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Exclusivity, Competition and the Irrelevance of Internal

Investment*

by

Catherine C. de Fontenay, Joshua S. Gans and Vivienne Groves**


First Draft: 9th September, 2009
This Version: 29th September, 2009

This paper considers the effect of exclusive contracts on investment


decisions in a market with two upstream and two downstream firms. Segal and
Whinston’s (2000) irrelevance result is generalized and it is shown that exclusive
contracts have no effect on the equilibrium level of internal investment for the
contracted parties when competition exists in both the upstream and downstream
markets. Furthermore, by considering a more competitive environment we are
able to demonstrate that strongly internal investment by rival upstream-
downstream bargaining pairs is similarly unaffected by the presence of exclusive
contracts.

Keywords. exclusive contracts, irrelevance result, Shapley value, upstream


competition, bargaining.

*
Responsibility for all errors lies with the authors. We thank participants at the EARIE conference 2009
and Ilya Segal for helpful discussions. Financial assistance from an ARC Discovery Grant is gratefully
acknowledged.
**
Melbourne Business School, University of Melbourne. All correspondence to J.Gans@unimelb.edu.au.
The latest version of this paper will be available at www.mbs.edu/jgans.
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1. Introduction

In 2007, Apple Inc announced the introduction of the iPhone in the United States. At the
same time, it announced that the exclusive carrier for the iPhone would be AT&T (then
Cingular). One of the reasons cited was AT&T’s investment in enabling ‘visual voicemail’ (a
new and potentially revolutionary way of accessing voicemails). That investment was specific to
the iPhone and required to enable the service. It had no value outside of the relationship between
Apple and AT&T – it was purely internal.
The notion that exclusive contracts are utilized to encourage certain types of investment –
particularly, specific ones – has been long-standing (Klein, 1988; Frasco, 1991). However, this
argument has been challenged by Segal and Whinston (2000). Their irrelevance result shows
that in a market with one downstream buyer, one upstream seller, and one upstream potential
entrant, exclusive contracts have no effect on the level of relationship-specific (internal)
investment.1 In their model, firms’ payoffs are a function of their marginal contribution to
feasible coalitions. Segal and Whinston allow parties to exclusive contracts to renegotiate in the
event that both parties can be made better off if the contract is suspended and the downstream
firm is allowed to trade with the incumbent. Exclusive contracts eliminate the payoff from
coalitions which do not include the two parties to the contract, because the two parties cannot
negotiate to release each other from exclusivity. Investments, however, only raise the payoffs to
coalitions which do include both parties to the agreement, and so the increase in profits available
to investing parties is independent of whether exclusive contracts exist or not.
Of course, the Apple/AT&T situation is one where there is competition both amongst
phone manufacturers and mobile carriers. While the return to internal investment, in a market
with a bottleneck firm in one segment, does not change when there can be renegotiation amongst
the contracted parties, the question is whether internal investment is similarly unaffected when
there is an additional independent entity in the other segment. In an important generalization to
the Segal and Whinston environment, we demonstrate that the irrelevance result continues to
hold in a market with both downstream and upstream competition. Moreover, we demonstrate
that exclusive contracts signed by one upstream/downstream pair do not effect the strongly

1
Internal investment between two firms is defined as investment that only affects the payoff from bilateral trade
between the investing parties, and does not affect the payoff from bilateral trade between any other pairs..
3

internal2 investments of the other pair. Nonetheless, internal (or relationship-specific)


