-
Title
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Empirical Models of Bilateral Contracting
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Author
-
Lee, Robin S.
-
Research Area
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Social Institutions
-
Topic
-
Work and the Economy
-
Abstract
-
This essay briefly surveys the empirical literature on bilateral contracting. The focus is on contracting between firms in vertical markets, and I discuss recent approaches to modeling their determination and the impact of contractual restrictions on competition, industry structure, and welfare. I also highlight challenges facing future research in this area.
-
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extracted text
-
Empirical Models of Bilateral
Contracting
ROBIN S. LEE
Abstract
This essay briefly surveys the empirical literature on bilateral contracting. The focus
is on contracting between firms in vertical markets, and I discuss recent approaches
to modeling their determination and the impact of contractual restrictions on competition, industry structure, and welfare. I also highlight challenges facing future
research in this area.
INTRODUCTION
Perhaps the simplest market transaction is one firm selling a good to any
interested party at a set price. Yet transactions between firms are often more
complex, particularly if goods are specialized and the surplus generated by
the transaction depends on effort or investment by the participants. There
may be restrictions placed on trading with other partners, quality guarantees, or covenants on behavior; there may be bundling requirements, quantity
discounts, or revenue sharing agreements; furthermore, terms of the transaction may not be fixed but rather negotiated between parties, as is often the
case when the firms trading are monopolists or oligopolists in their respective markets. These agreements between firms, or bilateral contracts, govern
a significant amount of inter-firm economic activity; given their prevalence,
they are an active area of economic research.
Although these issues may seem specific to industrial organization and
related fields examining competition and market structure, their implications
are much broader. For example, if prices between firms are bargained over
as opposed to unilaterally chosen by one party, the extent to which costs
can be passed-through the vertical chain may be very different; this in turn
affects the predicted impacts of tariffs or other supply-side interventions and
shocks. Furthermore, many industries are themselves large enough to warrant specific attention. A prime example is the US healthcare sector, in which
Emerging Trends in the Social and Behavioral Sciences. Edited by Robert Scott and Stephen Kosslyn.
© 2015 John Wiley & Sons, Inc. ISBN 978-1-118-90077-2.
1
2
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
all major players (hospitals, physician groups, insurers) bilaterally contract
with one another to determine provider networks and reimbursement rates;
this affects utilization, costs, and ultimately welfare in a $2.6 T industry (over
17% of US GDP).
This essay will briefly (and by no means comprehensively) overview recent
empirical literature on bilateral contracting between firms and discuss challenges likely to be faced by future work. I will focus primarily on agreements
in vertical markets between upstream (e.g., manufacturers or wholesalers)
and downstream (e.g., retailers) firms; this paradigm also includes supply
chains, buyer–seller networks, and industries where consumers access the
goods or services of firms through a “platform” intermediary.
FOUNDATIONAL RESEARCH
A large number of empirical papers studied the trade-off between intra-firm
transactions and inter-firm market transactions, some intermediated by bilateral contracts: that is, the “make-or-buy” decision. Framed often as a test of
transaction-costs (Coase, 1937; Klein, Crawford, & Alchian, 1978; Williamson,
1975) and property rights (Grossman & Hart, 2001; Hart & Moore, 1990) theories of the firm, these papers provided evidence suggesting transactions
which are more costly in some regards—leading to both anticipated and realized inefficiencies due to contractual incompleteness or asset specificity—are
more likely to be conducted within the firm via integration as opposed outside the firm via contracts [see Joskow (2008) and Klein (2008) for surveys].
Another substantial body of literature focused on the consequences
of exclusive restraints in vertical markets. These papers generally made
little distinction between exclusive contracts and integration (although in
certain industries, this distinction is not an issue as integration is explicitly
prohibited by law or regulation); rather, they questioned whether restraints
such as minimum retail pricing, exclusive dealing, or tying can adversely
affect competition or welfare. Theory on this issue delivers ambiguous
predictions: papers have shown, for example, exclusive dealing can be
anticompetitive by deterring entry or foreclosing rivals, or procompetitive
by aligning incentives and encouraging investment (c.f. Whinston, 2006).
Early work was primarily case based (e.g., Marvel, 1982) or reduced-form
[i.e., empirically detailing the relationship between variables of interest; e.g.,
Sass (2005)], relying on cross-sectional and/or time-series variation, event
studies, or natural experiments. A survey by Lafontaine and Slade (1999)
found that many of these papers, across different industries, suggested
voluntarily imposed restraints were welfare enhancing, whereas those
imposed by government intervention appeared to have been detrimental to
welfare.
Empirical Models of Bilateral Contracting
3
More recently, there have been several papers employing structural
empirical methods to evaluate the impact of various contractual restrictions.
Leveraging theoretical models of consumer and firm behavior tailored to
particular institutional environments, these papers have been able to recover
unobserved parameters of interest, such as supplier costs (Asker, 2005;
Villas-Boas, 2007). Furthermore, by estimating what are meant to be policy
invariant parameters—that is, parameters detailing consumer and firm
behavior that are not specific only to the context being studied—governing
supply and demand, structural models have also been used to evaluate
what-if counterfactual scenarios: instead of requiring explicit variation
across markets or time, these models simulate what would happen under
hypothetical changes to the contracting environment. Papers in this vein
have examined the elimination of revenue sharing contracts and bundling
requirements in video rental markets (Ho, Ho, & Mortimer, 2012; Mortimer,
2008), the relaxing of exclusive arrangements in the smartphone (Sinkinson,
2011) and the movie exhibition industry (Wozniak, 2013), liberalizing
selective and exclusive distribution systems in the European car market
(Brenkers & Verboven, 2006), the interaction of resale-price-maintenance
on the propagation of cost shocks (Bonnet, Dubois, Villas-Boas, & Klapper,
2013), and the impact of hospital mergers on reimbursement rates (Capps,
Dranove & Satterthwaite, 2003; Ho, 2009).
CUTTING-EDGE RESEARCH
There are two important features that more recent structural papers have
explicitly introduced in their empirical analysis of bilateral contracts. The
first is motivated by the fact that prices and terms of agreement are not
necessarily set solely by one-side of the market; as many contracts are signed
between oligopolistic or monopolistic firms, neither side is necessarily
a price-taker or setter. Indeed, empirical evidence has shown prices are
often negotiated [e.g., between wholesalers and supermarket retailers as
in Draganska, Klapper, & Villas-Boas (2010) and Meza and Sudhir (2010)],
and that firm size interacted with a measure of competitive conditions can
explain variation in pricing discounts among firms (e.g., Ellison & Snyder,
2010; Sorensen, 2003). Bargaining in the presence of externalities among
multiple parties is a difficult theoretical problem in general. However,
recent empirical work has commonly used a simple extension of the Nash
bargaining model (Nash, 1950) to accommodate several firms (Horn &
Wolinsky, 1988) by assuming each pair of firms simultaneously and bilaterally bargain; topics analyzed include the impact of a la carte pricing in
cable markets (Crawford & Yurukoglu, 2012), and hospital negotiations with
insurers (Gowrisankaran, Nevo, & Town, 2013; Ho & Lee, 2013) and medical
4
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
device suppliers (Grennan, 2013). The generality and applicability of this
bargaining concept in applied work is still being explored (Collard-Wexler,
Gowrisankaran, & Lee, 2014), and there is clearly potential for alternative
approaches.
