Why Use Requirement Contracts? The Tradeoff between Price Premium and Breach

36 Pages Posted: 14 Aug 2015

See all articles by Eric Bennett Rasmusen

Eric Bennett Rasmusen

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy

Date Written: July 23, 2015

Abstract

A requirements contract is a form of exclusive dealing in which the buyer promises to buy a particular product only from one seller. This paper models a common-sense motivation for such contracts: that the buyer wants to ensure a reliable supply at a pre-arranged price without the need for renegotiation. The model requires that the buyer be unsure of his future demand, that a seller make an investment specific to the buyer, and that the transaction costs of revising or enforcing contracts be high. Transaction costs are key, because without them a better outcome can be obtained with a fixed-quantity contract. The fixed-quantity contract, however, can result in breach. If transaction costs make efficient breach too costly, option and requirements contracts have the advantage of not inducing inefficient performance. A requirements contract has the further advantage that it balances the profits of the seller across states of the world and thus allows for an average price closer to marginal cost.

Keywords: Hold-up, long-term contracts, requirements contracts, relational contracts, exclusive dealing, expectation damages, option contracts, procurement

Suggested Citation

Rasmusen, Eric Bennett, Why Use Requirement Contracts? The Tradeoff between Price Premium and Breach (July 23, 2015). Kelley School of Business Research Paper No. 15-58. Available at SSRN: https://ssrn.com/abstract=2643192 or http://dx.doi.org/10.2139/ssrn.2643192

Eric Bennett Rasmusen (Contact Author)

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy ( email )

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