Describe the theoretical model studied in Landeo and Spier’s paper “Naked Exclusion: An Experimental Study of Contracts with Externalities”

Answer

Question One

1. In naked exclusion, Landeo and Spier argue that incumbent firms can exploit externalities among the downstream buyers in order to control the entry of new firms in the market using exclusive contracts. The theoretical model studied in naked exclusion focused in three stages; in the first stage, the incumbent monopolist offers the buyers in the market exclusive contracts   through simplistic payments that they need to accept simultaneously (Landeo & Spier 2009). If the two buyers accept the exclusive contracts, new entrants will not join the market because joining will not make economic sense. If only one buyer among the two accepts the exclusive contract, then there is a free buyer in the market a factor that incentivizes the new entrant to enter the market. In the third stage of the model, the incumbent monopolist sets high prices for the buyer bound by the exclusive contract on the other hand, due to competition, the new entrant sets competitive prices which are lower than those paid by the captive buyers.  However, the scenario changes if the new entrant fails to enter the market at the second stage. in such a case the free buyer will be at the mercy of the incumbent monopolist in terms of price.
2. The theoretical predictions result in two prepositions; in the first preposition the incumbent seller is unable to discriminate between the buyers and needs to choose one. The scenario will result in multiple perfect Nash equilibria where some options will deter entry into the market while the other options will promote entry into the market. The second preposition is where the incumbent seller is able to discriminate the buyers. The seller will adopt a divide and conquer strategy by offering the tow buyers different offers. The situation will create a perfect Nash equilibrium which will deter the entry of new players into the market.
3. Under discrimination, it is expected that endogeneity would induce lower rates of acceptance of the divide and conquer discrimination strategy. However, the results of the experiments show that endogeneity precludes any need for fairness and reciprocity from buyers and elicits equilibrium behavior from buyers a move that leads it increased exclusion rates for divide and conquer offers.
4. The policy application of the study is the creation of antitrust laws to reduce the chances of the creation of incumbent monopolies powerful enough to control entry into the market. The laws reduce the chances of having exclusive contracts that eliminate other layers from the market.

Question Two

1. The theoretical model studied by Fonseca and Theo-Normann is known as the infinitely repeated Bertrand Game in explicit and tacit collusion environments ether with or without communication. The model posits that collusion in a state of Bertrand market, can be sustained at equilibrium point using a grim-trigger strategy. This means the players could opt to use self-enforcing collusion since it can be sustained at equilibrium or tacit collusions since it is not dependent on explicit communications. This theoretical model works under certain conditions. This includes duopolies of more than 2 firms, with homogenous products, no capacity constraints and all the firms in the market have a discount factor of not more than 1.
2. The goal of the study was to experimentally examine the degree to which communication affects the outcome of oligopolies. A detailed look at the journal article by Fonseca and Theo-Normann shows that their study had the goal of exploring the difference between tacit and explicit collusions (Fonseca & Normann 2012). To achieve this goal, they investigated the impact of communication on experimental markets. They compared the behavior of Bertrand oligopolies with a number of firms. Additionally, the study compared pricing behavior of the firms with or without the possibility of communicating among the firms in the market.
3. The experimental implementation of the stated theoretical model followed specific experimentation procedures. This included analyzing a Bertrand oligopoly market with constant marginal production costs and inelastic demand. The dynamics of the tests were then altered to evaluate market behavior when there is communication and when there is lack of it. The practice of altering was dubbed as treatment. Six market groups were then generated for the two treatments. The game was simulated to make the findings.
4. The first finding is that an increase in the number of firms translates to decreases in prices in both communication and no-communication environment. This is because markets cannot be tacitly collusive when the number of firms is more than four. The second finding is that communication between the firms increases prices across some of the firms. Third, prices tend to be high in the no-talk environment compared to the talk environment. This phenomenon is known as the hysteresis effect of communication.

Question Three

1. According to Landao and Spiers’, incentive contracts are preferred because of a number of reasons. First, it motivates and rewards either the customers or the retailers (Landeo & Spier 2015). In regard to this statement, the authors note that collective rewards could be susceptible to free- riding compared to the non-collective rewards. This is because the moral hazard of the teams is usually highest in static and acute settings. Additionally, long term interactions during a crisis could help create an implicit incentive. Their argument s backed by a theoretical model posited by Che and Yoo, and published in the American Economic Review noting that group incentive contracts induces cooperation among teams at the lowest possible minimum costs.
2. The primary goal of the study was to experiment the impact of incentive contracts on teams. The paper study further sought to provide empirical evidence on factors that affect principal costs arising from team cooperation and team’s cooperation. This phenomenon is known as the principal’s cost of effort.
3. The experimental design is composed of two teams labelled long term and short-term teams. The teams have access to two communication treatments. These are two-way agent-agent communication and no-communication treatments. Both treatments help shape the intensity of cooperation equilibrium. The third element of the experimental design is a two strategic environment treatment. This environment can be regulated by computer administered rules governing rules, also known as exogeneous strategic environment or the human principal sharing rules also known as endogenous strategic environments. As part of the experimental design, the participants were subject to eight conditions and sessions ranging from 70 to 120 minutes (Landeo & Spier 2015). The environment could be adjusted to a content free environment controlled by networked personal computers and a dedicated software designed for the experiment. The experimental design led to the following main results. First, that communication increases cooperation rates among industry players. That long-term teams have higher cooperation rate than short term teams. Additional findings show that communication between agent could positively influence the intensity of cooperation among teams in the short term. These results align with the game theory and contract theory.
4. These results have an enormous impact on labor contracts. To begin with, the results help in understanding team dynamics thus, guiding the management on how to make contracts that will increase team cooperation both in the long term and short term. Secondly, the findings dictate the nature of communication to be maintained between the agents to have a positive influence on the cooperation of the team in the short term.

Question Four

1. According to Chicago School, exclusive dealing denotes a practice where the manufacturer limits a retailer to selling only their line of goods and brand. It could also involve retailers constraining manufacturer to sell exclusively to their outlets and not those of the rivals. Richard Posner and Robert Bork, the proponents of the Chicago school argue that given that incumbent firms cannot induce buyers to enter exclusive contracts, efficiency considerations must therefore explain why suppliers and manufacturers enter such arrangements and not anti-competitive motives (Landeo 2018). For the sake of achieving efficiency, the exclusive dealing contracts promote client specific investments by discouraging free-riding. For instance, a retailer might opt to trade in cheap goods that do not require advertisement rather than investing in advertising goods sold by every other retailer. Because of the efficiency, retailers and manufacturers who are bound by exclusive dealing and entry tend to earn monopoly profits which are higher because of the incumbent producer surplus. The buyer also benefits from the resultant buyer surplus.
2. The Chicago School argues that exclusive contracts are meant to enhance efficiency of the markets, rather than act as anticompetitive measures against other manufacturers and retailers. As much as this hypothesis holds for most industries, it fails to apply to the case of Anheuser-Busch Companies, Inc. because of the following reasons. First, the industry was not much regulated in the 1990s. For this reason, Anheuser-Busch adopted exclusive contracts as a strategy to prevent competition. This practice qualifies as a breach of antitrust which could be liable for punishment under the modern-day laws. The second feature that makes the beer industry different in the sense that beer manufacturers such as Anheuser-Busch have many brands. For instance, Anheuser-Busch had brands such as Budweiser, Busch, Michelob and Odoul’s. In addition, it had specialty beers which were distributed exclusively to few distributors. Third, the distributors opted to acknowledge the exclusive contract because it promised better returns compared to selling non-exclusive brands. As a result, they noted that they accepted the contracts because of individual interest and not collective interest.