March 3, 1998

Exclusionary contracts, competition and eciency 

Abstract
This paper reconsiders the analysis of the competitive eects of exclusive customer contracts. In
contrast to the previous literature, we do not restrict the contracting opportunities of any group
relative to any other. Specically, we postulate that there are two market segments composed of
small anonymous and large nonanonymous buyers. While the large buyers can contract with each
other and any rm in the market, it is assumed that no such opportunities exist for the small buyers.
That is, neither the large buyers nor rms can make contractual commitments with small buyers.
Firms must supply these buyers based on arms-length (single price oligopolistic) competition. In
this environment, we demonstrate that large buyers will have an incentive to form a coalition with
a single rm so as to extract rents from the small segment. As such, market dominance is the
unique equilibrium. This equilibrium is socially suboptimal as either production takes place at a
higher cost than is otherwise possible or there is a monopoly for small buyers with an associated
allocative loss. Journal of Economic Literature Classication Numbers: L42
Keywords: exclusionary contracts, competition, allocative eciency, anonymity.

Joshua S. Gans
Melbourne Business School
The University of Melbourne

Stephen P. King
Department of Economics
The University of Melbourne


The authors would like to thank Simon Grant and participants at the 1998 ANU Theory Workshop
for their helpful suggestions. Responsibility for all errors remains our own. Contact author: Joshua Gans,
Melbourne Business School, 200 Leicester Street, Carlton, Victoria, 3053, Australia; Fax: +61-3-9349-8133;
E-mail: J.Gans@mbs.unimelb.edu.au.
1 Introduction
A long-standing debate in industrial organization concerns the impact of incumbent-buyer
contracts on market competition. Do such contracts constitute an entry barrier or raise
rivals’ costs, leading to losses in productive or allocative eciency? The ‘Chicago School’
argues against such ineciencies (e.g., Posner, 1976; Bork, 1978). Buyers who enter into
exclusive arrangements with an incumbent rm will not agree to limit their future purchase
options unless they are fully compensated. However, concern about incumbent-buyer con-
tracts continues. William Shepherd argues that “the locking up of large customers ahead
of time in long-term contracts with price discounts, so that competitors are excluded from
competing for them for many years into the future” is a “well-advanced anticompetitive
activity.” (1997, p.169) He goes on ... “[t]he incentives for such a competitive underbidding
process are universal throughout the U.S. electricity industry,” and accompanies this with
evidence of the prevalence of such long-term contracts.
The goal of this paper is to examine the formal underpinnings of arguments such as
those of Shepherd. In so doing, we will maintain the ‘Chicago School’ standard of rational
buyer choice. We ask the question: in a free contracting environment, when might exclusive
contracts lead to ineciencies? In contrast to previous formal analyses, our results will
not rely on arbitrary contracting asymmetries among agents or transactions costs resulting
from contractual incompleteness or information asymmetries. As such, before outlining our
model, it is worth brie y remarking on alternative stories linking exclusionary contracts to
competitive ineciencies.
One story is based on the existence of privately-stipulated damages. Aghion and Bolton
(1987) argue that a liquidated damages clause makes a contract costly to renegotiate. In an
environment where entry is uncertain a customer will sign such a contract because, despite a
loss in rents when entry occurs, they receive a discount in the event that monopoly persists.
Aghion and Bolton demonstrate that such contracts result in entry barriers that deter some
ecient entry.1 An alternative story is based on the use of selective discounting in a

1
Spier and Whinston (1995) demonstrate that this argument is not robust to the possibility of renego-
tiation between the incumbent and the entrant. However, when there are relationship-specic investments,
the Aghion and Bolton conclusions can be restored.