investments between firms where only one firm is party to an exclusive agreement, or
investments between rival pairs which are not strongly internal can, in fact, be altered by such
agreements.
A critical input into our analysis is reliance on the Generalised Myerson-Shapley value as
constructed by de Fontenay and Gans (2005, 2008). This value arises out of a non-cooperative
bargaining game – familiar in work on bilateral vertical contracting – that involves upstream and
downstream firms engaged in pairwise negotiations where contract terms are difficult to observe
between negotiating pairs. Its usefulness is that it directs attention towards the graph of bilateral
relationships that are structurally possible within the industry. de Fontenay and Gans (2005)
apply this to vertical integration whereas here we consider exclusive contracting. Significantly, it
allows us to distinguish between one-sided exclusivity (whereby only one party is restricted in its
ability to contract elsewhere) and two-sided exclusivity (where both parties are restricted). This
is something that could not be analysed in settings where there was always a monopoly segment
in the market.
The use of a Shapley-like bargaining solution has been criticized by de Meza and
Selvaggi (2007). They provide an example of a Rubinstein bargaining game with delay, in which
the outside option does not affect the division of surplus but may be “exercised” if it is preferred
to the bargaining outcome. Under this non-linear structure, they can construct an example in
which for some parameter values, one firm does not invest without an exclusive contract,
because its bargaining position is so weak that it obtains its outside option.3 In contrast, the non-
cooperative game in de Fontenay and Gans (2008) demonstrates that in negotiations, agents are
dividing the surplus above their outside options, and thus outside options enter payoffs in a linear
fashion. For the reasons explored in de Fontenay and Gans (2005, 2008), we argue that the
Generalised Myerson-Shapley value is a useful and natural representation of the outcomes of
multi-lateral interactions along a vertical chain. Nonetheless, the baseline critique of de Meza
and Selvaggi (2007) – that certain bargaining games and some investments will negate the

2
We define internal investment as strongly internal if the value of the investment is unaffected by the presence of
other parties in the market.
3
We do not discuss the remainder of their paper, which is based on the fairly unusual assumption that while the
exclusive partners cannot agree to release each other from the contract, the downstream buyer can choose to re-sell
the supply to his competitor.
4

irrelevance result – is likely to continue to hold in an environment with both downstream and
upstream competition.
In section 2 we introduce notation and assumptions required for our model. Section 3
provides a proof for our main results: the irrelevance result in the presence of downstream
competition, and the effect of exclusive contracts on other investment choices in the market. We
demonstrate this finding in a market in which downstream firms do not pose competitive
externalities on one another. Although we provide no formal proof for our results in a market in
which competitive externalities exist, in Section 4 we discuss our finding that the irrelevance
result breaks down in the presence of externalities. The paper concludes in Section 5.

2. Model Set-Up

Here we outline the basic structure of the industry as well as the Generalised Myerson-
Shapley outcome as discussed in more detail in de Fontenay and Gans (2005, 2008).4

Notation

We consider an industry with two upstream firms, A and B, and two downstream firms, 1
and 2. Each firm has an associated asset or production technology denoted , , , and

that is essential for production. Upstream firms supply an essential input to the production
process of the downstream firms who generate valuable goods and services. In order to ensure
that the model is tractable downstream firms are assumed to require only the upstream input for
production. Relaxing this assumption would complicate notation without adding significant
insight.
Let be the quantity of inputs sold to by . Write as the cost to

upstream firm j of producing quantities and for downstream buyers 1 and 2, respectively.

Write as the profits of downstream firm i when it produces using of firm A’s

inputs and of firm B’s inputs gross of input costs. Consistent with the related literature, we

assume that downstream firms do not compete against one another. We comment in Section 4 on
what happens when this assumption is relaxed.
5

Let the maximum possible profit achievable when all assets are fully utilised, and firms
bargain bilaterally according to a predefined set of rules (discussed below), be given by
. Upstream firms are assumed to have no intrinsic value for the good; an upstream

firm’s profit is equal to the payment it receives from downstream firms, less its costs. This
implies that industry profits are the sum of downstream profits less upstream costs. Thus, we
write:
(1)

Note that this setup allows downstream firms to consider upstream inputs as either differentiated
or homogenous. Similarly, inputs from either upstream firm can potentially be used in the
production process of either downstream firm. The model is flexible in that it makes no
assumptions regarding the relationship between downstream profit and upstream inputs. Firms
can be asymmetric in the sense that one upstream firm may have higher costs than the other, and
one downstream firm may yield greater profits for a given set of inputs than its counterpart.

