ISSN (Print) 0473-453X

Discussion Paper No. 1122

ISSN (Online) 2435-0982

DEFENDING HOME AGAINST GIANTS:
EXCLUSIVE DEALINGAS A SURVIVAL STRATEGYFOR LOCAL FIRMS

Hiroshi Kitamura
Noriaki Matsushima
Misato Sato

March 2021

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

Defending Home against Giants: Exclusive Dealing as a
Survival Strategy for Local Firms*
Hiroshi Kitamura†

Noriaki Matsushima‡

Misato Sato§

March 8, 2021

Abstract
We consider exclusive contracts as a survival strategy for a local incumbent manufacturer
facing a multinational manufacturer’s entry. Although both manufacturers prefer to trade with
an efficient local distributor, trading with inefficient competitive distributors is acceptable only
to the entrant, owing to the entrant’s efficiency. Hence, such competitive distributors can be
an outside option for the entrant. As the entrant becomes efficient, the outside option works
effectively, implying that the entry does not considerably benefit the efficient local distributor.
Thus, the local manufacturer is more likely to sign an exclusive contract with the efficient
distributor as the entrant becomes efficient.

JEL classification codes: F21, F23, L12, L42
Keywords: Multinational firms; Exclusive dealing; Vertical relation; Market protection* We thank Akifumi Ishihara, Makoto Hanazono, and Tadashi Sekiguchi as well as the seminar participants at
Okayama University and Sappro Gakuin University. We gratefully acknowledge the financial support from JSPS
KAKENHI grant numbers JP15H05728, JP17H00984, JP18H00847, JP18K01593, JP19H01483, JP20K13485, and
20H05631 and the program of the Joint Usage/Research Center for “Behavioral Economics” at the ISER, Osaka
University. The usual disclaimer applies.
†
Faculty of Economics, Kyoto Sangyo University, Motoyama, Kamigamo, Kita-Ku, Kyoto-City 603-8555, Japan.
E-mail: hiroshikitamura@cc.kyoto-su.ac.jp‡
Institute of Social and Economic Research, Osaka University, 6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan.
E-mail: nmatsush@iser.osaka-u.ac.jp§
Corresponding Author: Graduate School of Humanities and Social Sciences, Okayama University, Tsushima-naka
3-1-1, Kita-Ku, Okayama 700-8530, Japan. E-mail: msato@okayama-u.ac.jp

1 Introduction
The influence of multinational firms’ entry on local firms’ survival strategies has attracted much attention in the business literature (Dawar and Frost, 1999; Bhattacharya and Michael, 2008; Kokko
and Thang, 2014; Wu et al., 2019) because multinational firms are usually highly productive (Helpman, Melitz, and Yeaple, 2004; Yeaple, 2009). Dawar and Frost (1999) indicate that, as a proactive
survival strategy for local firms, creating a strong distribution network is key to blocking the entry of giant firms such as multinational firms.1 Among business activities that can strengthen the
distribution network, signing an exclusive contract is a favored solution among local firms. For
example, a Russian personal computer manufacturer, Vist, has entered into exclusive distributionagreements with several key retailers in local markets in response to the entry of multinationalfirms such as Compaq, IBM, and Hewlett-Packard (Dawar and Frost, 1999). Another example isthe case of Eastman Kodak vs. Fuji, in which the former, a U.S. photographic film firm, complained that Fuji, its Japanese competitor, had established an exclusive relationship with several
Japanese wholesalers (Nagaoka and Goto, 1997).
Although an exclusive contract is the primary candidate strategy for incumbents to protect local
markets, the use of such a contract is usually difficult because trade with an efficient manufacturer,
such as a multinational firm, usually benefits a local distributor. A well-known result in the literature on competition policy, introduced in the literature review, is that an exclusive contract to deter
an efficient firm’s entry is not always achievable. Therefore, it is valuable to analytically show thepotential market environment when an exclusive contract is achievable.
Focusing on the features of giant firms, we construct a model of exclusive contracts in whicha local incumbent manufacturer makes an exclusive offer to a local distributor to deter the entry of a multinational manufacturer that is more efficient than the local incumbent manufacturer.
Although both manufacturers prefer to trade with the local distributor, there exist alternative but
1

Examples are provided in Section 5.3.