1
‘divide and conquer’ strategy. Rasmusen, Ramseyer and Wiley (1991)2 demonstrate that
buyers will be encouraged to purchase contracts for fear of being left to monopolistic market
conditions. In equilibrium, buyer contracts generate those monopolistic conditions, thereby
reinforcing the expectations of buyers.3
These formal stories have been criticised for their reliance on arbitrary assumptions re-
garding the nature of the contracting environment. Innes and Sexton (1994) summarise
these diculties. They highlight assumptions preventing entrants from contracting with
buyers prior to entry and demonstrate that equalising contracting opportunities could re-
store eciency. Constraints on the ability of buyers to coordinate are also central to the
RRW story. Finally, Innes and Sexton indicate that some results are driven by linear price
restrictions and that allocative ineciencies derived by RRW would be overcome with the
use of non-linear pricing.
The model in this paper will demonstrate the potential for ineciencies in an environment
that is not restricted by arbitrary assumptions on contracting. In particular, in addition to
the Chicago School standard on rational buyer choice, we impose the following rule. Any
buyer that can sign a contract with one rm can equally contract with other rms or other
buyers who also face the same contracting opportunities. In addition, contracts signed are
rst-best ecient in that they use non-linear prices if necessary and are not impeded by
incompleteness or information asymmetries in the bargaining process. This means that rms
face symmetric contracting opportunities with buyers (i.e., there is no rst mover advantage),
buyers can potentially cooperate, and there is a wide range of contracting options. In this
respect, we confront the key concerns identied by Innes and Sexton (1994).
Our model closely parallels the intuition given by Shepherd (1997) in which some buyers,
in eect, form coalitions with a rm to extract monopoly rents from other buyers.4 To
this end, a key innovation in our paper is to consider two types of buyers, anonymous and

2
Hereafter RRW.
3
Segal and Whinston (1996) both elaborate and extend the RRW results. Their paper, in contrast to
the analysis below, maintains asymmetric contracting options.
4
This diers from a ‘divide and conquer’ strategy in that buyers who contract do not do so in order to
avoid facing subsequent monopoly pricing. As noted earlier, that strategy is vulnerable to buyer coordination,
something that we allow for.

2
nonanonymous, distinguished by their ability to enter into contracts. Only a subset of buyers,
those who are nonanonymous, can be identied ex ante, and only these buyers can enter
into contracts with each other or with rms. In contrast, anonymous buyers cannot sign
exclusive contracts ex ante and are restricted to trade at arms-length on the mass market.
Given certain reasonable assumptions about the eect of competition on rm prots and
the contracting process, ecient production will never arise in equilibrium in our model.
Rather, it pays nonanonymous buyers to choose one of the potential suppliers to form a
coalition and extract rents from those buyers who are unable to sign contracts. In contrast
to previous models, our analysis does not rely on one rm being incumbent and the other
rm being an entrant, but allows for identical potential suppliers.5 Also, our focus is on
ecient production rather than exclusion. In equilibrium, both rms may compete for a
subset of customers, but social welfare will not be maximized because one rm is unable
to reach a minimum ecient scale of production. In some circumstances, one rm will be
excluded from production altogether.
Our categorization of buyers as ‘anonymous’ and ‘nonanonymous’ should not be inter-
preted literally. Rather, a buyer is anonymous if they are suciently small and/or trans-
action and negotiation costs are suciently high so that no other party is able to write an
individual contract with this buyer. Firms know that these buyers exist, and may even know
their identity ex ante, but individual contracting with these consumers is infeasible. In con-
trast, rms can write customer specic contracts with any nonanonymous buyer and these
buyers can also write contracts with each other. As an example, in the electricity, gas or
telecommunications industries we may think of large business customers as nonanonymous

5
In particular, our model follows RRW in that both rms are potentially equally ecient and social
welfare is maximised if both rms produce in equilibrium. This contrasts with Aghion and Bolton (1987)
and Innes and Sexton (1994) who consider contracts that exclude a more ecient entrant. As Spier and
Whinston (1995) note, an ecient entrant, that is one with lower production costs than the incumbent,
will always enter regardless of any exclusionary contract signed between the incumbent and buyers. This
is because the incumbent itself cannot commit not to purchase from the entrant in order to satisfy its
contractual arrangements. Indeed, it has an incentive to resell the entrant’s products to buyers as sub-
contracting supply entails lower costs. Therefore, the initial incumbent-buyer contract will never deter
entry and will not distort productive eciency. Spier and Whinston (1995) demonstrate, however, that the
existence of transactions costs, say because of non-contractable relationship-specic investments, could allow
productive ineciencies to arise again.