Timeline

We consider a four stage game:


• Stage 0 (contracting). Exclusive contracts are written.
• Stage 1 (investment). Firms choose their (internal) investment level.
• Stage 2 (bargaining). Firms bargain over quantities and prices for supply of inputs from
upstream firms to downstream firms.
• Stage 3 (production). Production takes place, inputs are delivered, and monetary
transactions occur.

The bargaining, contracting and investment stages are explained in more detail below.

Bargaining

Prices and quantities for inputs are negotiated on a bilateral basis between upstream and
downstream firms. We let denote the lump-sum payment from downstream firm i to upstream

firm j for a quantity of input . This setup avoids the problem of double marginalization that is

associated with linear pricing.


Each pair of firms bargains according to the protocol introduced by Binmore, Rubinstein
and Wolinsky (1986); firms make alternating offers to one another until an agreement is reached.
6

One firm makes an offer that its counterpart either accepts or rejects. If the offer is accepted, a
new pair start to bargain. If the offer is rejected, there is an infinitesimally small probability that
there will be an irrevocable breakdown in negotiations between that pair; if there is no
breakdown, the counterpart now has a chance to make a counter-offer. Other firms cannot
observe the details of the contract, but they do observe any breakdowns. In the event that

a negotiation breaks down, the entire sequence of negotiations begins again, without pairs who
have broken down. de Fontenay and Gans (2005) demonstrate that, under passive beliefs the
equilibrium payoffs to this game are a generalization of Myerson-Shapley values (GMSV); if
firms 1 and 2 are not competing in the downstream market, GMSVs reduce to exactly Myerson-
Shapley values.
The benefit to a firm of accepting a given offer is equal to its share of the total gains from
trade less its outside option. In this bargaining game the firm’s outside option is the amount that
it expects to receive from future bilateral trades if negotiations in the current state of play break
down. No firm will accept an offer less than this amount. We assume symmetry in the sense that
the gains from trade from any bilateral bargain should be equally split between the two parties
under negotiation. Importantly, de Fontenay and Gans (2008) show that, even in the presence of
externalities, the GMSV satisfy these two assumptions – namely, players are sharing gains from
trade above their outside options, and sharing equally. This provides an intuitive justification for
the use of GMSV in bilateral bargaining – cooperative bargaining payoffs satisfy the properties
of the non-cooperative game.

Coalitions

Myerson-Shapley values assign payoffs to players according to the marginal surplus that
they create by joining coalitions of other players. These coalitions are relevant in our non-
cooperative game, because breakdowns between pairs of firms who negotiate may leave agents
in smaller coalitions; thus these coalitions affect firms’ outside options. In our paper, the value of
the coalition is determined by the industry profit that can be generated when each member of that
coalition is active in the market. More specifically, it is equal to the sum of the profits of the
downstream firms less the costs of the upstream firms in the coalition, as in (1). We can write the
value created by smaller coalitions similarly. For example,
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(2)

There are two important points to note here. Firstly, the value that can be created by forming a
coalition must always be increasing in the number of members in the coalition. That is,
, and etc. Secondly, as a result of

this, we see that if one firm can be replaced by its rival and not change the coalition value, for
instance , the goods produced by those firms are perfectly
substitutable.

Exclusive contracts

There are several kinds of exclusive contracts available. First, there are one-sided
exclusive contracts where, say, signs a contract with agreeing not to purchase from UB

unless UA permits it. We refer to both and as being ‘contracted,’ but only is ‘bound’

by this contract. Second, there are two-sided exclusive contracts where, say, and sign a

contract where agrees not to purchase from UB unless UA permits it and agrees not to sell

to D2 unless D1 permits it. This contract is binding for both and . Importantly, we follow

Segal and Whinston (2000) and assume that such contracts are renegotiable after any
investments are made and so ‘external trading’ will occur if it is ex post efficient to do so.This
means that exclusive contracts do not impact on ex post surplus (holding investments constant)
but may impact on the division of that surplus. Specifically, as the parties to the exclusive
contract negotiate over their own terms of trade, if there is a breakdown in their negotiations, the
exclusivity provisions are enforceable and any party bound by them will not be able to trade with
other parties. In the case of a one-sided exclusive contract, this binds just one party, while for a
two-sided exclusive contract, any breakdown will remove either party from a productive role.
This means that in calculating the GMSV outcomes that, if an exclusive contract is in
force, coalitions that do not include both parties may be altered. For instance, if is bound to

then, for example, effectively becomes because cannot actually

produce in that coalition; and becomes 0. Table 1 lists the payoffs under no, one-sided,

and two-sided exclusive contracts between and .


