Espen R. Moen
Norwegian School of Management; Centre for Economic Policy Research (CEPR)
Norwegian Business School
June 22, 2005
CSIO Working Paper
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.
Number of Pages in PDF File: 22
Keywords: Exclusive contracts, breach penalties, entry, efficiency
JEL Classification: L42working papers series
Date posted: June 24, 2005
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