The second feature that has recently been incorporated into new empirical
work is the recontracting between new partners when evaluating a counterfactual regime. Although it is reasonable in certain circumstances to assume
the set of firms who come to an agreement does not change, in others environments it is less so. For example, when examining the consequences of banning integration and exclusive deals in the videogame industry, Lee (2013)
uses a simple model of how software titles choose to develop for hardware
platforms in order to predict the counterfactual decisions of previously exclusive titles. In general, a tractable model of recontracting for applied work
remains to be developed, and likely will rely on insights from both the bargaining (c.f. Muthoo, 1999) and strategic network formation (c.f. Jackson,
2008) literatures [see also Lee and Fong (2013)].
KEY ISSUES FOR FUTURE RESEARCH
Unquestionably, the primary obstacle facing current and future empirical
research on bilateral contracting between firms is the inaccessibility and
incomplete observability of these contracts. Insofar the precise terms of such
contracts are of significant strategic importance, they are often proprietary
or confidential (with disclosure occasionally subject to legal action). It is thus
not surprising that competitors, let alone academic researchers, are not privy
to them. Although there are exceptions (e.g., Dafny, 2010; Grennan, 2013;
Lafontaine & Slade, 2008), most researchers do not observe negotiated prices,
and instead attempt to infer them by leveraging theoretical assumptions.
However, these assumptions may be difficult to test or evaluate, which in
turn potentially limits the scope of the analysis or believability of results.
Although contractual terms (price, restrictions, duration) are often
extremely difficult to observe, it may be possible to obtain information on
the contracting space—that is, the restrictions on the types of contracts which
are employed in certain industries—more easily. Occasionally redacted or
censored contracts can be obtained in financial filings or court records, or
specific details can be obtained directly from conversations with industry
participants. This information, although limited, would still provide guidance toward tailoring analysis and justifying certain modeling assumptions.
Theoretical work on bilateral contracting, particularly in the presence of
externalities, is complex (Segal & Whinston, 2003), and results are sensitive
to set of contracts that can be offered. Thus, knowing certain institutional
tendencies or practices—for example, only linear fees as opposed to two-part
Empirical Models of Bilateral Contracting
5
tariffs are commonly used; royalty rates are flat, or have quantity discounts
which are activated at certain thresholds; or agreements are always of a
certain duration—can significantly narrow the scope of potential outcomes.
Such information would also enable researchers to expand their analysis
to address “non-price” elements of bilateral contracts. Similar to how papers
in finance utilize detailed information on lending contracts to examine
the impact of debt covenants (Bradley & Roberts, 2004; Matvos, 2013;
Roberts & Sufi, 2009), the availability of additional information could
allow for the empirical analysis of less often explored contractual features
(e.g., most-favored-nation agreements which limit discrimination across
contracting providers, evergreen clauses which stipulate automatic renewal
provisions, etc.). The sheer richness of true complexity of most contracts
may prove daunting if the objective is to engage with only “clean” tractable
environments; however, there is a danger in abstracting away features that
may prove to be as important in their own right.
Another piece of missing information is often, surprisingly, whether or
not two firms even have an existing contract or agreement in the first place.
Observing the start and end dates of contracts, or breakdowns during
negotiation, would allow models to begin incorporating dynamic concerns
and more sophisticated recontracting and bargaining features. In many markets, there is constant renegotiation—for example, health provider–insurer
networks change over time as hospital and medical groups join and leave
networks—and if firms anticipate future changes to the network when
contracting and bargaining, the contracting process and ultimately the
division of surplus would be affected (Lee & Fong, 2013). Observing the
length of any particular bilateral relationship (across potentially multiple
contracts) might also enrich research on relational contracting between firms
(c.f. Malcolmson, 2012), and also inform whether or not there are frictions
and switching costs when adjusting trading partners. Furthermore, there
may be state dependencies: for example, contract terms in the present may
be significantly influenced (and constrained) by what they were in the past.
This lack of easily accessible data poses a challenge to a researcher accustomed to readily cleaned or packaged sources; however, this also presents
a huge opportunity for academics willing to embark on creative and ambitious data collection projects. For instance, indirect means of gathering price
information can be as simple as recording content fees paid by distributors
to content providers from newspaper articles, or scraping negotiated prices
between hospitals and insurers from patient claims and billing data. Much
value will likely also be realized through more direct means: for example, by
researchers who are willing to become more closely engaged with industry
participants, and learn firsthand not only what occurs at the contracting table
but also the objectives and concerns of those whose livelihood is at stake.
6
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
In this regard, insights from other academic disciplines, including but not
limited to psychology and sociology, can play a role in enhancing our understanding of the contracting process.
Finally, although it is important to capture the important and relevant
institutional details of any market being analyzed, there is a concern that
insights gleaned from any study may only be specific to that particular
industry. Research on bilateral contracting is not necessary exempt from
criticisms regarding external validity; however, there is a sense in which our
understanding of these contracts is still nascent. Indeed, once there are a
greater number of detailed studies on contracting in different industries, it
will become easier to identify themes that are generalizable across markets.
CONCLUDING COMMENTS
How firms bargain and contract with one another is a key input for many
economic questions of interest. The set of promising empirical projects on
bilateral contracting has grown significantly over the past several years;
more detailed data on the underlying contracts between firms would
drastically expand the scope and sophistication of the questions being
addressed. Although early empirical work primarily tested theoretical
predictions, recent papers have shown the value of merging theoretical
insights and models with institutional detail and real world data; it is
likely that successful future research will continue in this manner, blending
together new insights from both theory and empirics.
REFERENCES
Asker, J. (2005 Unpublished). Diagnosing foreclosure due to exclusive dealing.
Bonnet, C., Dubois, P., Villas-Boas, S. B., & Klapper, D. (2013). Empirical evidence on the role of non linear wholesale pricing and vertical restraints on cost
pass-through. The Review of Economics and Statistics, 95(2), 500–515.
Bradley, M., & Roberts, M. (2004 Unpublished). The structure and pricing of corporate
debt covenants.
Brenkers, R., & Verboven, F. (2006). Liberalizing a distribution system: The European
car market. Journal of the European Economic Association, 4(1), 216–251.
Capps, C., Dranove, D., & Satterthwaite, M. (2003). Competiton and market power
in option demand markets. RAND Journal of Economics, 34(4), 737–763.
Coase, R. (1937). The nature of the firm. Economica, 4, 428–453.
Collard-Wexler, A., Gowrisankaran, G., & Lee, R. S. (2014 Unpublished). Bargaining
in bilateral oligopoly: An alternating offers representation of the “Nash-in-Nash” solution.
Crawford, G. S., & Yurukoglu, A. (2012). The welfare effects of bundling in multichannel television. American Economic Review, 102(2), 643–685.
Empirical Models of Bilateral Contracting
7
Dafny, L. (2010). Are health insurance markets competitive? American Economic
Review, 100(4), 1399–1431.
