Working Paper: CEPR ID: DP5257
Authors: Espen R. Moen; Christian Riis
Abstract: In an important paper, Aghion and Bolton (1987) argue that a buyer and a seller may agree on high liquidation damages in order to extract rents from future suppliers. As this may distort future trade, it may be socially wasteful. We argue that Aghion and Bolton's analysis is incomplete in some respects, as they do not model the entry of new suppliers. We construct a model where entry is costly, so that entering suppliers have to earn a quasi-rent in order to recoup the entry cost. Reducing an entrant's profits by the help of a breach penalty then reduces the probability of entry in the first place, thus making a breach penalty less attractive for the contracting parties. We show that the initial buyer and seller only have incentives to include a breach penalty if there is excessive entry without it. Forcing the initial buyer and seller to eliminate the breach penalty reduces welfare.
Keywords: exclusive contracts; breach penalties; entry; efficiency
JEL Codes: L42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| breach penalty (K35) | supplier entry (L81) |
| breach penalty (K35) | welfare outcomes (I38) |
| increased supplier entry (L11) | welfare outcomes (I38) |
| breach penalty = 0 (G33) | supplier entry (L81) |
| breach penalty = 0 (G33) | welfare outcomes (I38) |
| negative breach penalty (H26) | supplier entry (L81) |