3
while small residential customers are anonymous. In general, it does not pay a rm in any
of these industries to negotiate individual contracts with specic residential customers due
to the volume and uncertainty of their demand relative to contracting costs. In contrast,
customer specic contracts are common for large business customers (Shepherd, 1997). Al-
ternatively, one could view the anonymous group as future customers not currently known
to rms in the industry. Nonetheless, for ease of exposition, hereafter we will refer to anony-
mous buyers as ‘small’ and nonanonymous buyers as ‘large.’
The allocative eciency approach adopted by RRW was criticized by Innes and Sexton
because “price-quantity contracts are likely to be possible when exclusionary agreements are
possible.” (1994, p.567) That is, allocative ineciencies are the result of simple monopoly
pricing in RRW and could be resolved through the use of non-linear pricing or perfect price
discrimination. We accept Innes and Sexton’s criticism for large buyers and allow rms to
set general contracts for these customers. However, rms cannot contract at all ex ante with
small buyers and, while it is not ruled out by our assumptions on prots, it is unlikely that
rms would have the detailed knowledge of buyer willingness to pay to provide customer
specic non-linear prices when competing for this group of customers.
The result closest to ours in the literature is in Segal and Whinston (1996, Proposition 3).
This shows how entry deterrence may arise in the RRW framework when an incumbent can
‘divide’ customers by using discriminatory contracts. Unlike our model, however, the Segal
and Whinston environment does not provide buyers with the same contracting opportunities
in dealing with the entrant as are available to the incumbent.6 In addition, as noted earlier,
our model does not rely on any asymmetry in the ability of rms to write contracts and
allows for both rms to produce in equilibrium despite social welfare being suboptimal.
The paper proceeds as follows. Section 2 outlines the model. In particular, we present
the crucial assumption on competition for small buyers (A4) and provide examples where
this assumption is satised. Section 3 presents two alternative bargaining games between
large buyers and rms. The rst (section 3.1) allows large buyers to cooperate and write

6
While Segal and Whinston consider coalition-proof equilibria this involves non-binding agreements
between buyers after the entrant oers contracts. This contrasts with Proposition 1 below which allows
large buyers to make binding agreements before any rm oers contracts.

4
binding agreements to maximize each buyers payo before approaching the rms. The second
(section 3.2) does not allow any interbuyer contracting but involves rms simultaneously
bidding for large buyers. In both cases, we show that given the assumptions of the model,
overall production will always be socially inecient. A nal section concludes.

2 The model
2.1 Customers and demand
We begin by formally modelling the demand conditions in the industry. There is a set of
potential buyers N . These buyers are partitioned into two subsets, L whose elements are
ex ante large buyers and S which contains ex ante small buyers. Each buyer n ∈ N , has an
individual total willingness to pay for the good of vn (qn ) where qn is the quantity of the good
consumed by n. Assume that vn is twice continuously dierentiable for all n with vn′ > 0 and
vn′′ < 0. For any uniform price pn ∈ [0, vn′ (0)], denote by q˜n (pn ) the quantity for consumer
qn ) = pn .7
n such that vn′ (˜ To simplify notation, we regard all large buyers as identical, so
that vn (
) = vl (
) for all n ∈ L, and, in an abuse of notation, we denote the total number of
large consumers by L.
A rm can enter into an individual contract with a large buyer. Denote a contract with
buyer l ∈ L by (ql, Tl ) where ql  0 represents the quantity of the good transferred to l
and Tl is the net monetary payment by l to the relevant rm. Tl may be either positive or
negative. The total payo to the large buyer l from this contract is vl (ql ) Tl .
In contrast, rms can only set a uniform price for all small buyers. If a small buyer s
faces a simple linear price, p, it will purchase q˜s (p) and receive a total payo of vs (˜
qs ) pq˜s .

2.2 The rms

There are two identical rms that (potentially) can operate in the industry, denoted A and
B . For expository purposes, we follow the technological assumptions of RRW. That is, we
assume that:
7
In other words, q˜n (pn ) is the demand curve for consumer n.