Draganska, M., Klapper, D., & Villas-Boas, S. B. (2010). A larger slice of a larger pie?
An empirical investigation of bargaining power in the distribution channel. Marketing Science, 29, 57–74.
Ellison, S. F., & Snyder, C. M. (2010). Countervailing power in wholesale pharmaceuticals. Journal of Industrial Economics, 58(1), 32–53.
Gowrisankaran, G., Nevo, A., & Town, R. (2013). Mergers when prices are negotiated:
Evidence from the hospital industry. American Economic Review (forthcoming).
Grennan, M. (2013). Price discrimination and bargaining: Empirical evidence from
medical devices. American Economic Review, 103(1), 147–177.
Grossman, S. J., & Hart, O. D. (2001). The costs and benefits of ownership: A theory
of vertical integration. Journal of Political Economy, 94, 691–719.
Hart, O. D., & Moore, J. (1990). Property rights and the nature of the firm. Journal of
Political Economy, 98, 1119–1158.
Ho, J., Ho, K., & Mortimer, J. (2012). The use of full-line forcing contracts in the video
rental industry. American Economic Review, 102(2), 686–719.
Ho, K. (2009). Insurer-provider networks in the medical care market. American Economic Review, 99(1), 393–430.
Ho, K., & Lee, R. S. (2013 Unpublished). Insurer competition and negotiated hospital
prices.
Horn, H., & Wolinsky, A. (1988). Bilateral monopolies and incentives for merger.
RAND Journal of Economics, 19(3), 408–419.
Jackson, M. O. (2008). Social and economic networks. Princeton, NJ: Princeton University Press.
Joskow, P. L. (2008). Vertical integration. In C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp. 319–348). Berlin: Springer.
Klein, B., Crawford, R. G., & Alchian, A. A. (1978). Vertical integration, appropriable
rents, and the competitive contracting process. Journal of Law and Economics, 21,
297–326.
Klein, P. G. (2008). The make-or-buy decisions: Lessons from empirical studies. In
C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp.
435–464). Berlin: Springer.
Lafontaine, F., & Slade, M. (1999). The dynamics of franchise contracting: Evidence
from panel data. Journal of Political Economy, 107(5), 1041–1080.
Lafontaine, F., & Slade, M. (2008). Exclusive contracts and vertical restraints: Empirical evidence and public policy. In P. Buccirossi (Ed.), Handbook of antitrust economics. Cambridge, MA: MIT Press.
Lee, R. S. (2013). Vertical integration and exclusivity in platform and two-sided markets. American Economic Review, 103(7), 2960–3000.
Lee, R. S., & Fong, K. (2013 Unpublished). Markov perfect network formation: An applied
framework for bilateral oligopoly and bargaining in buyer-seller networks.
Malcolmson, J. M. (2012). Relational incentive contracts. In R. Gibbons & J. Roberts
(Eds.), The handbook of organizational economics. Princeton, NJ: Princeton University
Press.
8
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
Marvel, H. P. (1982). Exclusive dealing. Journal of Law and Economics, 25, 1–25.
Matvos, G. (2013). Estimating the benefits of contractual completeness. Review of
Financial Studies, 26(11), 2798–2844.
Meza, S., & Sudhir, K. (2010). Do private labels increase retailer bargaining power?
Quantitative Marketing and Economics, 8, 333–363.
Mortimer, J. H. (2008). Vertical Contracts in the Video Rental Industry. Review of Economic Studies, 75, 165–199.
Muthoo, A. (1999). Bargaining theory with applications. Cambridge, England: Cambridge University Press.
Nash, J. F. (1950). The bargaining problem. Econometrica, 18, 155–162.
Roberts, M., & Sufi, A. (2009). Renegotiation of financial contracts: Evidence from
private credit agreements. Journal of Financial Economics, 93(2), 159–184.
Sass, T. (2005). The competitive effects of exclusive dealing: Evidence from the U.S.
beer industry. International Journal of Industrial Organization, 23, 203–225.
Segal, I., & Whinston, M. D. (2003). Robust predictions for bilateral contracting with
externalities. Econometrica, 71(3), 757–791.
Sinkinson, M. (2011 Unpublished). Pricing and entry incentives with exclusive contracts:
Evidence from smartphones.
Sorensen, A. T. (2003). Insurer-hospital bargaining: Negotiated discounts in postderegulation Connecticut. Journal of Industrial Economics, 51(4), 469–490.
Villas-Boas, S. B. (2007). Vertical relationships between manufacturers and retailers:
Inference with limited data. Review of Economic Studies, 74(2), 625–652.
Whinston, M. D. (2006). Lectures on antitrust economics. Cambridge, MA: MIT Press.
Williamson, O. E. (1975). Markets and hierarchies: Analysis and antitrust implications.
New York, NY: Free Press.
Wozniak, K. (2013 Unpublished). Vertical restraints in the movie exhibition industry.
ROBIN S. LEE SHORT BIOGRAPHY
Robin S. Lee is an Assistant Professor of Economics at Harvard University.
Robin’s primary research fields are industrial organization and applied
microeconomic theory. His research focuses on bilateral oligopoly in networked industries and contracting and bargaining between firms with
market power. His recent work concentrates on platform intermediated
markets—with applications in hardware–software industries, content
distribution, and the healthcare sector—and examines the implications
of exclusive or selective contracting and vertical integration on industry
structure, competition and welfare. Robin received his AB and AM in
Economics and his PhD in Business Economics from Harvard University.
Personal webpage: http://www.robinslee.com
Curriculum vitae: http://www.robinslee.com/cv.pdf
Empirical Models of Bilateral Contracting
9
RELATED ESSAYS
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Global Economic Networks (Sociology), Nina Bandelj et al.
Intellectual Property (Economics), Michele Boldrin and David K. Levine
Trust and Economic Organization (Sociology), Karen S. Cook and Bogdan
State
Stability and Change in Corporate Governance (Sociology), Gerald F. Davis
and Johan S. G. Chu
Financialization of the US Economy (Sociology), Gerald (Jerry) F. Davis and
Suntae Kim
Architecture of Markets (Sociology), Neil Fligstein and Ryan Calder
The Reorganization of Work (Sociology), Charles Heckscher
Behavioral Economics (Sociology), Guy Hochman and Dan Ariely
Modeling Coal and Natural Gas Markets (Economics), Franziska Holz
Transformation of the Employment Relationship (Sociology), Arne L. Kalleberg and Peter V. Marsden
Economics and Culture (Economics), Gérard Roland
-
Empirical Models of Bilateral
Contracting
ROBIN S. LEE
Abstract
This essay briefly surveys the empirical literature on bilateral contracting. The focus
is on contracting between firms in vertical markets, and I discuss recent approaches
to modeling their determination and the impact of contractual restrictions on competition, industry structure, and welfare. I also highlight challenges facing future
research in this area.
