Exclusionary Contracts and Incentives to Innovate

This paper develops a game-theoretic model to study how exclusionary contracts affect firms’ incentives to invest in innovation. Several symmetric sellers compete to supply an identical product to a set of buyers, and each seller can invest in R&D to develop a higher-quality version of the product. Prior to choosing their R&D investments, sellers may offer exclusionary contracts to buyers. In equilibrium, all buyers sign an exclusionary contract with the same seller, which eliminates rival sellers’ incentives to invest in R&D and concentrates innovative effort in a single firm. Banning exclusionary contracts increases the aggregate probability of innovation and the joint surplus of buyers and sellers only when the R&D technology exhibits sufficiently strong diseconomies of scale.