The anti-trust division of the Justice Department and FTC are reviewing potentially anti-competitive practices by the dominant providers of wireless services.  In my previous post on the subject I discussed the theory of exclusive contracts as illegal barriers to entry.  In this post I will take up the conventional argument that an exclusive agreement can spur investment by providing a guaranteed return.

AT&T absorbed significant upfront costs by developing and expanding their 3G network at a time when only the Apple iPhone was capable of using its higher speeds and advanced capabilities.  AT&T and Apple entered into a relationship in which AT&T would be the exclusive provider of 3G wireless services for the iPhone and this guarantees AT&T a stream of revenue which would eventually recoup their investment and turn a profit.  If this exclusive contract were to be scrutinized by anti-trust authorities, AT&T could be expected to argue that without protection from future competition these revenues would not be guaranteed and they would not have been able to make the investment in the first place.

Putting this argument in its proper light requires paying close attention to the distinction between total profits and incentives at the margin.  To justify an exclusive contract on efficiency grounds it is not enough to show that exclusivity raises total profits, it must be shown that in addition it adds to the marginal incentives to invest in the new technology.

Imagine that AT&T has no contract with Apple.  The worry is that a competitor will develop a rival 3G network and compete with AT&T for Apple’s business.  If this happens, AT&T is left out in the cold and makes a loss on its investment.  On the other hand, if AT&T has a contract to be the exclusive iPhone 3G provider, then Apple cannot unilateraly break this contract and deal with the new entrant.  Of course if the new provider was a more attractive partner, perhaps because of lower costs or a better technology, Apple could try to buy out of the contract, but AT&T would not accept any payment less than what it would get from insisting on the exclusive contract.

Thus, with an exclusive contract, when a competitor appears AT&T is guaranteed a minimal payoff equal to the total revenue it would earn if it rejected any buyout and insisted on the exclusive deal.  This is the basis of the conventional intuition supporting exclusive dealing.  But what exactly determines this payoff?

The key to understanding this is to consider that once the contract is in place and AT&T’s investment is sunk, the two parties are in a situation of bilateral monopoly.  There is some total surplus that will be generated from their mutual agreement and this surplus will be divided between the two through some bargaining.  The exclusive contract determines the status quo from which they will bargain and the amount of surplus to divided is the gain from Apple switching to the new rival. Investment by AT&T improves the value to Apple from dealing with AT&T and while this raises AT&T’s status quo it also reduces the gain to switching to the new rival, and hence the bargaining surplus, by exactly the same amount.  In the resulting bilateral monopoly bargaining, these effects exactly counteract one another and the net result is that the contract adds nothing to AT&T’s marginal incentives to invest.

This is the insight of Segal and Whinston in their RAND paper “Eclusive Contracts and Protection of Investment.”

Ultimately, an exclusive contract only shifts surplus to the investing party in a lump sum, independent of the level of investment.  There are two implications of this.

  1. It cannot be argued that exclusive contracts are necessary for protection of investments.  The shifting of surplus could be just as easily achieved by replacing the exclusive contract with a lump-sum cash payment to AT&T.
  2. However, the argument described here cannot be the decisive plank in any anti-trust litigation.  If an anti-trust investigation were to go forward, AT&T/Apple could argue that instead of using the lump-sum payment (which may have been complicated if the size of the payment required is large) they chose to use an exclusive contract to do the surplus shifting.   That is, just noticing that exclusive contracts are not necessary, does not imply that they are not useful.  At best, there would have to be a finding that the exclusive contract had some other anti-competitive intent, and the arguments here would just be used to disarm any defense on the basis of necessity.