INTRODUCTION
Perhaps the simplest market transaction is one firm selling a good to any
interested party at a set price. Yet transactions between firms are often more
complex, particularly if goods are specialized and the surplus generated by
the transaction depends on effort or investment by the participants. There
may be restrictions placed on trading with other partners, quality guarantees, or covenants on behavior; there may be bundling requirements, quantity
discounts, or revenue sharing agreements; furthermore, terms of the transaction may not be fixed but rather negotiated between parties, as is often the
case when the firms trading are monopolists or oligopolists in their respective markets. These agreements between firms, or bilateral contracts, govern
a significant amount of inter-firm economic activity; given their prevalence,
they are an active area of economic research.
Although these issues may seem specific to industrial organization and
related fields examining competition and market structure, their implications
are much broader. For example, if prices between firms are bargained over
as opposed to unilaterally chosen by one party, the extent to which costs
can be passed-through the vertical chain may be very different; this in turn
affects the predicted impacts of tariffs or other supply-side interventions and
shocks. Furthermore, many industries are themselves large enough to warrant specific attention. A prime example is the US healthcare sector, in which
Emerging Trends in the Social and Behavioral Sciences. Edited by Robert Scott and Stephen Kosslyn.
© 2015 John Wiley & Sons, Inc. ISBN 978-1-118-90077-2.
1
2
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
all major players (hospitals, physician groups, insurers) bilaterally contract
with one another to determine provider networks and reimbursement rates;
this affects utilization, costs, and ultimately welfare in a $2.6 T industry (over
17% of US GDP).
This essay will briefly (and by no means comprehensively) overview recent
empirical literature on bilateral contracting between firms and discuss challenges likely to be faced by future work. I will focus primarily on agreements
in vertical markets between upstream (e.g., manufacturers or wholesalers)
and downstream (e.g., retailers) firms; this paradigm also includes supply
chains, buyer–seller networks, and industries where consumers access the
goods or services of firms through a “platform” intermediary.
FOUNDATIONAL RESEARCH
A large number of empirical papers studied the trade-off between intra-firm
transactions and inter-firm market transactions, some intermediated by bilateral contracts: that is, the “make-or-buy” decision. Framed often as a test of
transaction-costs (Coase, 1937; Klein, Crawford, & Alchian, 1978; Williamson,
1975) and property rights (Grossman & Hart, 2001; Hart & Moore, 1990) theories of the firm, these papers provided evidence suggesting transactions
which are more costly in some regards—leading to both anticipated and realized inefficiencies due to contractual incompleteness or asset specificity—are
more likely to be conducted within the firm via integration as opposed outside the firm via contracts [see Joskow (2008) and Klein (2008) for surveys].
Another substantial body of literature focused on the consequences
of exclusive restraints in vertical markets. These papers generally made
little distinction between exclusive contracts and integration (although in
certain industries, this distinction is not an issue as integration is explicitly
prohibited by law or regulation); rather, they questioned whether restraints
such as minimum retail pricing, exclusive dealing, or tying can adversely
affect competition or welfare. Theory on this issue delivers ambiguous
predictions: papers have shown, for example, exclusive dealing can be
anticompetitive by deterring entry or foreclosing rivals, or procompetitive
by aligning incentives and encouraging investment (c.f. Whinston, 2006).
Early work was primarily case based (e.g., Marvel, 1982) or reduced-form
[i.e., empirically detailing the relationship between variables of interest; e.g.,
Sass (2005)], relying on cross-sectional and/or time-series variation, event
studies, or natural experiments. A survey by Lafontaine and Slade (1999)
found that many of these papers, across different industries, suggested
voluntarily imposed restraints were welfare enhancing, whereas those
imposed by government intervention appeared to have been detrimental to
welfare.
Empirical Models of Bilateral Contracting
3
More recently, there have been several papers employing structural
empirical methods to evaluate the impact of various contractual restrictions.
Leveraging theoretical models of consumer and firm behavior tailored to
particular institutional environments, these papers have been able to recover
unobserved parameters of interest, such as supplier costs (Asker, 2005;
Villas-Boas, 2007). Furthermore, by estimating what are meant to be policy
invariant parameters—that is, parameters detailing consumer and firm
behavior that are not specific only to the context being studied—governing
supply and demand, structural models have also been used to evaluate
what-if counterfactual scenarios: instead of requiring explicit variation
across markets or time, these models simulate what would happen under
hypothetical changes to the contracting environment. Papers in this vein
have examined the elimination of revenue sharing contracts and bundling
requirements in video rental markets (Ho, Ho, & Mortimer, 2012; Mortimer,
2008), the relaxing of exclusive arrangements in the smartphone (Sinkinson,
2011) and the movie exhibition industry (Wozniak, 2013), liberalizing
selective and exclusive distribution systems in the European car market
(Brenkers & Verboven, 2006), the interaction of resale-price-maintenance
on the propagation of cost shocks (Bonnet, Dubois, Villas-Boas, & Klapper,
2013), and the impact of hospital mergers on reimbursement rates (Capps,
Dranove & Satterthwaite, 2003; Ho, 2009).
CUTTING-EDGE RESEARCH
There are two important features that more recent structural papers have
explicitly introduced in their empirical analysis of bilateral contracts. The
first is motivated by the fact that prices and terms of agreement are not
necessarily set solely by one-side of the market; as many contracts are signed
between oligopolistic or monopolistic firms, neither side is necessarily
a price-taker or setter. Indeed, empirical evidence has shown prices are
often negotiated [e.g., between wholesalers and supermarket retailers as
in Draganska, Klapper, & Villas-Boas (2010) and Meza and Sudhir (2010)],
and that firm size interacted with a measure of competitive conditions can
explain variation in pricing discounts among firms (e.g., Ellison & Snyder,
2010; Sorensen, 2003). Bargaining in the presence of externalities among
multiple parties is a difficult theoretical problem in general. However,
recent empirical work has commonly used a simple extension of the Nash
bargaining model (Nash, 1950) to accommodate several firms (Horn &
Wolinsky, 1988) by assuming each pair of firms simultaneously and bilaterally bargain; topics analyzed include the impact of a la carte pricing in
cable markets (Crawford & Yurukoglu, 2012), and hospital negotiations with
insurers (Gowrisankaran, Nevo, & Town, 2013; Ho & Lee, 2013) and medical
4
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
device suppliers (Grennan, 2013). The generality and applicability of this
bargaining concept in applied work is still being explored (Collard-Wexler,
Gowrisankaran, & Lee, 2014), and there is clearly potential for alternative
approaches.
The second feature that has recently been incorporated into new empirical
work is the recontracting between new partners when evaluating a counterfactual regime. Although it is reasonable in certain circumstances to assume
the set of firms who come to an agreement does not change, in others environments it is less so. For example, when examining the consequences of banning integration and exclusive deals in the videogame industry, Lee (2013)
uses a simple model of how software titles choose to develop for hardware
platforms in order to predict the counterfactual decisions of previously exclusive titles. In general, a tractable model of recontracting for applied work
remains to be developed, and likely will rely on insights from both the bargaining (c.f. Muthoo, 1999) and strategic network formation (c.f. Jackson,
2008) literatures [see also Lee and Fong (2013)].
