Market power and inefficiency: a contracts perspective

11© 1996 OXFORD UNIVERSITY PRESS AND THE OXFORD REVIEW OF ECONOMIC POLICY LIMITED

MARKET POWER AND INEFFICIENCY:A CONTRACTS PERSPECTIVE

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 12, NO. 4

JOHN VICKERSAll Souls College, University of Oxford1

I. INTRODUCTION

The trouble with the textbook monopolist is thatit supplies too few widgets. Price per widget iselevated above marginal cost, so consumption isinefficiently low, and a deadweight triangle lossresults. On this view, competition policy is abouttriangle elimination.

Of course it is about much more than that.Monopoly profits might be bad for incomedistributional objectives. They might inducewasteful rent-seeking activity. Cost efficiencymore generally might slacken because of thequiet life that monopoly provides. Monopolymight be bad for innovation and dynamicefficiency. These well-known points are obvi-ously important, but for the most part they willbe ignored in what follows.

Instead, the focus will be on the nature of thecommercial arrangements between firms andtheir customers—the contracts that are struckand the deals that are offered—which are oftenmuch more sophisticated than widgets being ongeneral sale at a constant price per unit. Indeed,the extra sophistication (involving, for example,product bundling, price discrimination, bans onresale, volume discounts, exclusivity conditions,refusals to sell, or long-term contracting), ratherthan just the level of the widget price, is pre-cisely what many competition cases are about.

Indeed, Article 86 of the Treaty of Rome, whichprohibits the abuse of a dominant position, spe-cifically refers to:

(c) applying dissimilar conditions to equivalent transac-tions with other trading parties, thereby placing them ata competitive disadvantage;

1 I am grateful to the Economic and Social Research Council and the Office of Fair Trading for research funding under the Contractsand Competition programme (grant L114251038). The paper was written during a period of sabbatical leave at London BusinessSchool. Thanks also go to Mark Armstrong, Tim Besley, Paul Geroski, Tore Nilssen, Robin Nuttall, the editors, and an anonymousreferee for valuable comments and suggestions. The usual disclaimer applies.

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(d) making the conclusion of contracts subject to accept-ance by the other parties of supplementary obligationswhich, by their nature or according to commercial usage,have no connection with the subject of such contracts.

The same language appears in clauses (d) and (e)of Article 85(1), which prohibits anti-competi-tive agreements and concerted practices.

The recent Microsoft case2 is a good illustrationof contractual arrangements, rather than simplypricing, being the focus of competition policyconcern. After several years of inconclusiveinvestigation by the US Federal Trade Commis-sion, in July 1994 the US government filed acomplaint against Microsoft for engaging inallegedly anti-competitive contracts for the sup-ply of its operating system software to personalcomputer (PC) manufacturers. The EuropeanCommission conducted a parallel investigation.The contractual terms at issue included long-term commitments, minimum purchase obliga-tions, and ‘per-processor’ payment conditionssuch that manufacturers paid Microsoft a royaltyfor each PC shipped, whether or not it containedMicrosoft operating system software. The gov-ernment’s case was that these practices wereexclusionary and helped Microsoft monopolizeoperating system software for PCs. At the sametime, the government filed a consent decree tosettle the case, which, among other things, pro-hibits Microsoft from engaging in the contrac-tual practices above. This settlement was ap-proved by the Court of Appeals in June 1995after the lower court had refused to approve it.

Contracting practices have been central to majorUS antitrust cases in the past, including: UnitedShoe Machinery (1953; issues included lease-only policies and bundling of repair services),Xerox (1975; lease-only policies, patent licens-ing), Sylvania (1977; exclusive territories in TVdistribution), IBM (1969-82; computer leasingpractices, bundling, tying), Monsanto v. Spray-Rite (1977; resale price maintenance for herbi-

cides), and Kodak (1992; tying photocopierrepair services).3

Examples of such practices being examined inimportant Article 86 cases include:4

• volume discounts/minimum quantity require-ments: Hoffman–La Roche (1979; vitamins),Michelin (1983; tyres);

• tying and bundling: IBM (1984; software,memory, and computer hardware), Hilti(1992; nails and cartridges), Tetra Pak (1994;cartons and filling machines);

• refusal to supply: Commercial Solvents (1977;nitropropane), Hugin (1979; spare parts forcash registers), Magill (1995; TV listings).

Needless to say, numerous Article 85 cases haveconcerned selective and exclusive distributionarrangements, territorial restrictions, and exclu-sive dealing and purchasing conditions (e.g. inbeer and petrol).

Further illustrations come from recent cases be-fore the Monopolies and Mergers Commissionin the UK:

• Gas (1988): issues included price discrimina-tion;

• Beer (1989) and Petrol (1990): vertical inte-gration and exclusive purchasing;

• New Motor Cars (1992): exclusive dealingand exclusive territories;

• Fine Fragrances (1993): selective distribu-tion, refusal to supply;

• Ice Cream (1994): freezer exclusivity;• Video Games (1995): pricing of games in

relation to consoles, licensing conditions.

A contracts approach will be used to analyse theefficiency properties of various commercial ar-rangements of these kinds in the presence ofmarket power. If individual or collective marketpower is absent, then there would seem to be nogood grounds for the competition authorities to

2 United States of America v. Microsoft Corporation, Civil Action No. 94-1564 (SS). See the summer 1995 issue of the AntitrustBulletin for a set of papers on the issues involved in this case.

3 See further Kwoka and White (1989, chs 6, 10, and 13), and Viscusi et al. (1995, chs 8 and 9) on economic issues in these andother US antitrust cases.

4 For details, see Freeman and Whish (1991–5), the comprehensive source on UK and EC competition law.

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J. Vickers

object to the nature of the deals, however curi-ous, that the rival firms offer to their potentialcustomers. But market power creates the possi-bility of substantial divergences between privateand social interests.

It must be noted, however, that market powerdoes not necessarily distort incentives. Considerthe situation of bilateral monopoly in which onebuyer and one seller are bargaining over theterms of trade. The Coase (1960) theorem im-plies that, in the absence of transactions costs , anefficient bargain will be struck and all gains fromtrade will be achieved, whatever the bargainingpowers of the parties.