5
A1 the average cost function of each rm C (Q) is non-increasing for Q < Q and C (Q) = C
for Q  Q, where Q is the minimum scale of production;
P
A2 Q > s∈S q˜s (C ). Serving only the small segment alone does not achieve cost mini-
mization; and

A3 Q  Lq˜l(C )/2. There is no natural monopoly in the large segment.

The last assumption here makes the problem interesting, as ecient production involves
both rms reaching minimum ecient scale. Unlike RRW, however, we do not necessarily
assume that Q > q˜l(C ). That is, a rm may be able to reach minimum ecient scale by
just serving a single large buyer.

2.3 Contracts and competition

Finally, we make some assumptions about the nature of competition. We assume that a
large buyer may contract with other large buyers and with the rms. However, rms may
not contract with each other due to standard antitrust laws against collusion and neither
large buyers nor rms can write individual contracts directly with small buyers.
Firms and large buyers contract before rms compete for small buyers. We consider a
number of models of this contracting process below. When rms compete for small buyers,
the level of competition will depend on each rm’s expectation of total quantity sold to both
buyer segments. For example, if both rms expect to sell at least Q in total, then both will
achieve minimum ecient scale and this will be re ected in the competition for small buyers.
But, if one rm does not expect to reach minimum ecient scale, possibly due to it only
serving a small number of large buyers, then this will impact on the (possibly asymmetric)
competition for small buyers.
Denote rm A’s sales to large customers by QLA , its subsequent sales to small customers
by QSA (QLA , QLB ) and its prots from sales to small customers by AS (QLA , QLB ). Equivalent
notation is used for rm B .8 By symmetry AS (x, y ) = BS (x, y ). We make the standard

8
That is QSB (QL L S L L
B , QA ) and B (QB , QA ).

6
assumption that a rm’s sales and prots from small buyers is non-increasing in its own
costs and non-decreasing in the other rm’s costs. In addition we assume that:

A4 For all (QLA , QLB ), AS (0, Q) + BS (Q , 0) = AS (Q, 0) + BS (0, Q)  AS (QLA , QLB ) +
BS (QLB , QLA ), with strict inequality if both QLA and QLB are at least Q.

Under A4, total prots from small buyers are maximized when one rm achieves minimum
ecient scale but the other rm does not. In particular, prots are strictly lower when
both rms achieve minimum ecient scale, i.e., AS (0, Q) + BS (Q, 0) > 2AS (Q, Q). The
increased competition when both rms operate eciently dissipates joint prots and more
than osets any cost savings. The following examples illustrate this assumption.

Example 1 Consider a model of homogeneous goods, Bertrand competition in the small

sector. There are two production techniques available to the rms. A ‘low volume’ technique
which has C (Q) =  for all Q, and a ‘high volume’ technique with C (Q) = C for all Q  Q
where  > C . Dene Q = CQ/. By free disposal, cost minimizing technology for the
rms is given by C (Q) =  for Q  Q , C (Q) = (CQ)/Q for Q < Q < Q and C (Q) = C
for Q  Q. This clearly satises A1. It is convenient to assume that 2Q > Q .
Demand in the small sector is linear with p = a b(QSA + QSB ) and a > . By A2,
Q  > (a C )/b. Suppose that B has contracted to sell at least Q to large buyers, achieving
minimum ecient scale and operating with a marginal cost of C . Firm A, however, has sold
nothing to the large sector. Then so long as (a )( C ) < bCQ, rm A will be excluded
entirely from the small sector with BS = ( C )(a )/b and AS = 0.9 In contrast, if rm
A also sells at least Q units to large buyers, both rms make zero prots from small buyers.
For other values of QLA and QLB there may be other (mixed strategy) equilibrium outcomes,
but these equilibria never involve a price that strictly exceeds . Clearly A4 is satised.

Example 2 Suppose competition is homogeneous goods Cournot for the small customers and
take the assumptions on technology and demand as given by the previous example. Further,
assume that a + C 2 < 0.