KEY ISSUES FOR FUTURE RESEARCH
Unquestionably, the primary obstacle facing current and future empirical
research on bilateral contracting between firms is the inaccessibility and
incomplete observability of these contracts. Insofar the precise terms of such
contracts are of significant strategic importance, they are often proprietary
or confidential (with disclosure occasionally subject to legal action). It is thus
not surprising that competitors, let alone academic researchers, are not privy
to them. Although there are exceptions (e.g., Dafny, 2010; Grennan, 2013;
Lafontaine & Slade, 2008), most researchers do not observe negotiated prices,
and instead attempt to infer them by leveraging theoretical assumptions.
However, these assumptions may be difficult to test or evaluate, which in
turn potentially limits the scope of the analysis or believability of results.
Although contractual terms (price, restrictions, duration) are often
extremely difficult to observe, it may be possible to obtain information on
the contracting space—that is, the restrictions on the types of contracts which
are employed in certain industries—more easily. Occasionally redacted or
censored contracts can be obtained in financial filings or court records, or
specific details can be obtained directly from conversations with industry
participants. This information, although limited, would still provide guidance toward tailoring analysis and justifying certain modeling assumptions.
Theoretical work on bilateral contracting, particularly in the presence of
externalities, is complex (Segal & Whinston, 2003), and results are sensitive
to set of contracts that can be offered. Thus, knowing certain institutional
tendencies or practices—for example, only linear fees as opposed to two-part
Empirical Models of Bilateral Contracting
5
tariffs are commonly used; royalty rates are flat, or have quantity discounts
which are activated at certain thresholds; or agreements are always of a
certain duration—can significantly narrow the scope of potential outcomes.
Such information would also enable researchers to expand their analysis
to address “non-price” elements of bilateral contracts. Similar to how papers
in finance utilize detailed information on lending contracts to examine
the impact of debt covenants (Bradley & Roberts, 2004; Matvos, 2013;
Roberts & Sufi, 2009), the availability of additional information could
allow for the empirical analysis of less often explored contractual features
(e.g., most-favored-nation agreements which limit discrimination across
contracting providers, evergreen clauses which stipulate automatic renewal
provisions, etc.). The sheer richness of true complexity of most contracts
may prove daunting if the objective is to engage with only “clean” tractable
environments; however, there is a danger in abstracting away features that
may prove to be as important in their own right.
Another piece of missing information is often, surprisingly, whether or
not two firms even have an existing contract or agreement in the first place.
Observing the start and end dates of contracts, or breakdowns during
negotiation, would allow models to begin incorporating dynamic concerns
and more sophisticated recontracting and bargaining features. In many markets, there is constant renegotiation—for example, health provider–insurer
networks change over time as hospital and medical groups join and leave
networks—and if firms anticipate future changes to the network when
contracting and bargaining, the contracting process and ultimately the
division of surplus would be affected (Lee & Fong, 2013). Observing the
length of any particular bilateral relationship (across potentially multiple
contracts) might also enrich research on relational contracting between firms
(c.f. Malcolmson, 2012), and also inform whether or not there are frictions
and switching costs when adjusting trading partners. Furthermore, there
may be state dependencies: for example, contract terms in the present may
be significantly influenced (and constrained) by what they were in the past.
This lack of easily accessible data poses a challenge to a researcher accustomed to readily cleaned or packaged sources; however, this also presents
a huge opportunity for academics willing to embark on creative and ambitious data collection projects. For instance, indirect means of gathering price
information can be as simple as recording content fees paid by distributors
to content providers from newspaper articles, or scraping negotiated prices
between hospitals and insurers from patient claims and billing data. Much
value will likely also be realized through more direct means: for example, by
researchers who are willing to become more closely engaged with industry
participants, and learn firsthand not only what occurs at the contracting table
but also the objectives and concerns of those whose livelihood is at stake.
6
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
In this regard, insights from other academic disciplines, including but not
limited to psychology and sociology, can play a role in enhancing our understanding of the contracting process.
Finally, although it is important to capture the important and relevant
institutional details of any market being analyzed, there is a concern that
insights gleaned from any study may only be specific to that particular
industry. Research on bilateral contracting is not necessary exempt from
criticisms regarding external validity; however, there is a sense in which our
understanding of these contracts is still nascent. Indeed, once there are a
greater number of detailed studies on contracting in different industries, it
will become easier to identify themes that are generalizable across markets.
CONCLUDING COMMENTS
How firms bargain and contract with one another is a key input for many
economic questions of interest. The set of promising empirical projects on
bilateral contracting has grown significantly over the past several years;
more detailed data on the underlying contracts between firms would
drastically expand the scope and sophistication of the questions being
addressed. Although early empirical work primarily tested theoretical
predictions, recent papers have shown the value of merging theoretical
insights and models with institutional detail and real world data; it is
likely that successful future research will continue in this manner, blending
together new insights from both theory and empirics.
REFERENCES
Asker, J. (2005 Unpublished). Diagnosing foreclosure due to exclusive dealing.
Bonnet, C., Dubois, P., Villas-Boas, S. B., & Klapper, D. (2013). Empirical evidence on the role of non linear wholesale pricing and vertical restraints on cost
pass-through. The Review of Economics and Statistics, 95(2), 500–515.
Bradley, M., & Roberts, M. (2004 Unpublished). The structure and pricing of corporate
debt covenants.
Brenkers, R., & Verboven, F. (2006). Liberalizing a distribution system: The European
car market. Journal of the European Economic Association, 4(1), 216–251.
Capps, C., Dranove, D., & Satterthwaite, M. (2003). Competiton and market power
in option demand markets. RAND Journal of Economics, 34(4), 737–763.
Coase, R. (1937). The nature of the firm. Economica, 4, 428–453.
Collard-Wexler, A., Gowrisankaran, G., & Lee, R. S. (2014 Unpublished). Bargaining
in bilateral oligopoly: An alternating offers representation of the “Nash-in-Nash” solution.
Crawford, G. S., & Yurukoglu, A. (2012). The welfare effects of bundling in multichannel television. American Economic Review, 102(2), 643–685.
Empirical Models of Bilateral Contracting
7
Dafny, L. (2010). Are health insurance markets competitive? American Economic
Review, 100(4), 1399–1431.
Draganska, M., Klapper, D., & Villas-Boas, S. B. (2010). A larger slice of a larger pie?
An empirical investigation of bargaining power in the distribution channel. Marketing Science, 29, 57–74.
Ellison, S. F., & Snyder, C. M. (2010). Countervailing power in wholesale pharmaceuticals. Journal of Industrial Economics, 58(1), 32–53.
Gowrisankaran, G., Nevo, A., & Town, R. (2013). Mergers when prices are negotiated:
Evidence from the hospital industry. American Economic Review (forthcoming).
Grennan, M. (2013). Price discrimination and bargaining: Empirical evidence from
medical devices. American Economic Review, 103(1), 147–177.
Grossman, S. J., & Hart, O. D. (2001). The costs and benefits of ownership: A theory
of vertical integration. Journal of Political Economy, 94, 691–719.
Hart, O. D., & Moore, J. (1990). Property rights and the nature of the firm. Journal of
Political Economy, 98, 1119–1158.
