Contract contingency in vertically related markets

• DOI: http://doi.org/10.1111/jems.12252
• Author: Emmanuel Petrakis,Emanuele Bacchiega,Olivier Bonroy
• Published date: 01 October 2018
• Date: 01 October 2018

772 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jems J Econ Manage Strat. 2018;27:772–791.

Received: 23 March 2017 Revised: 26 March 2018 Accepted: 29 March 2018

DOI: 10.1111/jems.12252

ORIGINAL ARTICLE

Contract contingency in vertically related markets

Emanuele Bacchiega1Olivier Bonroy2Emmanuel Petrakis3

1Dipartimento di Scienze Economiche, Alma

Mater Studiorum - Università di Bologna, Italy

2UniversitéGrenoble Alpes, INRA,

UMR GAEL, Grenoble, France

(Email: olivier.bonroy@inra.fr)

3Department of Economics, Univer-

sity of Crete, Rethymnon,Greece

(Email: petrakis@uoc.gr)

Correspondence

EmanueleBacchiega, Dipartimento di Scienze

Economiche,Alma Mater Studiorum - Univer-

sità di Bologna, Italy.

Email:emanuele.bacchiega@unibo.it

Abstract

Over the last years, courts are increasingly inclined to consider precontractual arrange-

ments as binding contracts, endowing them with commitment value that can be used

strategically by the party that proposes them. We study the optimal precontractual

arrangement offers of an upstream monopolist producing an essential input that may

sell to two vertically differentiated downstream firms. These arrangements concern

the exclusivity and the contingency of the contracts to be signed. Once the precon-

tractual arrangements have been determined, the terms of the contracts are negotiated

between the upstream supplier and the downstream firm(s). The distribution of bar-

gaining power during the contract terms negotiations is the main driving force of the

monopolist's choices. A powerful supplier always opts for an exclusive contract. By

contrast, a weaker supplier offers nonexclusivecontracts and makes each of them con-

tingent or noncontingent such as to guarantee the most favorableoutside option in its

negotiations.

1INTRODUCTION

Along production chains, the trading relationships among firms are governed by contracts that can take a variety of forms.1

Vertical contracting is thus crucial for determining the behavior and performance of firms in the production chain as well as

for the whole industry they operate in. Vertical contracting refers not only to the type of contracts used in the trading between

upstream and downstream firms but also to the process via which the specific contractual terms are determined. Although the

complete contractual terms that will be executed in case of successful negotiations must be included in the final contract, it is

common to observe that these final contracts originate from precontractual arrangements. These arrangements frame the ensuing

negotiations, which, in turn, determine the final contractual terms. In the legal jargon, such arrangements are often referred to as

“letters of intent,” “memorandums of understanding,” or “term sheets” and, historically, were not considered as binding by the

courts.2This entailed that no party could be held liable for breaching an agreement that was not contained in a formal, complete

contract. Yet, quoting Farnsworth (1987),

In recent decades, courts have shown increasing willingness to impose precontractual liability. (p. 222)

The characteristics that make precontractual arrangements enforceable and what actual obligations they entail depend on

each judicial system. Traditionally, though a debate exists, U.S. and continental Europe courts are more prone than English

ones to confer any liability based on preliminary agreements. However, in the recent years, in most countries the stance is

rapidly evolving toward the idea that a preliminary agreement at least engages the parties to continue the negotiations in good

We wish to thank Emilio Calvano, Vincenzo Denicolò, Andrea Giardini, Markus Reisinger, Tommaso Valletti, Thibaud Vergé, Christian Wey, the audiences

at XXXV Jornadas de Economía Industrial, Alicante 2015, 5th EIEF-Unibo-Bocconi IGIER Workshop on Industrial Organization, Rome 2015, CORE@50

conference, Louvain-la-Neuve, 2016, ASSET 2016 Thessaloniki, TSE Food Economics and PolicySeminar, 2016, the associate editor, and three anonymous

referees for extremelyuseful comments and discussions. The usual disclaimer applies.

BACCHIEGAET A L.3

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faith over the open terms, to eventually sign a final contract, see, for example, Draetta and Lake (1993), Ben-Shahar (2004),

Schwartz and Scott (2007), Cartwright and Hesselink (2008), Trakman and Sharma (2014), and the references therein.3It is

important to remark that the duty to negotiate in good faith does not impose to the parties to reach a deal at any cost, rather

to do their best efforts to reach a final agreement within the frame of the preliminary agreement. This paradigmatic shift has

important consequences as precontractual arrangements can no longer be considered as “cheap talk” but are now endowed with

commitment value and can be used strategically by the party that proposes them.