This case of perfect bargaining, rather than themore usual bench-mark of perfect competition,will be used as a reference point for the analysisbelow. This perspective will focus attention uponrelationships between market power and ineffi-ciency that are due to causes more fundamentalthan assumptions of linear pricing. Those under-lying causes generally involve problems of in-formation or of commitment.

The rest of the paper, which draws selectivelyfrom some of the recent theoretical literature oncontracts and competition,5 will consider vari-ous practices, which might give rise to competi-tion policy concerns, in special cases of thefollowing general framework.

Firm M has some market power. Its final con-sumers are denoted by C. There might be some‘downstream’ firms, denoted by D, intermediatebetween M and C. Firm M might have some(potential if not actual) rivals, denoted by R. It isassumed that firms are profit-maximizers andthat consumers have constant marginal utility ofincome, so there are no wealth effects and partialequilibrium assumptions hold. In the absence ofwealth effects, an outcome is efficient if, andonly if, it maximizes total surplus in the set offeasible outcomes. Otherwise, some other out-come could make all parties better off providedthat there is appropriate redistribution of surplus.If it is further assumed (this is no mild assump-

tion) that all firms and consumers have equalwelfare weight, then welfare is measured by totalsurplus—i.e. the simple sum of consumer sur-plus and industry profit.

Section II concerns pricing to final consumers—i.e. the relationship between M and C in theabsence of D and R—in particular price dis-crimination and non-linear pricing when thereare information constraints, and durable goodspricing when there are commitment constraints.Section III looks at aspects of ‘vertical’ contract-ing between M and the downstream firms D (butstill without rivals R) such as quantity discounts,resale restrictions (including resale price mainte-nance), and vertical integration. Both sections IIand III are about the exploitation of a dominantposition.

Section IV, on the other hand, examines anti-competitive conduct towards rivals R—for ex-ample long-term contracts, bundling, exclusivedealing, and vertical integration—that aims topreserve and extend M’s market power. Suchbehaviour can be privately profitable but so-cially inefficient for several reasons, includingthe avoidance of profit dissipation in favour ofconsumers, extraction of rival surplus, and ex-ploitation of consumer disunity.

Competition policy questions in this frameworkare viewed as questions about which contractforms and practices should be banned in whichcircumstances. That is, competition policy-mak-ers simply decide which constraints should beplaced upon the (bargaining) game betweenprivate parties. This contrasts with the moderntheory of monopoly regulation, in which thepolicy-maker chooses an optimal contract (ormenu of contracts) subject to information andcommitment constraints, subject to which thefirm then optimizes. The contrast should not betaken too far, since competition policy is after alla sort of regulation, but it seems realistic tomodel competition authorities as having morelimited instruments than monopoly regulators.The interesting question of why this is so is notpursued here.

5 Rey and Tirole (1996) provide a much more rigorous treatment of anti-competitive practices relating to bottleneck facilities.Caillaud and Rey (1995) give a succinct survey of the strategic use of vertical contracts to affect competition.

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In conclusion it is suggested that contract theoryand the bench-mark of the Coase theorem offersa useful perspective on a number of competitionpolicy problems which complements the morefamiliar view from price theory and the bench-mark of the Arrow–Debreu theorem.

II. EXPLOITING MARKET POWEROVER FINAL CONSUMERS

In this section we consider the basic reasons whyinefficiencies can arise in the relationship be-tween a firm that has some market power, de-noted by M, and the final consumer(s), denotedby C. The basic reasons have to do with informa-tion asymmetries and limited commitment pow-ers, neither of which is explicit in the textbookmonopoly problem.

(i) The Textbook Monopoly Problem

The textbook monopoly problem is that M, if itmust charge the same price per unit to all con-sumers irrespective of quantity purchased, willset that price above marginal cost. (Figure 1(a)illustrates.) As a result there is inefficiency be-cause too little output is supplied: consumers’marginal willingness-to-pay exceeds the mar-ginal cost of supply. However, the output that is

supplied is efficiently distributed among con-sumers.

Without the restriction to uniform pricing, profitand welfare could be much greater. In the ab-sence of information constraints (i.e. if M kneweach consumer’s demand curve), and if a ban onresale could be enforced, then if M could cred-ibly make take-it-or-leave-it offers to consum-ers, it could extract virtually all surplus by asimple two-part pricing deal with each con-sumer, in which marginal price was equal to themarginal cost of supply, and the fixed elementwas just less than the consumer’s surplus at thatprice. This ‘first-degree price discrimination’would attain the first-best—the optimal level ofoutput optimally distributed among consumers.More generally, if M did not have all the bargain-ing power, such contracts would ideally be ne-gotiated between M and each consumer, with thegains from (optimal) trade being shared betweenthem.

What prevents this? The first problem is infor-mation: M cannot extract all surplus if consum-ers’ willingness-to-pay is unknown. The secondproblem is that resale is typically hard to stop. IfM offered each consumer a two-part pricing dealof the kind described above, and if resale werecostless, then one consumer could buy a large

Figure 1

(a) Textbook Monopoly (b) Monopoly with Incomplete Information

p

p*

c

x*x

marginal revenue

triangle loss

demand: ( )x p

v

v*

c

1

1 – ( )F v

0

v_

‘MR( )’ v ≡v – [(1 – ( ))/( ( ))]v vF f

prob (trade)

‘expected demand’

15

J. Vickers

amount from M and profitably resell all of it(after meeting his own needs) by undercuttingM’s offers to other consumers. Thus M’s sales toconsumer h could come to compete with M’ssales to consumer k. In negotiation with M,consumer h might get a better deal from M bypromising not to engage in resale, but only ifsuch a promise is backed by credible commit-ment. Thus the resale problem can be seen in partas a kind of commitment problem.

The profitability of resale in this example arosefrom the fact that unit price varied with quantityin the deals offered to consumers. Resale mightalso be profitable when different consumers areoffered different deals (which was not an essen-tial feature of the example above). Only uniformpricing is immune to both kinds of resale. Thusone way of viewing the textbook monopolyproblem is as a reduced form of a larger con-strained optimization problem. Welfare implica-tions of the constraints implied by resale will beconsidered further below.