Ho, J., Ho, K., & Mortimer, J. (2012). The use of full-line forcing contracts in the video
rental industry. American Economic Review, 102(2), 686–719.
Ho, K. (2009). Insurer-provider networks in the medical care market. American Economic Review, 99(1), 393–430.
Ho, K., & Lee, R. S. (2013 Unpublished). Insurer competition and negotiated hospital
prices.
Horn, H., & Wolinsky, A. (1988). Bilateral monopolies and incentives for merger.
RAND Journal of Economics, 19(3), 408–419.
Jackson, M. O. (2008). Social and economic networks. Princeton, NJ: Princeton University Press.
Joskow, P. L. (2008). Vertical integration. In C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp. 319–348). Berlin: Springer.
Klein, B., Crawford, R. G., & Alchian, A. A. (1978). Vertical integration, appropriable
rents, and the competitive contracting process. Journal of Law and Economics, 21,
297–326.
Klein, P. G. (2008). The make-or-buy decisions: Lessons from empirical studies. In
C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp.
435–464). Berlin: Springer.
Lafontaine, F., & Slade, M. (1999). The dynamics of franchise contracting: Evidence
from panel data. Journal of Political Economy, 107(5), 1041–1080.
Lafontaine, F., & Slade, M. (2008). Exclusive contracts and vertical restraints: Empirical evidence and public policy. In P. Buccirossi (Ed.), Handbook of antitrust economics. Cambridge, MA: MIT Press.
Lee, R. S. (2013). Vertical integration and exclusivity in platform and two-sided markets. American Economic Review, 103(7), 2960–3000.
Lee, R. S., & Fong, K. (2013 Unpublished). Markov perfect network formation: An applied
framework for bilateral oligopoly and bargaining in buyer-seller networks.
Malcolmson, J. M. (2012). Relational incentive contracts. In R. Gibbons & J. Roberts
(Eds.), The handbook of organizational economics. Princeton, NJ: Princeton University
Press.
8
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
Marvel, H. P. (1982). Exclusive dealing. Journal of Law and Economics, 25, 1–25.
Matvos, G. (2013). Estimating the benefits of contractual completeness. Review of
Financial Studies, 26(11), 2798–2844.
Meza, S., & Sudhir, K. (2010). Do private labels increase retailer bargaining power?
Quantitative Marketing and Economics, 8, 333–363.
Mortimer, J. H. (2008). Vertical Contracts in the Video Rental Industry. Review of Economic Studies, 75, 165–199.
Muthoo, A. (1999). Bargaining theory with applications. Cambridge, England: Cambridge University Press.
Nash, J. F. (1950). The bargaining problem. Econometrica, 18, 155–162.
Roberts, M., & Sufi, A. (2009). Renegotiation of financial contracts: Evidence from
private credit agreements. Journal of Financial Economics, 93(2), 159–184.
Sass, T. (2005). The competitive effects of exclusive dealing: Evidence from the U.S.
beer industry. International Journal of Industrial Organization, 23, 203–225.
Segal, I., & Whinston, M. D. (2003). Robust predictions for bilateral contracting with
externalities. Econometrica, 71(3), 757–791.
Sinkinson, M. (2011 Unpublished). Pricing and entry incentives with exclusive contracts:
Evidence from smartphones.
Sorensen, A. T. (2003). Insurer-hospital bargaining: Negotiated discounts in postderegulation Connecticut. Journal of Industrial Economics, 51(4), 469–490.
Villas-Boas, S. B. (2007). Vertical relationships between manufacturers and retailers:
Inference with limited data. Review of Economic Studies, 74(2), 625–652.
Whinston, M. D. (2006). Lectures on antitrust economics. Cambridge, MA: MIT Press.
Williamson, O. E. (1975). Markets and hierarchies: Analysis and antitrust implications.
New York, NY: Free Press.
Wozniak, K. (2013 Unpublished). Vertical restraints in the movie exhibition industry.
ROBIN S. LEE SHORT BIOGRAPHY
Robin S. Lee is an Assistant Professor of Economics at Harvard University.
Robin’s primary research fields are industrial organization and applied
microeconomic theory. His research focuses on bilateral oligopoly in networked industries and contracting and bargaining between firms with
market power. His recent work concentrates on platform intermediated
markets—with applications in hardware–software industries, content
distribution, and the healthcare sector—and examines the implications
of exclusive or selective contracting and vertical integration on industry
structure, competition and welfare. Robin received his AB and AM in
Economics and his PhD in Business Economics from Harvard University.
Personal webpage: http://www.robinslee.com
Curriculum vitae: http://www.robinslee.com/cv.pdf
Empirical Models of Bilateral Contracting
9
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Empirical Models of Bilateral
Contracting
ROBIN S. LEE
Abstract
This essay briefly surveys the empirical literature on bilateral contracting. The focus
is on contracting between firms in vertical markets, and I discuss recent approaches
to modeling their determination and the impact of contractual restrictions on competition, industry structure, and welfare. I also highlight challenges facing future
research in this area.
INTRODUCTION
Perhaps the simplest market transaction is one firm selling a good to any
interested party at a set price. Yet transactions between firms are often more
complex, particularly if goods are specialized and the surplus generated by
the transaction depends on effort or investment by the participants. There
may be restrictions placed on trading with other partners, quality guarantees, or covenants on behavior; there may be bundling requirements, quantity
discounts, or revenue sharing agreements; furthermore, terms of the transaction may not be fixed but rather negotiated between parties, as is often the
case when the firms trading are monopolists or oligopolists in their respective markets. These agreements between firms, or bilateral contracts, govern
a significant amount of inter-firm economic activity; given their prevalence,
they are an active area of economic research.
Although these issues may seem specific to industrial organization and
related fields examining competition and market structure, their implications
are much broader. For example, if prices between firms are bargained over
as opposed to unilaterally chosen by one party, the extent to which costs
can be passed-through the vertical chain may be very different; this in turn
affects the predicted impacts of tariffs or other supply-side interventions and
shocks. Furthermore, many industries are themselves large enough to warrant specific attention. A prime example is the US healthcare sector, in which
Emerging Trends in the Social and Behavioral Sciences. Edited by Robert Scott and Stephen Kosslyn.
© 2015 John Wiley & Sons, Inc. ISBN 978-1-118-90077-2.
1
2
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
all major players (hospitals, physician groups, insurers) bilaterally contract
with one another to determine provider networks and reimbursement rates;
this affects utilization, costs, and ultimately welfare in a $2.6 T industry (over
17% of US GDP).
This essay will briefly (and by no means comprehensively) overview recent
empirical literature on bilateral contracting between firms and discuss challenges likely to be faced by future work. I will focus primarily on agreements
in vertical markets between upstream (e.g., manufacturers or wholesalers)
and downstream (e.g., retailers) firms; this paradigm also includes supply
chains, buyer–seller networks, and industries where consumers access the
goods or services of firms through a “platform” intermediary.