9
Note that if both A and B set price C then A will fail to sell Q units. The additional assumption is
required to guarantee that it is not protable for A to deviate and undercut rm B ’s price while producing
Q units.

7
 Suppose rm B has contracted to sell at least Q units to large customers but rm A has
failed to make any contractual sales to these customers. By the assumption that a + C 2 <
0, rm A is blockaded from entering the market for small customers unless the rm chooses
the high volume production technique. This follows as the monopoly price for a rm that has
achieved minimum ecient scale in the market for small customers is less than .
If rm A enters the market for small customers then the rm will produce Q units and
sell the minimum of (a + C )/3b and Q in equilibrium. However, from assumption A2, it is
never protable for rm A to sell Q units to the small customers, so that A will only produce
if (a + C )/3b < Q. In this case rm B will produce QSB = (a 2C )/3b. The equilibrium
price is p = (a + C )/3 with prots AS = [(a + C )2 /9b] CQ and BS = (a 2C )2/9b. Note
that if Q > (a + C )2 /9bC then AS < 0 and A will choose not to produce anything, leaving
rm B to act as a monopoly.10
Thus if a + C 2 < 0 and either Q  (a + C )/3b or Q > (a + C )2 /9bC then rm A will
not produce unless it contracts with some large buyers. Clearly, if rm A fails to make such
contracts, rm B operating at minimum ecient scale as a monopoly over small customers
maximizes the joint prot from these customers. It follows that the joint prots to rms A
and B in this situation are at least as great as the joint prots for any other values of QLA
and QLB and are strictly greater than if both A and B achieve minimum ecient scale and
compete as Cournot competitors for the small customers. Thus, A4 is satised.

Assumptions A1, A3 and A4 together imply that social surplus over small customers
is maximized when both rms reach minimum ecient scale production. Further, total
demand is suciently great so that both rms can reach minimum ecient scale. But, by
A2, a rm must contract with at least some large buyers to achieve a minimum ecient
scale.

10
It is obvious that there exist situations where Q > (a C )/b as required by A2, Q > (a + C )/3b
as required for rm A to contemplate production and Q > (a + C )2 /9bC for A to nd this production
unprotable in equilibrium.

8
3 Contracts to large buyers
Large buyers can sign contracts with rms and/or other buyers before competition for small
buyers commences. We consider two alternative bargaining situations below. The rst allows
for cooperation between large buyers before these buyers are approached by the rms. This
avoids the potential for one rm to exploit ‘buyer disorganization’ as occurs in the RRW
model (see Innes and Sexton, 1994) or to use discriminatory contracts and ‘divide and
conquer’ tactics as in Segal and Whinston (1996). Secondly, we consider non-cooperative
simultaneous bidding by the rms for large buyers. In each case, we show that the solution
will involve only one rm achieving minimum ecient scale so that the outcome is socially
inecient.

3.1 Large buyer cooperation

To analyze this case, we begin with the simple assumption that there is a single large buyer
and hence, no issue of cooperation. The game has the following stages:

1. The two rms independently and simultaneously oer the large buyer individual con-
tracts (ql , Tl ).

2. The buyer chooses which contract to accept or to wait to purchase from the mass
market. In the case of a tie, the buyer randomly chooses the winning rm.

3. Firms compete for uncontracted buyers, production begins and transfers are made.

Proposition 1 All subgame perfect equilibria of the above game involve a total quantity
of q˜l (C ) units being sold from a single rm to the large buyer for a transfer of Cq
 ˜l (C )


AS (Q, 0) BS (0, Q ) .