(ii) Incomplete Information and InefficientTrade

The following standard example shows howincomplete information can be a fundamentalcause of inefficiency when there is market power.Suppose that there is a single buyer whosemaximum willingness-to-pay for one unit ofoutput is v. Firm M, whose unit cost is c, cannotobserve v but knows that it is drawn from adistribution F(v) with density f(v). The function(1 – F(v)) is like a demand curve because ex-pected demand—the probability of there beingdemand for one unit at price v—is given by (1 –F(v)). Assume that there are potential gains fromtrade in the sense that v > c for at least a range ofv. Efficiency requires that trade occur if and onlyif v

≥ c.

Firm M’s problem is to design a mechanism—i.e. to offer a deal—that maximizes its expectedprofit subject to the facts that (i) each type ofbuyer will optimize given the deal on offer, and

(ii) a buyer will not accept a deal that yieldsnegative surplus. It can be shown that high-vtypes must be given strictly positive gains fromtrade in order to deter them from acting like low-v types. These ‘information rents’ increase as Mincreases the expected amount supplied. SinceM’s profit objective is equal to expected totalsurplus minus the buyer’s information rent, Mfinds it privately optimal to reduce the expectedamount supplied in order to curb the buyer’sexpected information rent.

The best deal for M to offer can be characterizedin a way that looks very familiar.6 Define MR(v)= v – (1– F(v))/f(v). This expression is the sameas that for the marginal revenue as a function ofprice v for a textbook monopolist facing demandcurve X(v) = 1 – F(v). The best deal for M to offeris such that trade occurs if and only if MR(v) ≥ c.Assuming that MR is a strictly decreasing func-tion, this can be achieved by M making a take-it-or-leave-it offer to supply one unit at the pricep that satisfies MR(p) = c. This price maximizesthe ‘profit’ function: (p – c)(1 – F(p)). Figure1(b) illustrates; its comparison with Figure 1(a)shows that the parallel with the textbook mo-nopoly problem could hardly be closer. Note,however, that the inefficiency resulting fromincomplete information is fundamental in thesense that it does not stem from any constraint oncontracting possibilities.

In the example just discussed, M was assumed tohave all the bargaining power. If, instead, thebuyer had the power to make a take-it-or-leave-it offer to M, and knew M’s cost level c, thenefficient trade would be accomplished. Thisillustrates the principle that it is desirable to givethe bargaining power to the informed party.7 Butwith two-sided asymmetric information, ineffi-ciency in trade might be inevitable, whatever thedistribution of bargaining power. For example,suppose that, in addition to v being unknown toM, the cost c is privately known by M butunknown to the buyer, and that it is unclearwhether there are gains from trade (i.e. v < c forsome v and c.) Then no mechanism exists that

6 See Bulow and Roberts (1990) for a much more general analysis with many buyers that relates auction theory to the economicsof price discrimination.

7 See Tirole (1988, p. 23).

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yields efficient trade without external subsidy.8

The information rents associated with efficienttrade would add up to more than the gains fromtrade—indeed, both buyer and seller would haveto be given all the gains from trade to induceefficient decisions—which obviously cannot hap-pen without external subsidy.

This simple example has illustrated the generalprinciple that information rents can thwart effi-ciency. This point is central to the modern theoryof monopoly regulation, but what has it got to dowith competition policy (apart from the fact thatcompetition policy is a kind of regulation)? First,since information rents may drive a wedge be-tween private and social welfare, they provide afundamental reason why, say, vertical relation-ships adopted by a firm with market power mightlead to inefficiency (see further section IV(ii)below).

Second, there are ways that competition cancurb information rents, thereby enhancing thescope for efficient trade. A property of the exam-ple above is that one agent (the seller) initiallyowned all the asset in question while the otherowned none. Cramton et al. (1987), in a moregeneral n-agent model, showed that efficienttrade can be attained if and only if asset owner-ship is sufficiently unconcentrated. More equalownership reduces information rents becauseagents, not knowing whether they will be buyersor sellers, have more balanced incentives re-garding the revelation of their valuations of theasset. In short, ownership structure can affectinformation rents and hence efficiency.

The focus of this section has been on efficientallocation or trade—sometimes called ex postefficiency. By contrast, ex ante investment effi-ciency is about incentives for investment deci-sions prior to trade, which, as is well known fromthe work of Williamson (1985) and others, mightbe suboptimal where non-contractible relation-ship-specific investments are concerned becauseof ex post hold-up problems. This large topic isaddressed by some of the other papers in thisissue; just a few remarks about competition andex ante investment incentives are in order here.

First, superficially ‘restrictive’ contracting ar-rangements (e.g. exclusive dealing contracts,which in simple form restrict retailers to theproducts of one manufacturer) can in somecircumstances be entirely sensible and efficientattempts to ameliorate hold-up problems. Thefact that they do not arise in textbook spotmarket competition does not mean that suchcontracts are not the result of competition,which should be assessed in terms of therivalry to offer deals rather than the nature ofthe deals that result.

Second, whereas joint ownership improved expost efficiency in the example above, it tends toworsen ex ante investment efficiency becausemore agents can extract ex post surplus. Moregenerally, ex post efficiency can impair ex anteinvestment efficiency by constraining contract-ing possibilities (see Hart, 1995). For example,contractual arrangements with good investmentincentives might be undermined by the knowl-edge that they will subsequently be renegoti-ated to ensure ex post efficiency. Such rene-gotiation, unless it incorporates new exog-enous information that could not be contractedupon before, tends to make matters worsebecause bargaining unconstrained by renego-tiation can generally do better than constrainedbargaining.

Third, where competition reduces the relation-ship-specificity of investment by reducing vul-nerability to ex post hold-up, it may promote exante investment efficiency.

Finally, bearing in mind the Coasian perspectivementioned in the Introduction, a comment onexternalities is appropriate. Farrell (1987), amongothers, has observed that informationasymmetries can undo the Coase theorem bymaking decentralized bargaining not only im-perfectly efficient but sometimes even inferior toinsensitive centralized mechanisms. Maskin(1994) showed that this observation is essen-tially not to do with externalities but with marketpower: ‘in spite of externalities and incompleteinformation, private contractual agreements suf-fice to achieve efficiency, so long as no agent is

8 Myerson and Satterthwaite (1983). See Bulow and Roberts (1990) for further exposition.

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J. Vickers

big enough to have significant market power’ (p.333). Thus the issue of market power is at theheart of debates about the Coase theorem onexternalities.