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TABLE 1: Myerson-Shapley Values *

*
Where (x,y) = (1,1) for no contracts, (1,0) when D1 imposes a one-sided exclusive contract on UA, (0,1) when UA
imposes a one-sided exclusive contract on D1, and (0,0) when UA and D1 sign a two-sided exclusive contract.

From Table 1 we see that when and sign an exclusive contract that binds , each

firm’s payoff decreases by the amount given in the x bracket. That is, players no longer receive
their marginal value from coalitions which include but not . Thus, for example, an

exclusive contract that binds causes ’s payoff to go up by


9

5
. Similarly, when and sign an exclusive

contract that binds , each firm’s payoff decreases by the amount given in the y bracket.

Investment

Finally, we consider the investment choice faced by firms. In order to generalise the
irrelevance result of Segal and Whinston we consider investment which is internal to bilateral
trade. That is, investment by a downstream (upstream) firm only improves the payoff from
bargaining with one of the two upstream (downstream) firms. Let be the (own) cost of

investment made by firm k. Let be the maximum industry profit in a coalition

of downstream firms and upstream firms when the investment, , takes place.

When no investment takes place, we write the coalitional value as .

We can now define the following.


Definition (Internal Investment). An investment, , that improves value in at least one
coalition is internal to if whenever
and/or .

Note that Segal and Whinston, in their three party context (with one downstream and two
upstream firms), defined an internal investment to D1 and UA, a, as one where
. The above definition generalizes this to include all other possible

coalitions.6
In contrast to Segal and Whinston, in our context here, an upstream firm has multiple
partners it can trade with.. The presence of rival firms may impact on the returns to various types

5
Note that signing an exclusive contract is profitable. ’s payoff decreases by
. Hence the net gain to and of signing an exclusive contract,

, is positive.
6
We follow Segal and Whinston by allowing any party to make an investment internal to any pair. In reality, one
imagines that it will be a party within the internal pair making the investment. In addition, for simplicity, we only
analyze investments in isolation. Our analysis would extend to the situations considered by Segal and Whinston
where multiple parties undertake particular internal investments simultaneously.
10

of internal investment. Consequently, we consider here a stronger criterion for an internal


investment.
Definition (Strongly Internal Investment). An internal investment to , , is
strongly internal to if for all and such that , ,
.

This definition says that an investment that is internal to is strongly internal if

additionally, the investment’s impact on any coalitional value that includes is

independent of the presence (or activity) of parties other than Di and Uj.

3. Irrelevance results

We now demonstrate that Segal and Whinston’s irrelevance result – that exclusive
contracts have no effect on the optimal level of internal investment between the contracted
parties – holds in the presence of both downstream and upstream competition. As well as
characterizing the internal investments between the parties to any exclusive contract we also
consider internal investments by the rival, uncontracted, pair of firms.
Proposition 1. An exclusive contract between D1 and UA (either one-or two-sided) has no effect
on the equilibrium choice of investments internal to and strongly internal to .

