatory offers. Proposition 4. When manufacturers can make discriminatory exclusive offers, the 20

22 outcome will be exactly the same as the case with non-discriminatory offers. Even though manufacturers are able to make discriminatory offers to the retailers, they never find it profitable to discriminate. The intuition is quite straightforward: in order to fully exclude the rival and become a single monopolist, the firm has to offer a compensation sufficiently high to the retailers so that both would like to sign up exclusively. The rival which is foreclosed would like to compete and avoid its foreclosure situation by attracting either one retailer or both, as long as the profit earned is positive. Discriminatory offers will make it more difficult for the manufacturer to exclude since the rival is now faced a better option to lobby the retailer which receives a lower offer. Therefore, it will never be optimal for either manufacturer to discriminate between retailers. Though it is free for both manufacturers to make different exclusive offers to sign up retailers, they all end up using the non-discriminatory offers in the consideration of efficiency. The implication of discriminatory offers is quite different from the existing literature on naked exclusion. When there exists a first-mover advantage of an incumbent, most of the literature predicts that discriminatory offers would favor exclusion than non-discriminatory offers, if there exists economy of scale for each firm to profitably operate and enough buyers are needed in order for entry. However, without economy of scale and first-mover advantages, the advantage of discriminatory offers no longer exists, since both manufacturers are ready to make exclusive offers and downstream buyers are free to choose the best offer that fits them. On the contrary, discriminatory offers will make exclusion even harder as the rival firm is more willing to compete. Therefore, different types of exclusive offers might have quite different effects on exclusion, the result of which strongly depends on whether first-mover advantage is assumed. 4.2 Sequential offers Due to a contracting externality between retailers, multiple monopoly equilibria exist when manufacturers are making exclusive deals simultaneously. This result differs significantly from the existing literature on naked exclusion where only one type of 21

23 exclusion outcome occurs. To see how the assumption of first-mover advantage is crucial, we consider a paralleling case where firms are making sequential exclusive offers. Different from the existing models, both firms are active and there is no entry decision of either. They are able to make exclusive deals but in a sequential order, which differs from the basic model. Due to the sequentiality of exclusive offers, the manufacturer who makes offers first now has a first-mover advantage. With the existence of first-mover advantage, a unique monopoly equilibrium exists, where the first-mover monopolizes. Proposition 5. When manufacturers make exclusive offers sequentially, a unique monopoly equilibrium exists in which the first-mover monopolizes, when upstream competition is strong and firms demand asymmetry is small. To study how sequential offers differ from simultaneous offers on affecting exclusion outcomes, we are interested in the range where multiple monopoly equilibria exist when firms are making simultaneous offers. Under the sequential offers, the first mover is always able to monopolizes uniquely. Following the same logic in the basic model, by offering a sufficiently high amount of compensations, the first mover is able to attract both retailers and enjoys the monopoly position. Sequential offers will solve the coordination failure between manufacturers and place an artificially advantage over the first-mover. Though the exclusion mechanism is different, the effect of sequential offers is quite similar as predicted in the naked exclusion literature, which solves equilibrium multiplicity issue and results in a unique exclusion outcome. 4.3 Nash bargaining When manufacturers are offering linear pricing contracts, double-marginalization problem occurs which lowers the channel profit of the two contracting parties. One way to extend the basic model is to replace the pricing mechanism with Nash bargaining. Suppose Nash bargaining occurs between a retailer and a manufacturer, if the retailer is the only seller of the manufacturer s products. No bargaining occurs if 22

24 both retailers buy from the same manufacturer. 16 When Nash bargaining occurs, let the retailer s bargaining power be α, and the manufacturer bargaining power is 1 α, where α (0, 1). 17 When both retailers buy from a different manufacturer and Nash bargaining happens, the contracting parties will maximize the joint profit and the relative bargaining power determines the corresponding profit for each party. Since the channel profit is maximized, double-marginalization problem no longer occurs. If we denote the joint profit for each channel as Π V i, 18 the profit for each party can be written as Π i = (1 α)π V i, π i = απ V i. Due to demand asymmetry, M 1 s dominance implies Clearly, if the joint profit Π V i Π V 1 > Π V 2, Π 1 > Π 2, π 1 > π 2. is decreasing as upstream competition becomes stronger, the two assumptions of A1 and A2 are satisfied. Therefore, the exclusion mechanism in the basic model also applies. Proposition 6. When Nash bargaining occurs, 1. multiple monopoly equilibria exist, when upstream competition is strong and the demand asymmetry is small; 2. a unique monopoly equilibrium exists in which the dominant firm monopolizes, when upstream competition is strong and the dominant manufacturer s demand advantage is strong. Without double-marginalization, the exclusion mechanism still holds: as upstream competition is strong and the demand asymmetry between two firms is small, exclusion equilibria exist in which one of the manufacturers monopolizes and excludes the 16 In this case, the manufacturer can simply make the same contracts to extract all the profit from retailers. And the two retailers will end up with zero profit, as the basic model. This is reasonable in the sense that there would be no incentive for the manufacturer to renegotiate with either retailer if it is the monopolist in the market. 17 Following the basic model, the profit for each party is assumed to be positive. Otherwise the exclusion mechanism might break down. See the two-part tariff case. 18 The profit is simply given by the duopoly profit under Bertrand competition, where Π V i = max pi (p i c)d i (p i, p j ), i j. 23