1. by Edmund Lou and Anatoly La Pere
Econ 702
1 Introduction
Using contracts is strategy in the entry-prevention game. These contracts in-
troduce social costs to one of the parties as a measure to prevent entry from
a potential competitor. In addition to clauses which may prescribe fees for
disloyalty or cancelling the contract, the social costs may include the superior
knowledge which the incumbent seller may possess about a potential entrant,
and even the length and complexity of the contract can act as a true indicator
of the probability of entry.
Aghion and Bolton conducted a survey on the literature on whether contracts
introduce social costs or e¢ ciency gains to competition. One reading, “Entry,
Capacity, Investment and Oligopolistic Pricing”by Michael Spence, argues that
engaging in entry-deterrence strategies by adjusting ‡exible instruments such as
prices or capacity may not improve resource allocation. Even if prices –usually
a signal of the probability of entry –accordingly fall as part of the strategy, pro-
duction and distribution may be ine¢ cient because of overinvestment in capital
that deters entry. (Spence, 1977). On the other side of the cost argument, the
book “The Antitrust Paradox”by Robert Bork shares the view of many other
antitrust practitioners who argue that exclusive contracts do not hurt competi-
tion, but rather allocate substantial bene…ts to the participating agents in the
contract. Bork’s arguments for the e¢ ciency gains in such contracts deal with
behavioral economics such as free-riding, hold-up, and planning. (Bork, 1978)
These two opposing arguments were represented in the controversial case of
United Company v. United Shoe Machinery Corporation (1922). The plain-
ti¤ took the position that engaging in entry-deterrent policy does not improve
welfare and that by engaging in restrictive competition strategies (mainly com-
plicated leasing contracts) which made it di¢ cult for entrants to tap into the
market and to o¤er alternative contracts, the defendant was being disadvan-
taged. Aghion and Bolton makes the clear assertion that exclusive contracts
between two parties are designed to prevent entry from a potential entrant. To
solidify their position, the authors extend the entry-prevention game: typically
two duopolists compete with each other to share the market. The game assigns
one player (the incumbent) a …rst-move advantage, whereby the player includes
in its information set the entrant’s strategy. These games have been thoroughly
explored, bringing insight into information sets, time horizon, and strategy.
When the buyer and the seller sign a contact, they are doing so with the
precise intention of having it breached. The primary instrument of this intention
is a clause for liquidated damages, what one might call a breakage fee. This
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2. clause is mainly designed to compensate the incumbent seller when the buyer
trades with the entrant. The clause restricts the buyer from trading with any
entrant unless the entrant’s prices are lower than the incumbent’s by the amount
or more of the liquidated damages. These damages, which are speci…ed in the
contract, act as an entry fee in the same way a monopoly sets its price. So by
breaching the contract, in the end, the buyer bene…ts from lower prices and the
incumbent is paid the liquidated damages. Thus, Aghion and Bolton conclude,
these contracts are designed to extract some of the surplus an entrant would
get if he enters the market and competes with the incumbent. Aghion and
Bolton con…rms such contracts introduce a social cost. This is because the
contract blocks entry from a potential entrant who may be more e¢ cient than
the incumbent seller. The cost the entrant faces comes in two di¤erent forms.
Either the entrant has to wait until the contract expires, or lower their prices
enough to induce the buyer to switch, thus e¤ectively paying liquidated damages
to the incumbent seller.
All other things being equal, the longer the contract term, the greater the
contract’s social cost. This knowledge motivated Aghion and Bolton to seek
the optimal length of a contract. Initially, the authors accepted the idea that
if you have two parties seeking a mutually advantageous contract, it is in their
best interest to sign the longest possible contract. However, empirical evidence
on contracts sharply contrasts this idea, and instead reveals contracts are short
lived. This interest in contract lengths is also shared by many other practi-
tioners including …nance professionals. However, the …nancial academics agreed
that looking at the nominal length of a contract, which is the speci…ed date at
which the contract expires once signed. Aghion and Bolton disagreed with this
approach as it was misleading and did not make the distinction between the
speci…ed length of contract and the actual length that the parties expect the
relationship to last at the time of signing.
2 The Symmetric Information Model
2.1. Model Setting. Consider a two-period model, where a single incumbent
seller trades 1 unit of indivisible good with the buyer. The latter has a reser-
vation price v = 1:The seller, who has a known unit cost of 1
2 ; is facing a
threat from entry. The entrant’s unit cost ce is unobservable, which follows
a uniformly distributed over [0, 1]. However, the distribution is assumed to
be common knowledge to both parties. If the entrant comes in and the buyer
did not sign the contract, then both suppliers compete à la Bertrand. Hence
the equilibrium price will be P = maxf1
2 ; cg: If the entry does not occur, the
entrant will make zero pro…t and the incumbent will charge a monopoly price
of 1. The entry only happens when c 1
2 ; which implies that the probability
of entry, denoted by , is
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