PROOF: Suppose D1 and UA can sign an exclusive contract. Consider D1’s incentive to
invest in . Let be D1 ’s payoff from making the investment, . If is internal,
the value of is given in Table 1 where is included in coalitional outcomes that
include both D1 and UA. All other coalition values will remain unchanged. For instance,
the first term of will be equal to , but the last term will remain
unchanged since . It is clear that since none of these coalitions
that benefit from the investment interact with the x or y terms in Table 1, none of these
coalitions are affected by exclusive contracts. Therefore D1’s equilibrium choice of
will not change. A similar analysis proves that the same result holds for investments
internal to D1 and UA undertaken by any of the remaining parties.
Secondly, consider the payoff to D2 in making an investment, a2, which is strongly
internal to UB. In this case there are coalitions which are affected by an exclusive
contract between D1 and UA. When D1 and UA sign an exclusive contract (whether it be
one- or two-sided) the payoff to D2, , decreases by the amount that the investment
adds to three-firm coalitions with include both D2 and UB, and also either D1 or UA.. In
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the event that an exclusive contract is signed, however, D2’s payoff, also increases by the
value that the investment adds to a coalition which includes only D2 and UB. Note that
since investment is strongly internal the amount by which D2’s payoff increases will be
equal to the value by which it decreases. That is,

Hence D2’s equilibrium choice of a2 will not change. A similar analysis proves that the
same result holds for investments internal to D2 and UB which are undertaken by any of
the remaining parties. A similar analysis proves that the same result holds for investments
internal to D2 and UB undertaken by any of the remaining parties.

The intuition behind the general irrelevance result in Proposition 1 is very similar to the intuition
behind Segal and Whinston’s irrelevance result with a downstream monopoly. Firstly, consider
D1’s incentives to make an investment internal to UA. Writing an exclusive contract eliminates
the possibility of certain coalitions, thus changing D1’s GMSV. None of these coalitions,
however, are affected by D1’s investment decision, since the only coalitions that are eliminated
are those which include either D1 or UA, and either D2 or UB. Such coalitions are unaffected by
internal investment by D1, since they do not include both D1 and UA. Similarly, the existence of
an exclusive contract between D1 and UA reduces the number of players in coalitions which
include either D1 or UA, and both D2 and UB. Again, since these coalitions do not include both D1
and UA, they are unaffected by investment. Hence, the amount by which firms’ GMSVs change
when D1 and UA write an exclusive contract is independent of the investment choice of D1.
Secondly, we demonstrate that D2’s incentives to make an investment strongly internal to
UB are independent of whether D1 and UA write an exclusive contract. The reasoning is very
similar to the case in which D1 makes the investment, yet slightly more subtle. In this case, the
coalitions for which the number of players is reduced do include both D2 and UB, and hence are
affected by investment. The trick here, however, is that it is always D1 or UA that is excluded
from these coalitions. Since, for any strongly internal investment, the additional value that
investment plays in the coalition is not affected by the absence or presence of D1 or UA, the
optimal level of investment is independent of the absence or presence of exclusive contracts.
What happens if an investment internal to is not strongly internal? The
following proposition demonstrates that the investment might be stimulated by an exclusive
contract between D1 and UA.
Proposition 2. Consider an investment, ak, internal (but not strongly internal) to . If
12

(i) ,
(ii) and
(iii)
then the equilibrium choice of ak made by D2 and/or UB will not fall (and may rise) if D1 and UA
sign an exclusive contract (either one-or two-sided).

PROOF: We examine the payoffs in Table 1 which interact with the coalitions inside the
(x, y) brackets. By (ii) and (iii) it is easy to see that the returns to investments which are
internal (but not strongly internal) to will rise if an exclusive contract is signed.
A similar analysis proves that the same result holds for investments internal to D2 and UB
undertaken by any of the remaining parties.

When investments are not strongly internal and rise when the uncontracted pair do not trade with
others, the returns from internal investment to an uncontracted pair are higher when the
uncontracted pair’s rivals sign an exclusive agreement. The exclusive contract eliminates
coalitions in which the investing downstream (upstream) firm must compete to trade with its
upstream (downstream) partner, and thus, eliminates coalitions in which the investing firm does
not fully reap the benefits of their internal investment.
Finally, we consider investments that are internal to pairs in which one firm is party to an
exclusive contract and the other is not.
Proposition 3. A one-sided exclusive contract which binds D1 (UA) has no effect on the
equilibrium choice of investments internal to ( ) but does impact the internal
investment in which D1 (UA) is party to a non-binding exclusive contract.
PROOF: Consider D1’s incentive to make an investment internal to . We can see
from Table 1 that in the event that D1 and UA sign a contract that binds D1 (that is x is 0),
D1’s payoff will change by . If D1 invests, then since
, , and the
amount by which D1’s payoff falls when there is an exclusive contract with UA will be
greater when D1 chooses to make an investment specific to UB. In the event that D1 and
UA sign a contract that does not bind D1 (x is 1), however, we see from Table 1 that since
the only terms that can be eliminated by the signing of an exclusive contract are those
which interact with the y term, and since none of these coalitions benefit from investment
specific to D1 and UB, D1’s choice of investment is unaffected. A similar analysis holds
for the remaining cases.