(iii) Incomplete Commitment Power: TheDurable Good Monopoly Example9

From the Coase theorem to the Coase conjec-ture. Coase (1972) argued that if the monopolistM is supplying a durable good—examples mightbe cameras, computer hardware, or photocopi-ers—it might enjoy no market power because ofa commitment problem. Immediately havingsupplied the consumers with the highest willing-ness-to-pay for the product, M would have anincentive to reduce price to attract the nexttranche of custom, and so on until all consumerswhose willingness-to-pay exceeds cost weresupplied. The trouble for M is that, anticipatingthe decline in prices, which in the limit wouldhappen ‘in the twinkling of an eye’, the high-valuation consumers would not be willing to paymuch above cost in the first place since theywould do better to delay a while until the pricehad fallen. Note that this problem would notarise if M could credibly commit itself not tolower prices, or commit itself to cease supplyat a certain point, which would limit the pricedecline so that monopoly profits could bereaped.

Exactly the same problem arises in bargainingmodels in which one party makes all the offers.In section II(ii) above it was implicitly assumedthat M, though suffering from incomplete infor-mation about the buyer’s valuation, could cred-ibly make a take-it-or-leave-it offer to the buyer.What if it cannot? Coase-conjecture reasoningsuggests that M would end up being forced tooffer to supply at cost, in which case tradeefficiency would be achieved, albeit at somecost in terms of delay, but that might be small ifthe interval between successive offers was short.Thus compounding M’s information problemwith the commitment problem, though doublybad for M, is excellent from the point of view ofsocial welfare. Likewise the durable good

monopolist would be compelled to supply theoptimal level of output.

But does the Coase conjecture stand up to ana-lytical scrutiny? This question has received ex-tensive game-theoretic analysis, and its answerhas been shown to depend on some delicatefactors including, for example, whether the dis-tribution of buyer types and the range of permis-sible prices are discrete or continuous—seeFudenberg and Tirole (1991, ch. 10) and von derFehr and Kühn (1995). In some circumstancesthe Coase conjecture holds; in others there aredynamic equilibria in which M achieves thetextbook monopoly profit level; and sometimesM can do better still and extract virtually allconsumer surplus.

Moreover, depending on what competitionpolicy allows, M might have ways of overcom-ing the Coasian commitment problem. For ex-ample, by adopting a lease-only policy—i.e.refusing to sell the good outright—M might beable to convert a durable good monopoly with acommitment problem into a non-durable serv-ices monopoly without one. Tying a non-dura-ble good to the durable good might have similareffects—see below.

(iv) Non-uniform Pricing10

Let us take stock of the discussion so far.Incomplete information and incomplete com-mitment powers may constrain M’s ability toextract the surplus potentially available. Thesame constraints can hamper efficient bar-gaining more generally. As a result, total sur-plus might well not be maximized. On theother hand, as the discussion about durablegoods monopoly illustrated, more constraintson M’s optimization might be better for wel-fare than fewer (even though the first-bestwould be attained with no constraints at all).When should policy constraints be added tofundamental information and commitmentconstraints faced by M (or by bargainers)? Inparticular, should departures from uniformpricing be allowed?

9 See Tirole (1988, section 1.5) for a more detailed account.10 See Varian (1989), Wilson (1993), and Armstrong (1996) for detailed analysis of this topic.

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At this point some notation is useful. Let th(x), the

deal offered by M to consumer h, be the amountthat h has to pay M to buy quantity (bundle) x.With uniform pricing, t

h(x) = px for all h. (Inter-

pret px as a vector product in the multi-productcase.) Uniform pricing has three characteristics:

• non-discrimination—the same deal is offeredto all consumers;

• linearity—expenditure is proportional to theamount(s) purchased; and

• separability—in the multi-product case theexpenditure needed to buy amount x

i of prod-

uct i is independent of purchases of otherproducts.

Standard examples of corresponding departuresfrom uniform pricing are:

• ‘third-degree’ price discrimination, th(x) =

phx, where identifiably different consumer

groups are charged different (linear) prices;11

• non-linear pricing (a type of ‘second-degree’price discrimination)—for example, priceschedules that give volume discounts; and

• bundling, where multiple products are soldonly (or more cheaply) in combination, andtying, where one product (the tying product)is sold on condition that the buyer purchaseanother product (the tied product) from theseller.

Obviously hybrids of these forms of non-uni-form pricing are possible. As discussed above,easy resale among consumers would underminesignificant departures from uniform pricing, solet us assume that that is not possible.

Assuming for simplicity that costs of supply donot vary among consumer groups, the basicwelfare economics of monopolistic third-degreeprice discrimination are as follows. Price dis-crimination results in an inefficient distributionof output among consumers because the mar-ginal utilities of different consumer groups areunequal. Thus the same total output could bebetter distributed. However, total output gener-

ally changes if price discrimination is permitted(though not in the case of linear demands and allmarkets served). If total output increases suffi-ciently, then the undesirable ‘unequal marginalutilities effect’ can be outweighed by a desirabletotal output effect. An important set of cases inwhich price discrimination is not only desirablein aggregate, but Pareto-improving given inde-pendent demands, is when it leads to the openingup of hitherto unserved markets. Overall, then,there can be no presumption that third-degreeprice discrimination in supply to final consum-ers is good or bad.

Much the same is true of non-linear pricing.Again, there is a negative effect due to unequalmarginal utilities (unless marginal price is con-stant across consumers, as with two-part pricing,or consumers are identical) and an ambiguoustotal output effect. Elements of the theory ofthird-degree price discrimination carry over ifeach increment of output (e.g. my tenth hour ofphone calls this week) is interpreted as a differ-ent market. Thus volume discounts may lead tothe opening up of ‘new markets’ for high usage.Non-linear pricing with volume discounts is likebundling inasmuch it is cheaper to buy two unitstogether than separately.

