The demand‐boost theory of exclusive dealing

• Author: Piercarlo Zanchettin,Giacomo Calzolari,Vincenzo Denicolò
• DOI: http://doi.org/10.1111/1756-2171.12338
• Published date: 01 September 2020
• Date: 01 September 2020

RAND Journal of Economics

Vol.51, No. 3, Fall 2020

pp. 713–738

The demand-boost theory of exclusive

dealing

Giacomo Calzolari∗,∗∗,∗∗∗,‡

Vincenzo Denicolò∗∗∗,‡

and

Piercarlo Zanchettin§

This article unifies various approaches to the analysis of exclusive dealing that so far have been

regarded as distinct. The common element of these approaches is that firms depart from efficient

pricing, raising marginal prices above marginal costs. We show that with distorted prices, ex-

clusive dealing can be directly profitable and anticompetitive provided that the dominant firm

enjoys a competitive advantage over rivals. The dominant firm gains directly, rather than in the

future, or in adjacent markets, thanks to the boost in demand it enjoyswhen buyers sign exclusive

contracts. We discuss the implication of the theory for antitrust policy.

1. Introduction

Exclusive-dealing agreements prohibit a buyer who purchases a firm’s product from buying

the products of the firm’s competitors. These agreements are common in vertical relations and

are generally regarded with suspicion by antitrust authorities. However, theory is unsettled and

the policy debate is still ongoing.

The contribution of this article is to unify three approaches to the analysis of exclusive

dealing that so far have been regarded as competing or, at best, unrelated: the linear pricing

model of Mathewson and Winter (1987), the moral hazard model of Bernheim and Whinston

∗European University Institute; giacomo.calzolari@eui.eu.

∗∗CEPR, Center for Economic and Policy Research.

∗∗∗University of Bologna; vincenzo.denicolo@unibo.it.

‡CEPR.

§University of Leicester; pz11@le.ac.uk.

Previous versions of this article circulated under the title “Exclusive Dealing with Costly Rent Extraction,” and “Ex-

clusive Dealing with Distortionary Pricing.” The authors are grateful to the Editor, David Myatt, and two anonymous

referees for detailed comments that greatly improved the exposition. The authors also thank Emilio Calvano, Philippe

Chone, David Gilo, Volker Nocke, Salvatore Piccolo, Giancarlo Spagnolo, Yossi Spiegel, Chris Wallace,Yaron Yehezkel,

and seminar participants at Bern, Mannheim, Paris Dauphine, Shanghai School of Economics and Finance, Jiao Tong

University, Luiss, Bologna,EUI, Catholic University (Milan), EIEF, the BECCLE Competition Policy Conference, the

CRESSE conference, OFCOM, and the European Commission for useful comments and suggestions.

© 2020, The RAND Corporation. 713

714 / THE RAND JOURNAL OF ECONOMICS

(1998, section V), and the adverse selection model of Calzolari and Denicolò (2013, 2015).

We demonstrate that, in fact, all these models share a common mechanism and thus represent

different versions of the same theory.

The theory can be explained in simple terms as follows. Consider the product market com-

petition among two or more firms that supply differentiated products. Abstracting from more

roundabout effects, the upside of exclusive dealing is that it increases the demand for the firm’s

product. The downside is whatever price reduction may be necessary to entice the buyer to enter

into the agreement, compensating him for the loss of the option of buying other products. This

creates a price-volume trade off, but one of a special nature.

The trade-off cannot be favorable if the firm prices efficiently, setting marginal prices at cost

and extracting the surplus by means of lump-sum payments. In this case, the increase in volumes

would not improve profitability, and the firm might have to reduce the fixed payment in order to

compensate the buyer for the loss in variety. But when the price-cost gap is strictly positive at

the margin, any increase in sales translates into higher profits. If the compensation required by

the buyer is not too large, exclusive dealing may then be profitable. Essentially, price distortions

create contractual externalities.

We shall refer to this explanation for exclusive dealing as the demand boost theory, as the

key insight is that exclusive dealing creates a boost in demand that may be directly profitable.

As said, profitability requires that marginal prices be distorted upward. We believe this as-

sumption is mild in both theory and practice. In real life, firms rarely rely only on fixed fees

to extract profits. Even when lump-sum payments are used, they are often supplemented with

marginal prices in excess of marginal costs.

At the theoretical level, this pattern of pricing is, indeed, optimal if fixed fees are an im-

perfect means of rent extraction. This may be so for a variety of different reasons. Consider, for

instance, the moral hazard model developed in section V of Bernheim and Whinston (1998).

Here, Bernheim and Whinston adapt to the analysis of exclusive dealing a framework,originally

proposed by Rey and Tirole (1986), in which buyers are risk-averse retailers who face uncertain

demand. In this setting, fixed fees expose retailers to the risk of making large payments even if

demand turns out to be low. To reduce the risk, upstream firms lower their fixed fees and distort

marginal prices upward.

As another example, consider the model of adverse selection of Calzolari and Denicolò

(2013, 2015). In this model, firms do not exactly know the buyers’ willingness to pay for their

products, as in the pioneering contributions of Mussa and Rosen (1978) and Maskin and Riley

(1984). Fixed fees may then create a distortion at the extensive margin by excluding some low-

demand buyers. Balancing distortions at the extensive and intensive margins, firms optimally set

marginal prices above marginal costs.

These are just two examples. There may be other reasons why firms distort marginal prices

upward. As we show, however, the source of price distortions is not important: the theory applies

whenever marginal prices exceed marginalcosts, and for whatever reason. This makes the theory

robust and broadly applicable.

According to the demand-boost theory, the competitive effects of exclusive dealing are as

follows. On the one hand, exclusive dealing deprives consumers of product variety. On the other

hand, it changes the nature of competition: with exclusivecontracts, fir ms compete for the whole

market rather than for each marginal unit. Although the competition for marginal units is attenu-

ated by product differentiation, that for the entire market is not, as it takes place in utility space,

where product differentiation is irrelevant.

The effects of this change in the mode of competition depend on the structure of the market

and in particular on the size of the dominant firm’s competitive advantage over its rivals. When

the competitive advantage is big, exclusivedealing may increase prices, or else reduce them only

slightly.In this case, exclusive dealing is profitable for the dominant firm, and consumers may be

harmed both in terms of higher prices and reduced variety. Remarkably, these negativeeffects are

immediate and direct. In most of the alternative theories, by contrast, exclusive dealing entails

C

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