Proof: We begin with a series of observations. (1) From A1, the surplus that is created from
sales to the large buyer is maximized when it purchases a total quantity q˜l (C ) from rms
that achieve minimum ecient scale (MES). (2) From A3, this total quantity exceeds Q,
so from A4, total rm prots from small buyers is maximized if only one rm sells quantity
q˜l (C ) to the large buyer and the other rm makes no sales to it. (3) Further, as prots from

9
sales to small buyers is non-increasing in own costs and non-decreasing in other rm costs,
AS (˜
qi (C ), 0) = AS (Q, 0) must be the maximum prot that any individual rm can make
from sales to small buyers. Note that the minimum prots that can be achieved by any rm
in the game is AS (0, Q ), which arises if the rm makes zero sales to the large buyer and the
other rm achieves minimum ecient scale in sales to that buyer.
First, to show that having the identiable buyer purchase q˜l (C ) units from a single rm
 ˜l (C )


for a transfer of Cq  S (Q, 0)  S (0, Q ) is an equilibrium of the game, assume
A B

that rm A oers this contract to the buyer. By observations (2) and (3), rm B knows that
if the large buyer accepts this contract, rm B will achieve prots AS (0, Q) while rm A
will achieve AS (Q, 0) from small buyers. As the large buyer chooses randomly if indierent
between contracts, rm B is just indierent to oering the large buyer the same contract
as oered by rm A and rm B gains no benet by deviating from such an oer. Hence,
both rms oering these contracts forms a subgame perfect Nash equilibrium of the bidding
game.
To show that all equilibria involve oer and acceptance of these contracts, consider any
other simultaneous oers where there is a positive probability that neither oer involves
the contract quantity and transfer stated in the proposition. If a contract with a positive
probability of acceptance has a quantity other than q˜l (C ) then the rm oering that contract
can protably deviate and alter the quantity to equal q˜l(C ) and raise the transfer so that the
contract is still accepted by the large buyer with the same probability. Thus, any contract
with a positive probability of acceptance must involve quantity q˜l(C ). If a contract with
a positive probability of acceptance involves this quantity but has a higher transfer, then
the oering rm makes a loss if the contract is accepted and will deviate. If the contract
involves a lower transfer then it pays the other rm to deviate and oer a contract with
the same quantity but a lower transfer. Such a deviation is protable because it does not
eect competition for the small consumers but raises prot from the large consumer when
the contract is accepted.
Finally, it is trivial that the large buyer will never prefer to deviate and wait for the mass
market competition. 2

10
 The buyer is able to extract all of the rents from the small market segment. This
is because of the nature of the bargaining process and one could imagine more general
bargaining solutions as relaxing this implication.
Turning to the situation in which there are L large buyers, we can modify the game to
add a cooperation stage. The game has the following stages:

1. Large buyers cooperatively form bidding groups and contract to receive their Shapley
value (i.e., they equalize their per large buyer payo).

2. The two rms simultaneously oer each group, g , a contract (qg , Tg ).

3. Each group chooses which contract to accept or to wait to purchase from the mass
market. In the case of a tie, the group randomly chooses the winning rm.

4. Firms compete for uncontracted buyers, production begins and transfers are made.

We dene a solution of the game as an outcome that maximizes the per large buyer payo,
given that the bidding behavior of the rms forms a subgame perfect equilibrium.

Proposition 2 A subgame perfect equilibrium of the above game involves a total quan-
tity of Lq˜i (C ) units being sold from a single rm to all large buyers for a total transfer
 ˜i (C )


of LCq AS (Q, 0) BS (0, Q) . Further no equilibrium involves the large buyers pur-
chasing sucient quantities from both rms so that each attains minimum ecient scale in
total production.

Proof: Suppose that all large buyers have formed one bidding group. Then, by Proposition
1, they will choose the purchase quantity and pay the total transfer of the proposition. From
observations (1) and (3) in the proof of Proposition 1, the bidding subgame equilibrium when
large buyers form a single group maximizes the total surplus available to large buyers (as the
rm produces at MES) and total prots from small buyers, and allows large buyers in total
to seize all of this above the minimum prots achievable by a rm. Thus, as it achieves the
maximum possible payo for large buyers as a group, it maximizes per large buyer payo
and is a solution of the game.

