Long-term business contracts can stand in the way of healthy competition
Competition, an essential component of healthy markets, leads to better products, lower prices, and greater innovation — especially when there’s room for new entrants to move in. But according to new research from the UBC Sauder School of Business, some companies are choking off the path that would allow those new businesses to set up shop — and they’re doing it using long-term contracts.
Some long-term contracts between businesses are essential; for example, a car manufacturer might secure a multiyear contract with a steel manufacturer to ensure a steady supply of the necessary material, and a predictable price.
Others, however, can use those long-term contracts to block competitors from entering the market. If the price is right it can be a solid deal for both parties in the contract, but that doesn’t necessarily mean it’s a winning approach overall.
“There was a feeling among many economists that if two sides sign a contract, it must be making them both better off and therefore must be a good thing. So why should we stop it?” says study co-author and UBC Sauder professor Thomas Ross. “But what we show is even if those two groups are better off, there is someone who is worse off, and that's the entrant who should have come in. So, if we consider everybody's welfare all together, we could actually be worse off.” And, he also explains, “it is possible that if the buyer agrees to the contract only because it fears the incumbent will cut it off from supply before the entrant has an opportunity to set up, the buyer can actually be worse off than if long-term contracts were not used.”
The effect can be especially harmful when there is product differentiation, because not only can it keep prices high; it can limit the number of options available to consumers. For example, if the incumbent company is producing salt and the entrant also wants to produce salt, a long-term contract may not harm consumers — and if it keeps prices down it can actually be beneficial. However, if the entrant is offering a new type of breakfast cereal, and it’s different from the existing company’s cereal, then blocking entry can be more problematic.
“If a product is different, then there are two benefits to having the entrant come in. If there's any competition at all it will drive down prices, but it also offers the market a new alternative,” says Ross. “Some people will actually prefer the entrant's product to the original product, so even at the same price, they might be happier because they're getting a breakfast cereal that's closer to their ideal mix of sugar and crunch,” he adds with a laugh. “So, product variety is a good thing.”
Ross says that while long-term contracts are commonplace between businesses, they are relatively rare at the consumer level, with the exception of things like cable and cell phone contracts, which are primarily used to cover the cost of pricey equipment and phones.
The study also looks at the potential benefits of non-exclusive long-term contracts; for example, a motor oil supplier could demand a certain level of purchasing from an auto manufacturer, but would allow that automaker to purchase additional supplies from other motor oil makers. Ross says such contracts can be a winning strategy, because they can keep prices down and provide predictability while still allowing room for new entrants.
Businesses on the buying end should think about the consequences of locking things up long-term, Ross adds, and if they are feeling cornered, they might want to get in touch with competition authorities.
“If businesses are having long-term contracts pushed on them, I would encourage them to think about the consequences of limiting entry that might benefit them in the future,” he says. “And if they're being confronted by some dominant firm that’s telling them to sign these long-term contracts, and they don’t have a lot of choice, they might want to talk with the Competition Bureau.”
Thomas Ross holds the UPS Foundation Professorship in Regulation and Competition Policy, is the Director of the Phelps Centre for the Study of Government and Business, and is a professor in the Strategy and Business Economics Division at the UBC Sauder School of Business. He co-authored “Long-term contracts as barriers to entry with differentiated products” with Sebnem Gavin, a Senior Economist with Innovation, Science and Economic Development Canada. The paper was published in the July 2018 edition of the International Journal of Industrial Organization.