A requirement that M offer the same deal to allconsumers effectively denies M the use of infor-mation about observable differences amongthem. A requirement that M offer linear andseparable terms to all denies M the opportunityto sort consumer types. In a sense, therefore,bans on price discrimination and related prac-tices can have the effect of worsening M’s infor-mation constraint, which, as has been seen,might or might not be good for welfare overall.On the other hand, a ban on price discriminationmight help M overcome a commitment problem.Consider again the Coase conjecture that M’smarket power, if it is a durable good monopolist,will be undermined unless it can credibly com-mit not to reduce price over time. If M wererequired to offer the same deal to consumersover time, its credibility problem would be solved!

11 More generally, third-degree price discrimination involves different prices being charged in different markets, whether or notthere are distinct consumer groups in each market.

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J. Vickers

Tying might offer the durable goods monopolistan alternative escape. Durable goods are oftenuseful only in combination with non-durablegoods or services—e.g. cameras with film, orcopiers with paper. (Of course film is durable inthe physical sense that it does not rapidly de-grade if properly stored; but it is non-durable inthe economic sense that its use today precludesits use tomorrow.) By tying the non-durablegood to the durable good so as to extract mo-nopoly profit via the tied good (even if thatwould be competitive otherwise) rather than thedurable good, M might be able to overcome thecredible commitment problem. Here it is not thatmarket power is leveraged from the tying goodto the tied good, but that tying prevents theevaporation of market power; without it theremight be no monopoly profit to be had.

The table below summarizes the effects on wel-fare and on M of banning (i) lease-only policiesand tying, and (ii) intertemporal price discrimi-nation, in the setting of the Coase durable goodmonopoly problem.

Policy Welfare Firm M

Ban on lease-only or tying + –Ban on price discrimination – +

This illustrates that adding policy constraints toM’s problem can be ambiguous not only forwelfare, but also for M when it faces commit-ment constraints.

None of this is to say that price discrimination,non-linear pricing, bundling, and tying (andassociated resale restrictions) are necessarilymotivated by attempts to exploit market powermore effectively. Such practices can be quiteconsistent with more-or-less competitive behav-iour. For example, if there are fixed costs orcross-product economies of scope per consumer,then the most vigorous competition for customcould well result in a winning deal that involvesdifferent mark-ups on different products, vol-ume discounts, etc. The problem facing eachbidder for custom is to maximize profit subject to

giving the consumer a bit more utility than thenext-best offer. This is just like a Ramsey prob-lem, and it is well known that Ramsey pricingtypically involves differing price-cost mark-ups,and so on.12

III. EXPLOITING MARKET POWEROVER DOWNSTREAM FIRMS

In many competition cases the customers of theallegedly dominant firm are other firms—retailers,say—rather than final consumers. What differencedoes that make? First, each retailer cares about theterms on which its rivals are obtaining inputsfrom M. Second, non-uniform pricing to retailerfirms might be more practicable and involvelower transactions costs per unit than such pric-ing to final consumers. For example, they mightbe naturally averse to reselling to rival retailers.Third, whereas final consumers usually facetake-it-or-leave-it offers from M, retailers mayhave bargaining power, including the power tonegotiate private deals with M. Their bargainingpower might be enhanced by the ability to inte-grate upstream into M’s activity.

Finally, retailers make decisions—other thanwhether and how much to buy—that affect M.As well as their price or output decisions in thedownstream market, retailers can confer otherimportant externalities on M, for example byenhancing sales or product quality by makinginvestments and efforts that cannot be con-tracted for directly. Such ‘vertical’ externalities,and ‘horizontal’ externalities between retailers(e.g. one retailer free-riding on valuable promo-tional activity provided by another), sometimesprovide good justifications for non-linear whole-sale pricing and contractual ‘restrictions’, suchas exclusive territories, exclusive dealing, andpossibly even resale price maintenance. Theycan be quite consistent with effective competi-tion in the sense of vigorous rivalry that en-hances efficiency. However, in order to focussimply on how contracts with downstream firmsmay affect market power and efficiency, weshall abstract from externality considerationsexcept those involving price or output decisions.

12 For related reasons, Ramsey pricing emerged in Bliss’s (1988) model of retail competition.

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(i) Constraints on Profit Maximization andExtraction13

For concreteness, assume that there is a fixednumber n of symmetric downstream firms thatproduce a homogeneous product under constantreturns to scale. Firm M, which has constantmarginal cost c upstream, supplies a key input tothe downstream firms. Suppose that M can offera two-part wholesale pricing contract, and let{a

r, w

r} denote the contract terms offered to

downstream firm r, where ar is the fixed fee, and

wr is the marginal input price. So there are

volume discounts if ar > 0. Let d(w) be the

marginal cost, which is assumed not to vary withoutput, of a downstream firm facing marginalinput price w. If there are fixed coefficients indownstream production, then d(w) is linear in w,but otherwise it is concave because substitutionaway from the M’s input will occur as w rises.Assume that a uniform price p holds in the finalproduct market. Under various assumptionsabout downstream competition, includingCournot, p will depend on d(w).

Firm M has two instruments—w and a—but toachieve maximum profit it must meet three ob-jectives, namely (i) minimizing the industry costlevels, (ii) maximizing industry profit given theindustry cost level, and (iii) extracting all indus-try profit for itself. However, with fixed inputcoefficients and no further constraints on con-tracting possibilities, M can both create andextract the maximum possible industry profit.The marginal input price w can be set so as toinduce the monopoly final product price p*, andthe fixed element a can extract all downstreamprofit. There being no cost-minimization prob-lem with fixed coefficients, M’s two instrumentssuffice to attain its first-best outcome. Similarly,with constant returns and fixed n, profit extrac-tion happens automatically if perfect competi-tion reigns downstream.14 In that case and withfixed coefficients, a uniform wholesale price walone suffices to achieve the first-best for M.