11
 That all solutions involve large buyers purchasing quantities from rms so that only one
rm can achieve MES in total production follows from A4 and the solution presented in the
Proposition. If both rms achieve MES in total production then this cannot increase the
surplus available from the supply of large buyers and will decrease the total prots from
small buyers when compared to the solution presented in the proposition. Further, in this
solution, the large buyers seize all this surplus and prots above 2AS (0, Q). Consequently
contracting so that both rms achieve MES must lower per large buyer payos below that
achievable by the above solution, so that such contracts cannot be a solution to the game.
2
When large buyers cooperate they act as a single agent and have an incentive to pursue
any gains from trade with individual rms. These gains from trade involve exerting market
power on small buyers. Given A4, these gains are maximized when one rm is prevented
from reaching a minimum ecient scale. Even when each individual large buyer could allow
a rm to reach minimum ecient scale, as a group they have an incentive to prevent this
from occurring. While social eciency is maximized when both rms reach a minimum
ecient scale, this does not occur in equilibrium. It is in the interests of large buyers and a
single rm to enter into an exclusive arrangement so as to raise the costs of the other rival
and maximize prots accruing to the more ecient rm in competition for small buyers.
The behavior presented in Proposition 2 may be viewed as predatory. One rm contracts
to sell below cost to large buyers. In so doing, that rm denies its competitor sucient
market share to achieve minimum cost production. The competitor suers lower prots in
subsequent competition for small customers and may choose not to produce at all, while the
predator recoups its losses by extracting increased prots from small customers.
Unlike most alternative models, this predatory behaviour does not rely on information
asymmetries either between rms (e.g., Tirole, 1988) or between a rm and an outside
party (e.g., Snyder, 1996). A key distinction between standard predation and the behaviour
presented in Proposition 2 is that it is initiated by one group of consumers who gain at the
expense of other consumers.

12
3.2 Simultaneous bidding
The analysis above relied on the ability of large buyers to coordinate their behavior. Al-
ternatively, suppose the game had the following stages where large buyers are unable to
cooperate with each other prior to being approached by a rm:

1. Each rm simultaneously oers an individual contract (ql , Tl) to each large buyer, l .

2. Each large buyer chooses which contract to accept or to wait to purchase from the
mass market.

3. Firms compete for uncontracted buyers, production begins and transfers are made.

In equilibrium, each large buyer l ∈ L will simply choose the contract that oers them the
greatest individual utility. Proposition 3 shows that there is no Nash equilibrium where both
rms achieve minimum ecient scale.11

Proposition 3 There is no equilibrium of the above game where both rms achieve mini-
mum ecient scale.

Proof: Suppose such an equilibrium exists. Partition the set of large buyers L into LA
and LB where the subscript refers to the rm that contracts with the relevant customer l in
equilibrium. We know for rm B that
X X
Tl  q l (C ) ( B (Q  , Q  ) B (0, Q )) (1)
l ∈ LB l ∈ LB

If (1) did not hold, then rm B would prefer to deviate, set ql = 0 for all l ∈ LB and serve
no large customers. This deviation would yield rm B prots of BS (0, Q ) from the whole
game. In contrast, the maximum prots rm B could receive from not deviating would be
BS (Q, Q ) + l∈LB (Tl ql (C )). But substitution shows that this is less than BS (0, Q )
P

when (1) is violated.

11
As our concern is the achievement of socially ecient production, we ignore mixed strategy equilibria
which only achieve eciency with positive probability less than unity.

13
 Consider a deviation by A from the putative equilibrium where both rms achieve min-
imum ecient scale. In particular, suppose A oers the ‘equilibrium’ contracts to all cus-
tomers l ∈ LA but deviates and oers each customer l ∈ LB an identical contract to B but
with the transfer reduced by an arbitrarily small positive amount, ε. A will then win all the
large buyers. The net gain to A from this deviation is,

X
AS (Q, 0) AS (Q, Q) +


Tl q l (C )  (2)
l ∈ LB

The rst two terms of (2) represent the extra prots A will make in the mass market for
small customers by preventing B from selling any output to large buyers. The third term in
(2) represents the cost of out bidding B.
Substituting (1) into (2), the net gain to rm A from deviating is no less than
X
AS (Q , 0) AS (Q, Q) BS (Q, Q ) + BS (0, Q) ε
l ∈ LB