FOUNDATIONAL RESEARCH
A large number of empirical papers studied the trade-off between intra-firm
transactions and inter-firm market transactions, some intermediated by bilateral contracts: that is, the “make-or-buy” decision. Framed often as a test of
transaction-costs (Coase, 1937; Klein, Crawford, & Alchian, 1978; Williamson,
1975) and property rights (Grossman & Hart, 2001; Hart & Moore, 1990) theories of the firm, these papers provided evidence suggesting transactions
which are more costly in some regards—leading to both anticipated and realized inefficiencies due to contractual incompleteness or asset specificity—are
more likely to be conducted within the firm via integration as opposed outside the firm via contracts [see Joskow (2008) and Klein (2008) for surveys].
Another substantial body of literature focused on the consequences
of exclusive restraints in vertical markets. These papers generally made
little distinction between exclusive contracts and integration (although in
certain industries, this distinction is not an issue as integration is explicitly
prohibited by law or regulation); rather, they questioned whether restraints
such as minimum retail pricing, exclusive dealing, or tying can adversely
affect competition or welfare. Theory on this issue delivers ambiguous
predictions: papers have shown, for example, exclusive dealing can be
anticompetitive by deterring entry or foreclosing rivals, or procompetitive
by aligning incentives and encouraging investment (c.f. Whinston, 2006).
Early work was primarily case based (e.g., Marvel, 1982) or reduced-form
[i.e., empirically detailing the relationship between variables of interest; e.g.,
Sass (2005)], relying on cross-sectional and/or time-series variation, event
studies, or natural experiments. A survey by Lafontaine and Slade (1999)
found that many of these papers, across different industries, suggested
voluntarily imposed restraints were welfare enhancing, whereas those
imposed by government intervention appeared to have been detrimental to
welfare.
Empirical Models of Bilateral Contracting
3
More recently, there have been several papers employing structural
empirical methods to evaluate the impact of various contractual restrictions.
Leveraging theoretical models of consumer and firm behavior tailored to
particular institutional environments, these papers have been able to recover
unobserved parameters of interest, such as supplier costs (Asker, 2005;
Villas-Boas, 2007). Furthermore, by estimating what are meant to be policy
invariant parameters—that is, parameters detailing consumer and firm
behavior that are not specific only to the context being studied—governing
supply and demand, structural models have also been used to evaluate
what-if counterfactual scenarios: instead of requiring explicit variation
across markets or time, these models simulate what would happen under
hypothetical changes to the contracting environment. Papers in this vein
have examined the elimination of revenue sharing contracts and bundling
requirements in video rental markets (Ho, Ho, & Mortimer, 2012; Mortimer,
2008), the relaxing of exclusive arrangements in the smartphone (Sinkinson,
2011) and the movie exhibition industry (Wozniak, 2013), liberalizing
selective and exclusive distribution systems in the European car market
(Brenkers & Verboven, 2006), the interaction of resale-price-maintenance
on the propagation of cost shocks (Bonnet, Dubois, Villas-Boas, & Klapper,
2013), and the impact of hospital mergers on reimbursement rates (Capps,
Dranove & Satterthwaite, 2003; Ho, 2009).
CUTTING-EDGE RESEARCH
There are two important features that more recent structural papers have
explicitly introduced in their empirical analysis of bilateral contracts. The
first is motivated by the fact that prices and terms of agreement are not
necessarily set solely by one-side of the market; as many contracts are signed
between oligopolistic or monopolistic firms, neither side is necessarily
a price-taker or setter. Indeed, empirical evidence has shown prices are
often negotiated [e.g., between wholesalers and supermarket retailers as
in Draganska, Klapper, & Villas-Boas (2010) and Meza and Sudhir (2010)],
and that firm size interacted with a measure of competitive conditions can
explain variation in pricing discounts among firms (e.g., Ellison & Snyder,
2010; Sorensen, 2003). Bargaining in the presence of externalities among
multiple parties is a difficult theoretical problem in general. However,
recent empirical work has commonly used a simple extension of the Nash
bargaining model (Nash, 1950) to accommodate several firms (Horn &
Wolinsky, 1988) by assuming each pair of firms simultaneously and bilaterally bargain; topics analyzed include the impact of a la carte pricing in
cable markets (Crawford & Yurukoglu, 2012), and hospital negotiations with
insurers (Gowrisankaran, Nevo, & Town, 2013; Ho & Lee, 2013) and medical
4
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
device suppliers (Grennan, 2013). The generality and applicability of this
bargaining concept in applied work is still being explored (Collard-Wexler,
Gowrisankaran, & Lee, 2014), and there is clearly potential for alternative
approaches.
The second feature that has recently been incorporated into new empirical
work is the recontracting between new partners when evaluating a counterfactual regime. Although it is reasonable in certain circumstances to assume
the set of firms who come to an agreement does not change, in others environments it is less so. For example, when examining the consequences of banning integration and exclusive deals in the videogame industry, Lee (2013)
uses a simple model of how software titles choose to develop for hardware
platforms in order to predict the counterfactual decisions of previously exclusive titles. In general, a tractable model of recontracting for applied work
remains to be developed, and likely will rely on insights from both the bargaining (c.f. Muthoo, 1999) and strategic network formation (c.f. Jackson,
2008) literatures [see also Lee and Fong (2013)].
KEY ISSUES FOR FUTURE RESEARCH
Unquestionably, the primary obstacle facing current and future empirical
research on bilateral contracting between firms is the inaccessibility and
incomplete observability of these contracts. Insofar the precise terms of such
contracts are of significant strategic importance, they are often proprietary
or confidential (with disclosure occasionally subject to legal action). It is thus
not surprising that competitors, let alone academic researchers, are not privy
to them. Although there are exceptions (e.g., Dafny, 2010; Grennan, 2013;
Lafontaine & Slade, 2008), most researchers do not observe negotiated prices,
and instead attempt to infer them by leveraging theoretical assumptions.
However, these assumptions may be difficult to test or evaluate, which in
turn potentially limits the scope of the analysis or believability of results.
Although contractual terms (price, restrictions, duration) are often
extremely difficult to observe, it may be possible to obtain information on
the contracting space—that is, the restrictions on the types of contracts which
are employed in certain industries—more easily. Occasionally redacted or
censored contracts can be obtained in financial filings or court records, or
specific details can be obtained directly from conversations with industry
participants. This information, although limited, would still provide guidance toward tailoring analysis and justifying certain modeling assumptions.
Theoretical work on bilateral contracting, particularly in the presence of
externalities, is complex (Segal & Whinston, 2003), and results are sensitive
to set of contracts that can be offered. Thus, knowing certain institutional
tendencies or practices—for example, only linear fees as opposed to two-part
Empirical Models of Bilateral Contracting
5
tariffs are commonly used; royalty rates are flat, or have quantity discounts
which are activated at certain thresholds; or agreements are always of a
certain duration—can significantly narrow the scope of potential outcomes.
Such information would also enable researchers to expand their analysis
to address “non-price” elements of bilateral contracts. Similar to how papers
in finance utilize detailed information on lending contracts to examine
the impact of debt covenants (Bradley & Roberts, 2004; Matvos, 2013;
Roberts & Sufi, 2009), the availability of additional information could
allow for the empirical analysis of less often explored contractual features
(e.g., most-favored-nation agreements which limit discrimination across
contracting providers, evergreen clauses which stipulate automatic renewal
provisions, etc.). The sheer richness of true complexity of most contracts
may prove daunting if the objective is to engage with only “clean” tractable
environments; however, there is a danger in abstracting away features that
may prove to be as important in their own right.