However, outside the special cases just men-tioned, compromises have to be made when Mhas fewer instruments than objectives. If there isimperfect competition downstream, and if M isconstrained—by policy or by inability to stopresale—to set a = 0, then the classic doublemark-up problem arises. Unable to extract down-stream profit by fixed fees, M optimally sets w >c. To this upstream mark-up is added the down-stream mark-up p – d(w) > 0. Industry profit isnot maximized, and M cannot get all of it. Withfixed coefficients, consumers are worse off, andwelfare is lower, than if M operated as a verti-cally integrated monopoly. But with variablecoefficients, these welfare comparisons are am-biguous, because M’s market power is weak-ened the more that downstream firms can substi-tute away from its input (which with w > c willhappen excessively from the point of view ofproductive efficiency, other things being equal).

(ii) The Secret Deals Problem15

A quite different, and perhaps more fundamen-tal, type of constraint applies to M if it cannotcommit itself not to do secret bilateral deals withdownstream firms. Assume that downstreamfirms compete in Cournot fashion and that eachmakes its input and output decisions simultane-ously. Then, if contracts are bilateral and secret,and in the absence of other instruments, Mcannot avoid contract terms that involve w = c,in which case firms behave just as they would inCournot competition facing the true marginalcost for the input. To see why w = c is compelled,consider the optimal bilateral deal between Mand downstream firm j. Being secret, the terms ofthe deal will not affect the expected output fromother downstream firms, nor their input pur-chase. So M and j should maximize their jointprofit taking as given the behaviour of otherfirms. This is done by keeping j’s marginalincentive in line with M’s—in other words bysetting the (marginal) price of the input equal tomarginal cost. This will be anticipated by all.

13 See Tirole (1988, ch. 4) for a more detailed and rigorous analysis.14 Further issues relating to cost efficiency arise if the number of downstream firms is endogenous and/or returns to scale are not

constant.15 The discussion in this sub-section and the next is based on Hart and Tirole (1990), O’Brien and Shaffer (1992), McAfee and

Schwartz (1994), and Rey and Tirole (1996, section 4.1). Those papers indicate that the assumptions that downstream firms playCournot and that each makes its input and output decisions simultaneously can be varied without changing the basic results.

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Thus Cournot—rather than monopoly—outputand profit prevail. Firm M may be able to extractall that profit via the fixed fee element, but itsmonopoly power is undone by the inabilitycredibly to resist the temptation to do secretbilateral deals with downstream firms. All it cando is to divert to itself the profit resulting from therelatively modest market power arising fromCournot competition downstream.

Vertical restraints might enable M to overcomethis profit dissipation problem. For example,resale price maintenance or exclusive territoriescould remove the competition externality be-tween downstream firms. Policy that prohibitedsuch practices by a dominant input suppliercould therefore help to undermine attempts by Mto restore its market power.

On the other hand, some types of policy inter-vention could have the perverse effect of assist-ing the solution to M’s commitment problem.For example, if the prohibition in Article 86(c)against ‘applying dissimilar conditions to equiva-lent transactions with other trading parties,thereby placing them at a competitive disadvan-tage’ meant that M would have to offer the samedeal to all, then the temptation to do deals withmarginal price equal to marginal cost would dis-appear. Policy hostility towards quantity discountscould also help to weaken the temptation, sincethe ability to charge fixed fees was crucial to theunravelling of market power in the example above.In these cases the addition of a policy constraint toa commitment constraint might be beneficial for Mbut detrimental to final consumers.

This suggests that M might try to impose equiva-lent constraints on itself, for example by con-tracts with downstream firms that guarantee thatthe terms offered to any one would entitle othersto the same terms or to equivalent rebates. Butthis requires observability of contract terms—expost if not ex ante. If contractual terms areunobservable, but it is observable (and verifi-able) whether or not M is supplying other firms,then M can achieve its first-best outcome bycontracting exclusively with one downstreamfirm and refusing to supply others.

(iii) Vertical Integration to Preserve MarketPower

If, however, M has no good contractual way ofrestricting its dealings with downstream firms,then vertical integration might solve its crediblecommitment problem (see Hart and Tirole, 1990).Supplying other downstream firms would cutthe profit of M’s downstream unit because of thenegative competition externality between down-stream firms. Vertical integration, by internal-izing this externality, raises the opportunity costof supplying others to a prohibitive level (at leastin the symmetric setting under consideration),and so makes refusal to supply credible. Notethat, as in the example of tying discussed insection II(iii) above, the purpose of verticalintegration here is not to leverage dominancefrom one market to another, but to preventdominance in one market being undermined bya credibility problem.

By way of summary, the table below contraststhe effects on welfare and firm M of banningvertical integration (VI) by M in (i) the traditionaldouble mark-up model with fixed coefficients,and (ii) the secret deals model.

Effect of VI ban Welfare Firm M

Double mark-up problem – –Secret deals problem + –

This illustrates how the effects of policy can besensitive to the nature of the fundamental con-straints facing the dominant firm.

IV. ANTI-COMPETITIVE BEHAVIOURTOWARDS RIVALS

Until now attention has been focused on theexploitation of market power by M in the ab-sence of rivals. However, much competitionpolicy is about anti-competitive behaviour to-wards rivals rather than exploitative behaviourtowards customers. The former might well be anecessary condition for the latter, since if com-

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petition is effective, customers will not generallybe vulnerable to exploitation.16

From a Coasian perspective, it is a natural thoughtexperiment to consider collusion among firms,and more generally to think about the grandcoalition of all firms and consumers, which inidealized circumstances would maximize totalavailable surplus by having the most efficientfirms efficiently supplying optimal quantitiesand varieties to consumers. In particular, it isworth keeping in mind the question: ‘Why wouldM exclude a more efficient rival R when it couldmake more profit by contracting with R to pro-duce instead, thereby extracting some of R’sefficiency advantage for itself?’