But, by A4, AS (Q , 0) + BS (0, Q) > AS (Q, Q ) + BS (Q, Q). Thus, there exists a value of
ε > 0 so that deviation by A is protable.
As we have shown a protable deviation for A from the putative equilibrium where
both rms achieve minimum ecient scale, the equilibrium does not exist and there is no
equilibrium of the simultaneous contracting game where both rms achieve minimum ecient
scale. 
When large buyers cannot cooperate, their ability to extract the maximal return from
the small buyers is impeded. Nonetheless, Proposition 3 demonstrates that productive ine-
ciencies still occur in equilibrium with at least one rm prevented from reaching a minimum
ecient scale.
In a variety of circumstances, simultaneous bidding for large buyers will result in a mixed
strategy equilibrium. However, if L = 2 there is a pure strategy equilibria where the large
buyers seize maximal gains from trade.12 For example, consider the situation in which both

12
Note by A3 that when L = 2 only one large buyer is needed to achieve MES.

14
rms oer identical contracts to each large buyer,
 
 ˜l (C ) 1 [ S (Q , 0)
(ql, Tl ) = q˜l (C ), Cq BS (0, Q)]
2 A
Assume that when the large buyers observe these contracts they both choose to buy from
rm A. To see that this is an equilibrium, it is clear that it does not pay B to deviate and
win both large buyers. If B deviates and oers one buyer a contract (˜( q C ),  + Cq
 ˜(C )) and
has this contract accepted then its net gain is B (Q, Q ) +  B (0, Q). Noting that the
deviant contract will only be accepted by the large buyer if  < [AS (Q, 0) BS (0, Q)]/2.
Substitution and comparison with A4 shows that it never pays B to deviate and oer a
contract that will be accepted by one large buyer. Hence, the contracts form an equilibrium.

4 Conclusion
The model presented in this paper answers the full range of criticisms that have been levelled
at the formal literature on anticompetitive exclusive customer contracts. With rational
buyers and no arbitrary contracting asymmetries, our analysis shows that exclusive buyer
contracts may be written that lead to a loss in social welfare. Allocative ineciencies may
arise through uniform monopoly pricing for one class of buyer. Productive ineciencies
may also occur because one rm that actively competes in the market is unable to achieve
minimum ecient scale.
Our underlying assumptions shed light on when the problem of inecient buyer con-
tracts are likely to arise. A key innovation underlying our results is the separation of large
(nonanonymous) and small (anonymous) buyers. If all buyers are able to directly contract
with either rm and with each other then there is little likelyhood of inecient contracts.
Rather, anticompetitive eects are more likely to be observed when there is a natural division
of buyers; for example into industrial and household users. Shepherd’s (1997) observations
of potentially undesirable exclusive contracts in the deregulating US electricity industry is
a natural consequence of our model.
The model also focuses attention on the relative size of the two buyer segments. For
exclusive contracting to raise anticompetitive concerns, the ‘small’ customer segment of the

15
market must be insucient to allow two rms to achieve minimum ecient scale. At the
same time, the market as a whole cannot be natural monopoly if competitive production
is socially desirable. Further, if the ‘small’ customer segment is insignicant compared to
the ‘large’ buyer segment, then any social loss from anticompetitive contracting will also be
insignicant.
The nature of competition, as summarised by assumption A4, is also critical. Loosely
speaking, if competition is more intense for the small customer segment of the market,
then the gains that can be achieved by undermining this competition through exclusive
contracting with large buyers will be greater. In contrast, if competition for small customers
is relatively benign, so that joint rm prots tend to rise rather than fall as one rm achieves
economies of scale, then the anticompetitive rents that large buyers seize through contracting
will dissapear.
In contrast to other literature in this area, our model does not require any rm asymme-
tries. there is no ‘incumbent’ or ‘entrant’ in our model. While we believe that the lack of
any imposed rm asymmetry is a signicant advantage of our model, there are clearly some
practical situations where these distinctions are important. While beyond the scope of this
paper, the analysis above could be extended to issues of incumbency advantage (that is, the
role of sunk costs and rst mover advantages).

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16
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