Internal investment between two parties will become less lucrative when one party signs a
binding agreement with a third party. In this event, the number of feasible coalitions in which the
internal investment is profitable will fall, and so the range of investment costs over which the
13

investing firm will be compensated shrinks. For example, D1’s investment internal to UB will
benefit from fewer coalitions once an exclusive contract is signed (so long as that contract is
binding for D1). This implies that when D1 signs such contracts, it is less likely to make
investments internal to parties with whom it cannot trade without agreement from UA.
Thus, our analysis demonstrates that internal investments between the contracted pair and
strongly internal investments between the uncontracted pair are unaffected by exclusive
contracts. However, internal investments of the uncontracted pair which are not strongly internal
are in fact affected by such exclusive contracts. In the Segal and Whinston (2000) case where
there is a single downstream firm, investments by that firm specific to the external upstream firm
(or entrant in their case) may be diminished by the exclusive contract it signs with the existing
upstream firm (or incumbent). We also show that exclusive contracts between an uncontracted
firm and a contracted firm which is bound by that party can reduce internal investments.
Anticipating this lack of investment might conceivably deter such entry.

4. Competitive externalities

A follow-on and more comprehensive paper (de Fontenay, Gans and Groves, 2009)
generalizes the model in this paper to allow for competitive externalities between downstream
firms. We briefly mention these findings.
Importantly, we find that the irrelevance result breaks down in the presence of such
externalities. Our findings show that internal investment by either D1 or UA is not affected by
exclusive contracts between the pair. Investment by D2 or UB, however, is more likely when D1
and UA are engaged in an exclusive contract even when that investment is strongly internal. Why
is this the case? The existence of competitive externalities implies that an increase in trade
between D1 and UB lowers the return to trade between D2 and UB. As in de Fontenay and Gans
(2005), when competitive externalities exist in a coalition with one upstream and two
downstream firms, monopoly profits cannot be achieved. The upstream firm always has an
incentive to sell more than the monopoly quantity. Aware of this, each downstream firm will
only accept an offer equal to their Cournot quantity. This implies that the return to D2’s
investment is lower in a coalition which includes its rival than a coalition which does not. Hence,
14

D2 has more incentive to invest when its downstream rival is engaged in an exclusive contract
since it reaps a greater share of the return from investment specific to UB.

5. Conclusion

This paper demonstrates that the irrelevance result of Segal and Whinston (2000) holds
in the presence of both upstream and downstream competition: exclusive contracts have no effect
on the equilibrium level of internal investment for the contracting pair. Our research indicates
three important results. Firstly, the presence of a downstream rival does not change the fact that
the conditions under which a downstream firm makes relationship-specific investments are
unaffected by exclusive contracts written with that upstream firm. Secondly, the conditions under
which a downstream firm chooses to engage in investment strongly internal to an upstream firm
are independent of the rival upstream and downstream firms’ decision to sign an exclusive
contract with one another. If such investments are not strongly internal, however, exclusive
contracts signed by the rival pair may lead to a rise in investment. Lastly, internal investment
between a pair of firms is less likely to occur when one firm signs a binding exclusive contract
with the other firm’s rival.
15

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de Fontenay, C.C., and J.S. Gans, “Bilateral Bargaining with Externalities.” Mimeo, Melbourne
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de Meza, D., and M. Selvaggi, “Exclusive Contracts Foster Relationship-Specific Investments.”
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