Another piece of missing information is often, surprisingly, whether or
not two firms even have an existing contract or agreement in the first place.
Observing the start and end dates of contracts, or breakdowns during
negotiation, would allow models to begin incorporating dynamic concerns
and more sophisticated recontracting and bargaining features. In many markets, there is constant renegotiation—for example, health provider–insurer
networks change over time as hospital and medical groups join and leave
networks—and if firms anticipate future changes to the network when
contracting and bargaining, the contracting process and ultimately the
division of surplus would be affected (Lee & Fong, 2013). Observing the
length of any particular bilateral relationship (across potentially multiple
contracts) might also enrich research on relational contracting between firms
(c.f. Malcolmson, 2012), and also inform whether or not there are frictions
and switching costs when adjusting trading partners. Furthermore, there
may be state dependencies: for example, contract terms in the present may
be significantly influenced (and constrained) by what they were in the past.
This lack of easily accessible data poses a challenge to a researcher accustomed to readily cleaned or packaged sources; however, this also presents
a huge opportunity for academics willing to embark on creative and ambitious data collection projects. For instance, indirect means of gathering price
information can be as simple as recording content fees paid by distributors
to content providers from newspaper articles, or scraping negotiated prices
between hospitals and insurers from patient claims and billing data. Much
value will likely also be realized through more direct means: for example, by
researchers who are willing to become more closely engaged with industry
participants, and learn firsthand not only what occurs at the contracting table
but also the objectives and concerns of those whose livelihood is at stake.
6
EMERGING TRENDS IN THE SOCIAL AND BEHAVIORAL SCIENCES
In this regard, insights from other academic disciplines, including but not
limited to psychology and sociology, can play a role in enhancing our understanding of the contracting process.
Finally, although it is important to capture the important and relevant
institutional details of any market being analyzed, there is a concern that
insights gleaned from any study may only be specific to that particular
industry. Research on bilateral contracting is not necessary exempt from
criticisms regarding external validity; however, there is a sense in which our
understanding of these contracts is still nascent. Indeed, once there are a
greater number of detailed studies on contracting in different industries, it
will become easier to identify themes that are generalizable across markets.
CONCLUDING COMMENTS
How firms bargain and contract with one another is a key input for many
economic questions of interest. The set of promising empirical projects on
bilateral contracting has grown significantly over the past several years;
more detailed data on the underlying contracts between firms would
drastically expand the scope and sophistication of the questions being
addressed. Although early empirical work primarily tested theoretical
predictions, recent papers have shown the value of merging theoretical
insights and models with institutional detail and real world data; it is
likely that successful future research will continue in this manner, blending
together new insights from both theory and empirics.
REFERENCES
Asker, J. (2005 Unpublished). Diagnosing foreclosure due to exclusive dealing.
Bonnet, C., Dubois, P., Villas-Boas, S. B., & Klapper, D. (2013). Empirical evidence on the role of non linear wholesale pricing and vertical restraints on cost
pass-through. The Review of Economics and Statistics, 95(2), 500–515.
Bradley, M., & Roberts, M. (2004 Unpublished). The structure and pricing of corporate
debt covenants.
Brenkers, R., & Verboven, F. (2006). Liberalizing a distribution system: The European
car market. Journal of the European Economic Association, 4(1), 216–251.
Capps, C., Dranove, D., & Satterthwaite, M. (2003). Competiton and market power
in option demand markets. RAND Journal of Economics, 34(4), 737–763.
Coase, R. (1937). The nature of the firm. Economica, 4, 428–453.
Collard-Wexler, A., Gowrisankaran, G., & Lee, R. S. (2014 Unpublished). Bargaining
in bilateral oligopoly: An alternating offers representation of the “Nash-in-Nash” solution.
Crawford, G. S., & Yurukoglu, A. (2012). The welfare effects of bundling in multichannel television. American Economic Review, 102(2), 643–685.
Empirical Models of Bilateral Contracting
7
Dafny, L. (2010). Are health insurance markets competitive? American Economic
Review, 100(4), 1399–1431.
Draganska, M., Klapper, D., & Villas-Boas, S. B. (2010). A larger slice of a larger pie?
An empirical investigation of bargaining power in the distribution channel. Marketing Science, 29, 57–74.
Ellison, S. F., & Snyder, C. M. (2010). Countervailing power in wholesale pharmaceuticals. Journal of Industrial Economics, 58(1), 32–53.
Gowrisankaran, G., Nevo, A., & Town, R. (2013). Mergers when prices are negotiated:
Evidence from the hospital industry. American Economic Review (forthcoming).
Grennan, M. (2013). Price discrimination and bargaining: Empirical evidence from
medical devices. American Economic Review, 103(1), 147–177.
Grossman, S. J., & Hart, O. D. (2001). The costs and benefits of ownership: A theory
of vertical integration. Journal of Political Economy, 94, 691–719.
Hart, O. D., & Moore, J. (1990). Property rights and the nature of the firm. Journal of
Political Economy, 98, 1119–1158.
Ho, J., Ho, K., & Mortimer, J. (2012). The use of full-line forcing contracts in the video
rental industry. American Economic Review, 102(2), 686–719.
Ho, K. (2009). Insurer-provider networks in the medical care market. American Economic Review, 99(1), 393–430.
Ho, K., & Lee, R. S. (2013 Unpublished). Insurer competition and negotiated hospital
prices.
Horn, H., & Wolinsky, A. (1988). Bilateral monopolies and incentives for merger.
RAND Journal of Economics, 19(3), 408–419.
Jackson, M. O. (2008). Social and economic networks. Princeton, NJ: Princeton University Press.
Joskow, P. L. (2008). Vertical integration. In C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp. 319–348). Berlin: Springer.
Klein, B., Crawford, R. G., & Alchian, A. A. (1978). Vertical integration, appropriable
rents, and the competitive contracting process. Journal of Law and Economics, 21,
297–326.
Klein, P. G. (2008). The make-or-buy decisions: Lessons from empirical studies. In
C. Menard & M. M. Shirley (Eds.), Handbook of new institutional economics (pp.
435–464). Berlin: Springer.
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ROBIN S. LEE SHORT BIOGRAPHY
Robin S. Lee is an Assistant Professor of Economics at Harvard University.
Robin’s primary research fields are industrial organization and applied
microeconomic theory. His research focuses on bilateral oligopoly in networked industries and contracting and bargaining between firms with
market power. His recent work concentrates on platform intermediated
markets—with applications in hardware–software industries, content
distribution, and the healthcare sector—and examines the implications
of exclusive or selective contracting and vertical integration on industry
structure, competition and welfare. Robin received his AB and AM in
Economics and his PhD in Business Economics from Harvard University.
Personal webpage: http://www.robinslee.com
Curriculum vitae: http://www.robinslee.com/cv.pdf
Empirical Models of Bilateral Contracting
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