EconS Long Term Contracts

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1 EconS Long Term Contracts Eric Dunaway Washington State University eric.dunaway@wsu.edu Industrial Organization Eric Dunaway (WSU) EconS 425 Industrial Organization 1 / 17

2 Introduction Let s nish up our discussion on entry deterrence by looking at contractual behavior. Firms can o er exclusive contracts to consumers that tie that consumer s purchase to the rm over multiple periods. Eric Dunaway (WSU) EconS 425 Industrial Organization 2 / 17

3 We haven t talked much about contacts yet, but we should establish a few general ideas. In the real world, contracts are associated with transaction costs. It costs money to have lawyers write contracts, and more money to have those contracts reviewed. We re going to assume this away for now, though (it ll come back later). We also assume that contracts are fully enforceable. Eric Dunaway (WSU) EconS 425 Industrial Organization 3 / 17

4 Contractual relationships between rms are very common. Most suppliers mandate that a minimum percentage of shelf space in a retailer be dedicated to their product. Some suppliers require anticompetition agreements, as well (this is common in malls). All of these agreements between rms come with an adjustment in the cost of the product being sold. Firms can also form these kind of agreements with their consumers. Eric Dunaway (WSU) EconS 425 Industrial Organization 4 / 17

5 Consider the case of an incumbent rm operating as a monopolist. The market they serve consists of N identical consumers who value their good at V. It costs c = V 2 to produce the good. Naturally, the incumbent will choose to charge a price of p = V to this market, and their pro t level is π = pq cq = VN V 2 N = N V 2 Suppose now that the monopolist faces an entrant into this market. The entrant has di erent costs from the monopolist, which can take any value from 0 to V randomly. Eric Dunaway (WSU) EconS 425 Industrial Organization 5 / 17

6 If the entrant has costs higher than the monopolist s costs, V 2, they will not enter the market. The monopolist could just set their price equal to V 2 would have zero sales. This happens half of the time. and the entrant If the entrant has costs lower than the monopolist s costs, they want to enter the market. They can set a price equal to V 2 ε where ε > 0 and claim the whole market from the monopolist. (For ease, we ll just assume this value is V 2 ) This happens the other half of the time. Eric Dunaway (WSU) EconS 425 Industrial Organization 6 / 17

7 Suppose that this market has two periods. In the rst period, the incumbent acts as a monopolist. In the second period, the potential entrant appears with probability 0.5. Thus, the incumbent s expected pro ts are π 1 = N V 2 {z} First Period + (0.5)N V {z 2} No Entry + (0.5)0 = 0.75NV {z } Entry and the consumers expected price in the second period is p = (0.5)V + (0.5) V = 0.75V {z } {z 2} No Entry Entry Eric Dunaway (WSU) EconS 425 Industrial Organization 7 / 17

8 Suppose now that at the end of the rst period, the incumbent o ers their consumers a contract for the second period. The contract requires that the consumers purchase from the incumbent at the second period at a price of p = 0.75V (Their expected price). If the consumers violate the contract, they face a ne of V 2 that is paid to the monopolist. If the entrant has higher costs than the incumbent, this is a great deal. The consumers receive a discount in the second period. If the entrant has lower costs than the incumbent, this is a terrible deal. The consumers would rather receive the lower price. Eric Dunaway (WSU) EconS 425 Industrial Organization 8 / 17

9 Now, suppose the entrant had slightly lower costs than the incumbent, V 4 < c < V 2 If they used their previous strategy of pricing at p = V 2 ε, any consumer that accepts the contract will not purchase from them, as they ll be required to pay a ne of V 2 to the monopolist, for a total cost to the consumer of V as opposed to 0.75V from accepting the contract. If the entrant, however, had much lower costs than the incumbent, c < V 4 now they could price at p = V 4 ε and even those who accepted the contract from the incumbent will be better o purchasing from the entrant and just paying the ne. Their total cost is V 4 ε + V 2 = 0.75V ε. Eric Dunaway (WSU) EconS 425 Industrial Organization 9 / 17

10 If consumers accept the contract, it s now only pro table for the entrant to enter if their costs are below V 4. This only happens a quarter of the time (probability 0.25). So should the consumers accept the contract? Their expected price with the contract is p = (0.75)(0.75V ) + (0.25)(0.75V ε) = 0.75V 0.25ε which is less than their expected price without the contract, so they accept the contract. Eric Dunaway (WSU) EconS 425 Industrial Organization 10 / 17

11 Should the incumbent o er the contract? Their expected pro ts become π 1 = N V + (0.75) N V N V = NV {z} {z } {z } First Period No Entry Entry (Fine) which is higher than their expected pro t without the contract, so they o er it. Thus, in equilibrium, the incumbent o ers the contract, they accept it, and the entrant now only enters a quarter of the time. The incumbent has e ectively deterred entrance half of the time for the entrant. Eric Dunaway (WSU) EconS 425 Industrial Organization 11 / 17

12 This example would be more interesting if we considered the consumers attitude torwards risk. By accepting the contract, they are choosing a certain outcome. By not, they are accepting two di erent outcomes that also imply risk. We implicitly assumed that consumers were risk neutral in this example. Their payo was simply their remaining surplus. Had consumers been risk averse (loss averse, more consistent with reality), the incumbent could have charged an even higher price and still gotten the consumers to sign. Had consumers been risk loving, the incumbent would have had to lower the price it o ered. Eric Dunaway (WSU) EconS 425 Industrial Organization 12 / 17

13 Detecting Predatory Behavior Naturally, predatory behavior from rms is highly illegal. Proving that pricing is predatory, however, can be quite di cult. A common rebuttal to predatory accusations is to claim that the price is simply more competitive. The Chicago School, in particular, strongly suggested that price decreases upon observing entry were just the result of competitive pressures, rather than any kind of illegal behavior. They oated the idea that predatory pricing was irrational since it led to losses for the rm. Eric Dunaway (WSU) EconS 425 Industrial Organization 13 / 17

14 Detecting Predatory Behavior One generally accepted method for detecting predatory pricing comes from Areeda and Turner (1975), where any rm that prices below their short run variable cost is pricing predatorially. They use this value since marginal cost is very hard to observe. Note that this is below the shutdown price of the rm. While a good starting point, it s still possible for rms to price below marginal cost (which would be predatory), but still above their average variable cost, and thus get away with predation. It did, however, refute the view of the Chicago School. Eric Dunaway (WSU) EconS 425 Industrial Organization 14 / 17

15 Summary Long term contracts can deter entry into a market by tying consumers to a rm over multiple periods. They re generally frowned upon in a legal setting, but small scale usage is allowed. Detecting predatory behavior is di cult. Eric Dunaway (WSU) EconS 425 Industrial Organization 15 / 17

16 Next Time Repeated Games Reading: Eric Dunaway (WSU) EconS 425 Industrial Organization 16 / 17

17 Homework 5-1 Return to our contract example from before. Suppose now that consumers are risk averse. Their payo becomes p V p where the square root term is added to imply risk aversion. Suppose that an entrant enters the market with probability With no contract o ered to the consumer, what is their expected payo in the second period? 2. Suppose that the incumbent o ered a contract to the consumer at the end of the rst period that lets the consumer purchase the product from the incumbent at a price of p = 0.85V in the second period, and if they violate this contract, they must pay p = V to the incumbent (This will completely deter entry if they accept it). What is the consumer s payo if they accept the contract? Should they accept it? 3. What is the highest price the incumbent could charge in a contract they o er to the consumer? (Hint: de ne the price as a proportion of V ) Eric Dunaway (WSU) EconS 425 Industrial Organization 17 / 17