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Vertical Restraints as Tools to Reduce Risks Associated with Cooperative Specific Investments (the Logic of Vertical Self-Restraints)

Vertical Restraints as Tools to Reduce Risks Associated with Cooperative Specific Investments (the Logic of Vertical Self-Restraints)

Journal of Institutional Studies, , Vol. 11 (no. 2),

The paper discusses an alternative to vertical integration – the vertical restraints (VRs) which have been the subject of numerous studies in neo-institutional economics. It offers a new approach to analysis of vertical restraints as voluntary self-restraints in the situations of uncertainty. Not limited to consideration of uncertainty generated by market shocks (Rey and Tirole, 1986; Hansen and Motta, 2016), this approach takes into account possible termination of initial contract between firms at the ex post stage, i.e. when specific investments have been already made. Risks of contract termination are especially significant for so-called «cooperative» specific investments which might be defined as investments favorably affecting the outside options of opposite side, i.e. the investor’s partner. Lotteries associated with cooperative specific investments are characterized by higher risk than lotteries associated with selfish specific investments (positively affecting the investor’s outside options) because cooperative specific investments (unlike selfish specific investments) increase the risk of initial contract termination and often worsen the investor’s outside options. Firms actively respond to risk of contract termination by choosing an under-investment strategy. The problem of underinvestment could be solved by an advance compensation paid by a supplier to retailers for taking risk associated with specific investments. Unfortunately, the implementation of this scenario is complicated by threat of double moral hazard. VRs voluntarily adopted by the supplier may be considered as substitutes to such compensation. They can increase the attractiveness of lotteries associated with specific investments by improving the retailer’s probability beliefs or payoffs in uncertain outcomes: VRs redistribute control in favor of the dealers reducing the uncertainty they face; VRs may be interpreted as an element of the signaling activity aimed to convince the dealer of the supplier’s willingness to continue cooperation at the ex post stage; in case the supplier prefers to interrupt the business agreement with the dealer at the ex post stage, the VRs, such as exclusive territories, will ensure that the dealer gets at least partial compensation for contract termination; and finally, VRs limit the possible redistribution of quasi-rent between the supplier and the dealer in the internal trade.


Keywords: vertical restraints; compensation for risk; vertical self-restraints; cooperative specific investments

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