Collusion among firms, even if legal, might bedifficult for several reasons. First, unless bindingagreements are possible, collusion might (ormight not17) be undermined by cheating—a kindof credibility problem. Second, for reasons re-lated to those discussed in section II(ii) above, itmight be impossible to arrive at efficient agree-ments because of asymmetric information aboutfirms’ costs.18 Third, the profitability of collu-sion might be undermined by entry. Fourth, as ageneral proposition it cannot be assumed that thebinding agreements reached in equilibrium in abargaining process will necessarily maximizetotal surplus (even if transfer payments are pos-sible within coalitions).19

Even if firms can successfully collude, the cartelis likely to face constraints in its dealings withconsumers (see section II) that cause grave inef-ficiencies. Thus anti-collusion policy is a clearcase where the addition of policy constraints—bans on horizontal agreements, and on practices(e.g. kinds of information sharing) that facilitatetacit collusion—to firms’ optimization problemsis eminently sensible. Indeed, Article 85(1) of

the Treaty of Rome has price fixing, productionlimitation, and market sharing among its primetargets.

(i) Avoidance of Profit Dissipation

The difficulty, if not unlawfulness, of collusionleads to the first reason why M, if threatened byone or more rivals R, might have a strong incen-tive to exclude them from the market—the avoid-ance of profit dissipation in the direction ofconsumers in the event of competition. Thegeneral principles of strategic and predatorybehaviour to exclude and deter rivals are wellestablished in the literature,20 and need not berepeated here.

An instance of those principles relating to con-tracts is Whinston’s (1990) model of tying toextend market power from one market to an-other. The idea is that tying, if it is a crediblecommitment, can make the incumbent’s pro-spective reaction to entry more aggressive—anexample of the so-called ‘top dog’ strategy. Thereason is as follows. Suppose that M monopo-lizes the tying product A but faces potentialcompetition in the market for the tied product B(the markets A and B may be quite unrelated).Entry by R into the B-market would involvesome sunk cost, however. Without tying, M’sresponse to entry might not be so harsh as todeter entry. Tying will make M more aggressiveinasmuch as each unit of B won by R deprives Mof profit on a unit of A as well as a unit of B. Bymaking M more aggressive, tying might cause Rnot to enter at all.

If the two products are perfect complementsconsumed in fixed proportions, this argumentdoes not work on its own, because M couldextract all available profit, plus some of anyefficiency advantage enjoyed by R, without

16 It should, however, be noted that in some circumstances, for example in the presence of consumer switching costs, customersmight be vulnerable to ex post exploitation even if competition for their custom ex ante was effective. See Klemperer (1995) for anoverview of competition in the presence of consumer switching costs.

17 It is well known that collusive outcomes can sometimes be sustained without binding agreements, for example in infinitelyrepeated games when discounting is not too great. See Tirole (1988, ch. 6) on dynamic oligopoly theory.

18 See, for example, Kihlstrom and Vives (1992).19 See, for example, Ray and Vohra (1996), who show the possibility of robust inefficient outcomes in a model of coalition formation

with binding agreements.20 See Tirole (1988, chs 8 and 9).

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entering the B-market, by setting a suitably highA-price. But if there is a limit to the A-price thatM can charge—for example because there is analternative, albeit less efficient, A-producer towhom customers would turn if M set a high A-price—then the private motive for socially inef-ficient tying may be re-established.

For simplicity, suppose that the consumer de-mands one unit of a system consisting of one-A-plus-one-B up to a reservation price that is vgreater than M’s cost of producing a system, andthat M is α more efficient than the next mostefficient A-producer, who cannot produce Bs,but β < α less efficient than a potential rival B-producer, who cannot produce As. AssumeBertrand competition. Without tying, M’s maxi-mum profit is α, social efficiency prevails, andconsumers gain a large proportion of total sur-plus. With a credible commitment to tying, how-ever, M would undercut its rivals on price,leaving them with no business. Foreseeing this,the B-producer would not enter. Then M canextract almost all the consumer surplus of v. Thiscould well be greater than α, but there is socialinefficiency because of the exclusion of themore efficient rival B-producer.

Anti-competitive practices to raise rivals’ costs,even if they do not exclude rivals, can be prof-itable insofar as they avoid the dissipation ofprofit towards consumers. Ordover et al. (1990)argued that, in a model with symmetric duopolyat each stage of production, vertical mergerwould raise the input costs of the unintegrateddownstream firm by increasing the market powerof the unintegrated upstream firm on whom itrelies for its inputs, thereby allowing the inte-grated firm to raise price and profit at the ex-pense of consumers. Hart and Tirole (1990)questioned the assumptions in this analysis aboutthe integrated firm’s commitment not to supplyothers and about uniform price contracts, butshowed that with asymmetric upstream firms,there was an anti-competitive motive for verticalintegration by the more efficient upstream firmeven when those assumptions were relaxed. Thefundamental reason is the same as that discussedin III(iii) above: integration makes credible re-fusal to supply, or at least increases the price at

which M would be prepared to supply, by raisingits opportunity cost of supplying inputs to rivals.

Finally, it should be noted that, while the focusof this section is on contracting behaviour thatharms M’s actual or potential rivals, it is quitepossible for vertical contracts (without any hori-zontal collusion) to have the effect of avoidingprofit dissipation by ‘softening’ competition—to the detriment of consumers and overall wel-fare, but to the advantage of M’s competitors. Adiscussion of this point is outside the scope ofthis paper (see Caillaud and Rey, 1995).

(ii) Extraction of Rival Surplus

A second reason why it might be in M’s interestto exclude a rival more efficient than itself has todo with attempts to extract part of the rival’sefficiency advantage. Aghion and Bolton (1987)examine whether long-term contracts with cus-tomers might act as a barrier to the entry of amore efficient rival firm. On the face of it onemight think not. Why would customers denythemselves the opportunity to transfer their cus-tom to such a firm?

Suppose that the efficiency advantage of therival firm R, denoted by y, is information that isprivate to R. Welfare maximization requires thatR displace M if and only if y > 0, in which caseR captures all of any efficiency advantage that ithas. But the joint interest of M and theconsumer(s) C does not coincide with overallwelfare; it is equal to the expected value ofwelfare minus R’s profit. They would do well toarrange things so that R pays C a fee (y

0 , say) inthe event of entry. The optimal y0 for the coali-tion of M and C strikes a balance betweenincreasing the amount of rival surplus extractedin the event of entry and reducing the probabilityof entry. Generally y0 > 0 will be optimal, whereasy0 = 0 would be best for welfare. (The parallelwith the example of inefficient trade under in-complete information in section II(ii) above isvery close indeed.)

