I. A Simple Model. Players: Sellers, I and E, and a consumer Period 1: Seller I and the buyer can make an exclusive contract. Period 2: Seller E decides.

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Presentation transcript:

I. A Simple Model. Players: Sellers, I and E, and a consumer Period 1: Seller I and the buyer can make an exclusive contract. Period 2: Seller E decides whether to enter the market or not. If she enters, she will compete against seller I. If she does not enter, seller I will be a monopolist..

Contents of the exclusive dealing: The buyer will buy products from only seller I. Therefore, if the buyer and seller I make an exclusive contract, there is no reason for the entrant to enter the market, and seller I will be the monopolist.

Q1: Can the exclusive contract prevent an entry by an efficient firm? Q2: Is it profitable for seller I?

The answer by Chicago School is quite a counter intuitive. They said, “No, the exclusive contract is not a profitable choice for seller I and, it cannot prevent an entry by an efficient firm.”

Suppose that they make an exclusive contract. In the case, seller E will not enter the market. Seller I becomes a monopolist, and the buyer faces only one firm, seller I. Seller I will charge a monopoly price. As the graph below shows, the consumer surplus is the area of shaded triangle.

Suppose that the buyer does not make an exclusive contract. Then, seller E will enter the market and compete against seller I. The competition between them will lower the market price. The price will be lower than the monopoly price.

Q1: Please get what is the new level of consumer surplus. Q2: Which case brings a higher consumer surplus? Q3: How much does the incumbent need to compensate for the consumer to make an exclusive contract? Q4: How much profit does seller I make after the buyer agrees on the exclusive contract?

If the buyer signs contract with Seller I, consumer surplus becomes $5. If the buyer doest not, consumer surplus becomes $17. Consumer will sign the contract only if Seller I compensate for the $12, the amount of loss in consumer surplus.

Then, what is the extra profit earned by Seller I by making the exclusive contract? Ans: $9 However, Seller I has to compensate $12 for the consumer. What is the overall profit from the exclusive contract? -$12+$9 = -$3

Conclusion: The exclusive contract is not profitable.

The 1 st Response: Multiple Buyers with A high fixed entry cost In the benchmark model, there is only 1 buyer. What would happen if there are multiple buyers? Assumption: 1) Suppose there are 3 multiple buyers. 2) Seller E will enter the market profitable only if E can sell at least 2 buyers. That is, there is a high fixed entry cost. In order to cover the fixed cost, the entrant must sell at least two products.

If Seller I can make exclusive contracts with 2 of the 3 buyers, the entrant will not enter the market. The third consumer must buy a product from seller I no matter what she makes an exclusive contract with seller I or not. In the previous numerical example, it costs 12 to make each exclusive contract, and the monopoly profit from each consumer is 9.

Q1: At most, how much does it cost to make exclusive contracts with two buyers? Q2: What is the total monopoly profit from the monopoly position?

(-$12+$9) + (-$12+$9)+9 = $27-$24 = 3 Conclusion: When there are multiple buyers and there is a high fixed cost, an exclusive contract can be a profitable choice for Seller I.

The 2 nd Response: Profit Squeeze Suppose that c I =1/2, c E =1/3, and the consumer valuation is one. Without the exclusive dealing, the competition between the entrant and the incumbent makes the market price ½. The consumer’s surplus is ½. The incumbent's profit is zero. The entrant’s profit is 1/6.

The content of exclusive dealing: You will buy a product from me at ½. If you breach this contract, you must pay 1/6 -e as penalty. Instead, I will give you z if you sign this contract.

After this contract, the buyer will buy a product from the entrant only if ½<1-p E -(1/6-e) That is, the entrant will set p E at 1/3+e. The incumbent’s profit: 1/6-e-z The customer’s payoff: z+1/2 The entrant’s payoff: e As long as 0<z<1/6, the incumbent and the customer can ‘profit squeeze’ the entrant.