In this paper, we investigatethe optimal precontractual arrangement offers of an upstream monopolist selling an essential input

to downstream firms, which produce vertically differentiated final goods. These offers concern some features of the contracts

to be signed, and in particular, their exclusivity and their contingency. Once the contracts have been selected, their terms are

negotiated between the upstream supplier and the downstream firm(s). Assuming that contracts take the form of two-part tariffs,

we inquire into the following issues. Does the upstream supplier have incentives to foreclose one of the downstream firms by

offering an exclusive contract to the other firm? And if so, the foreclosed firm will be the high- or the low-quality one? When the

upstream firm offers nonexclusive contracts to both downstream firms, what will be the specific type of these contracts? Under

what conditions will it offer a contingent contract that allows renegotiation of contract terms with one downstream firm in case

of breakdown in the negotiations with the other one?4Or, when will it offer a noncontingent contract not allowing for such

renegotiations? What are the market and societal implications of the upstream monopolist's contract configuration selection?

We consider a vertically related industry with an upstream monopolist and (potentially)two downstream firms. The upstream

supplier produces an essential input that sells to one or both downstream firms, depending on its decision at the outset of the game

to offer an exclusive or twononexclusive contracts, respectively. The downstream firms are endowedwith different technologies

that allow the production of different output qualities using the same input (see Gabszewicz & Thisse, 1979; Shaked & Sutton,

1983).5If the upstream supplier chooses to offer contracts to both downstream firms, it must also decide whether each of them

is contingent or noncontingent. A contingent contract is more flexible and allows negotiating parties to set different contractual

terms in case of agreement and in case of disagreement in the rival bargaining pair. This flexibility is absent under a noncontingent

contract.

We study a three-stage game with observable actions. In the first stage, the upstream monopolist decides to offer an exclusive

contract or two nonexclusive ones. This is a precontractual arrangement that, in legal terms, can be materialized by using a

letter of intent wherewith the upstream firm sets out its intentions about the number and type of contractual relations to enter.6

If the monopolist opts for an exclusive relation, it also decides to which of the downstream firms to make the offer.7In the

case of nonexclusivity, it also decides the configuration of contracts to be offered, that is, two contingent, two noncontingent,

or mixed (one contingent and another noncontingent) contracts.8In the second stage, negotiations over contract terms take

place between the upstream monopolist and the downstream firm(s). In case of nonexclusive contracts, these negotiations take

place simultaneously and separately between the upstream supplier and each of the downstream firms. In the last stage, under

nonexclusive contracts, the downstream firms compete in the market by selecting their prices; under an exclusive contract, the

downstream monopolist sets its price.

As the alternative types of nonexclusive contracts are central in our analysis, a discussion in detail of their features will

be of great help for the sequel. A nonexclusive contract signed between the upstream supplier and a downstream firm can be

of two types: contingent and noncontingent. A contingent contract contains specific terms in the event of a breakdown in the

negotiations in the rival bargaining pair. An immediate consequence is that the outside options for the negotiating firms fully

internalize the implications of the negotiation failure in the rival pair. By contrast, a noncontingent contract does not allow for

renegotiation of contract terms in case of a breakdown in the negotiations in the rival bargaining pair. As a consequence, the

outside options for the negotiating firms are determined by their equilibrium contractual terms. Therefore, the crucial difference

between the two types of nonexclusive contracts lies on the outside options that are attributed to negotiating parties under each

of them (see, e.g., Milliou & Petrakis, 2007).9

Our analysis highlights the role of the bargainingpower distribution between the upstream supplier and each of the downstream

firms for the optimal selection of contracts. In particular, when the upstream supplier is quite powerful, it offers an exclusive

contract to the high-quality downstream firm, whereas it selects two nonexclusivecontracts when its bargaining power is not too

high. The upstream supplier faces the following trade-off when selecting between an exclusive and two nonexclusive contracts.

Under an exclusivecontract, competition downstream is absent altogether, therefore, under two-part tariff contracts, the vertically

integrated structure's outcome is obtained. Yet, the upstream supplier's outside option (i.e., its profits when the negotiations with

the downstream firm break down) is nil in this case. This entails that its share of the vertically integrated entity's profits is

proportional to the upstream bargaining power. The lower the latter, the smaller the profit that the upstream supplier is able

to extract. By contrast, with nonexclusive contracts that are negotiated simultaneously and separately, competition downstream

erodes part of the aggregate producer surplus (O'Brien & Shaffer, 1992). Yet, with nonexclusivecontracts, t he upstreamsupplier