Firm M and C can arrange things in this way ifthey can sign a (non-renegotiable) contract thatstipulates a penalty in the event that C breaches

24


its contract to buy from M. If C has to pay y0 to

M if it switches to R, then R will have to reduceits price accordingly to win C’s custom, andhence some of its efficiency advantage getstransferred to the others. Thus it could well be tothe advantage of M and C to create a hurdle,though not a prohibitive barrier (since surplus isextracted only if R does enter), for a moreefficient R to overcome. Extraction of rival sur-plus is both the motive for, and source of ineffi-ciency of, this practice. If more efficient rivalsgot no surplus anyway—for example if R con-sisted of two or more equally efficient rivals thatcompeted in Bertrand fashion—then rival sur-plus would be extracted in any event, and M andC would gain nothing from a breach of contractpenalty clause.

The proviso about renegotiation is important. IfR is more efficient than M, then it would be in theparties’ mutual interest to renegotiate terms thatexcluded R so as to ensure ex post efficiency. (IfR had to cede a fraction of its efficiency advan-tage to others in this renegotiation, that wouldbenefit M and C, but no social inefficiencywould result.)

However, Spier and Whinston (1995) have shownthat inefficient exclusion can occur by othermeans, involving non-contractible, sunk ex anteinvestment, even if renegotiation ensures ex postefficiency. This is ironic inasmuch as ex anteinvestment incentives are a common efficiencydefence for contractual restrictions. The basicidea is that more ex ante investment by M, bylowering M’s ex post cost level, will reduce thesurplus available to a more efficient rival (unlessthat is squeezed to zero anyway by cut-throatinter-rival competition). So there are sociallyexcessive incentives for ex ante investment byM. As a result, there are occasions on which arival is excluded that was ex ante more efficient,but thanks to M’s strategic behaviour not ex postmore efficient than M.

(iii) Exploitation of Customer Disunity21

There is another, quite different reason whyconsumers might rationally sign contracts com-

mitting them to buy from M even if that deniedthem the opportunity to switch their custom to amore efficient rival R. If there are economies ofscale, then there is no inconsistency between thestatements:

(i) that consumers collectively would do better ifnone signed up with M, and

(ii)that it is in the interest of each consumer tosign up with M if all (or enough) others do so.

The reason is that a consumer left stranded whileothers have committed to M has little protectionfrom R’s competition if R has high unit cost atsmall scales of production (despite having a costcurve everywhere below M’s). So there is anequilibrium in which all sign up with the lessefficient firm M, and which could be very prof-itable for M. In this static setting it would also bean equilibrium for all to buy from R. However,the incumbent firm might have the advantage ina dynamic model with successive generations ofbuyers insofar as the current generation ignoredthe externality to their successors that wouldresult from R moving down its average costcurve. This possibility of ‘serial exclusion’ re-quires analysis.

V. CONCLUDING REMARKS

In very general terms, there are three broad atti-tudes towards the competition policy treatment ofcommercial deals, contracts, and arrangements(including full integration between firms) that donot conform to the textbook model of widgetstraded on a spot market at a uniform price.

The first is suspicion: If uniform pricing happensin competitive spot markets, then more complexarrangements perhaps suggest possible abuse ofmarket power. This attitude suggests a rebuttablepresumption against agreements and practicesthat differ substantially from standard uniformpricing. There might be some merit in this viewas far as horizontal price-fixing or output-shar-ing agreements are concerned, but more gener-ally it is untenable. Vigorous competition isquite consistent with the emergence of efficient

21 See, for example, Tirole (1988, pp. 197–8) and Rasmusen et al. (1991).

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non-spot contracts and arrangements in a widevariety of circumstances. Conversely, spot deal-ings are quite consistent with the exploitation ofmarket power, as the textbook monopolist illus-trates.

The second attitude, generally associated with‘Chicago’, is friendliness. Where market poweris absent, contractual arrangements are shapedentirely by considerations of efficiency; wheremarket power is present, the same is true because(except for horizontal price-fixing, etc.) contrac-tual arrangements generally cannot increase theamount of market power so should be presumedto enhance efficiency. For example, what coulda dominant firm gain by requiring consumers todo something against their wishes, or by exclud-ing a more efficient firm with whom a mutuallybeneficial deal could in principle be struck? Thisattitude suggests a laissez-faire policy stancetowards commercial deals and arrangements(except for the obvious horizontal ones).

The third attitude is a hybrid consisting of (i)friendliness in evidently competitive conditions(not to be equated with conditions of spot marketcompetition), (ii) hostility towards horizontalprice/quantity arrangements, and (iii) an inquir-ing attitude otherwise (e.g. towards vertical re-straints where market power is present). By‘inquiring’ is meant neither laissez-faire norstrong presumptions for or against. That said, itmight be good procedure to place the burden ofproof on the perpetrator of the practice or theparties to the arrangement, if only because oftheir likely informational advantage.

This paper has been unsympathetic to the firstattitude, sympathetic to the second insofar as itposes good questions, but ultimately favourableto the third attitude. The abstract justification forthis view is as follows.

Unconstrained market power, or unconstrainedbargaining, would maximize total surplus.22

Applying policy constraints (e.g. bans on long-term contracts) when no other constraints ex-ist could only reduce total surplus. But funda-mental constraints—primarily relating to in-formation and commitment problems—limitcommercial possibilities. Dominant firms, in-cluding the textbook monopolist, face sec-ond-best problems. Adding policy constraintsto the fundamental constraints will often (but,where commitment constraints exist, not al-ways) make matters worse for the dominantfirm, but little can be said in general abouttheir effect on total surplus, especially sincethe scope for divergence between private andsocial interest appears to be large in manyrealistic settings.

Among other things, the recent literature onindustrial organization and contracts, of whichjust a small part has been discussed here, hasshown that the ‘Coasian’ question—why won’tefficient outcomes be achieved without policyintervention?—is a good question but one thathas fundamental and robust answers once natu-ral information and commitment constraints aretaken into account. Whether and in what formpolicy intervention should take place is anothermatter.

22 It should be stressed again that welfare is measured by total surplus only under strong distributional assumptions.

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Market power and inefficiency: a contracts perspective