1

inefficient competitive distributors, which are downstream competitive fringes. We consider thecase in which, owing to its efficiency, only the multinational manufacturer can use the downstream
competitive fringe as an outside option. Such outside options are notable features of multinationalfirms, which often have a network of switching options that is unavailable to local firms (Kogut
and Kulatilaka, 1994; Tong and Reuer, 2007).2
By introducing non-linear wholesale pricing and a general demand function, we show that theexistence of the downstream competitive fringe allows the local incumbent manufacturer to protect
the local market from multinational entry via exclusive contracts if the multinational manufacturer
is efficient and the manufacturers have strong bargaining power over the local distributor.
To understand this result, consider the impact of the downstream competitive fringe on industry profit allocation after entry. If the multinational manufacturer is marginally more efficient thanthe local incumbent manufacturer, the competitive fringe does not significantly affect the industry profit allocation after entry. That is, the model structure basically coincides with that in theabsence of the competitive fringe. If the entry of the multinational manufacturer occurs in thiscase, the upstream competition allows the local distributor to earn higher profits, thereby preventing the local incumbent manufacturer from profitably compensating the local distributor throughan exclusive contract. Therefore, exclusion cannot be an equilibrium outcome. Conversely, as
the multinational manufacturer becomes increasingly efficient, the competitive fringe works effectively and empowers the multinational manufacturer to exploit higher profits when manufacturers
have strong bargaining power. In this context, exploitation implies that entry does not significantly
increase the local distributor’s profit. Thus, exclusion can be an equilibrium outcome.
We also check the robustness of these results. First, exclusion outcomes are attainable evenwhen the marginal cost of the multinational manufacturer is sufficiently low as long as the fixed
cost of entry is adequately high. Second, in the appendix, we show that exclusion outcomes are2

See also Petersen, Welch, and Welch (2000) for a discussion on the switching options available to multinationalfirms.

2

attainable even in the case of downstream entry by inverting the vertical relationship; that is, abundant options of input suppliers may facilitate downstream exclusion through exclusive supply contracts. Thus, we can apply this study’s exclusion mechanism to diverse vertical relationships in thereal world.
The exclusion mechanism presented in this study provides important policy implications fromseveral perspectives. First, the results provide important policy implications for the invitation ofmultinational firms. Since multinational entry usually has a positive impact on host countries, suchas technology transfer and physical capital inflows, the host country government often removes
official barriers, including taxes and legal systems, to promote multinational entry. Moreover,
local firms seems to have difficulties in using exclusive contracts as a survival strategy becauseof the high efficiency of multinational firms. However, let us consider the distribution options thatmultinational firms possess. There is a possibility whereby not only the local manufacturer but also
the local distributor has an incentive to sign exclusive contracts, which discourages multinational
entry. Thus, the host country government should pay attention to the anticompetitive activities of
local firms.
Second, this study’s findings also provide an important implication for multinational firms’
entry decisions; as an alternative distribution channel becomes efficient, an efficient firm can experience difficulty when entering a host market with exclusive business practices. The developmentof information and communication technology helps firms establish alternative distribution channels more easily (World Bank, 2009). Such development seemingly facilitates the entry of firms
with high efficiency. However, the results herein imply that such development may help local
manufacturers protect their local markets through exclusive contracts. From the viewpoint of amultinational firm’s location strategy, the abundant trading-partner choices in preparation for entry
into a new market may be harmful to the efficient entrant. Moreover, as global sourcing advances,the multinational entrant has rich options to procure inputs for the case of downstream entry, which
may allow the local downstream incumbent to defend the local market through exclusive supply
3

contracts.
Finally, the findings provide important policy implications for competition policy. The Chicago
School argument, which states that exclusive contracts are not signed to exclude the efficient entrant, cannot be applied if we consider the possibility that the entrant has abundant trading options.
Although we consider the case of multinational entry, we can apply the model in this study to thesituation in which an entrant, a dominant firm in a certain domestic market, tries to enter the market
in other regions to expand its business. Thus, we can apply the exclusion mechanism in this study
to the competition policy for cases in which an efficient firm tries to enter a new market in otherregions.
The remainder of this paper is organized as follows: Section 2 discusses the literature review.
Section 3 constructs the model. Section 4 analyzes the existence of exclusion outcomes under
two-part tariffs. Section 5 provides the extension analyses and discusses a survival strategy against
multinational entry and the validity of our model. Section 6 offers concluding remarks. Appendix
A presents the analysis of the case of downstream entry.

2 Literature Review
Studies on exclusive contracts under international circumstances are limited. Lin and Saggi (2007)
investigate the case in which foreign multinational firms make an exclusive supply offer with technology transfer to local suppliers when entering the local market. Raff and Schmitt (2006) explore
the contractual choice of local firms and of foreign firms exporting to a local market between exclusive dealing and common agency in an international oligopoly. The main difference between
these two studies and ours is that we investigate local firms’ exclusive offer to construct a barrier
to foreign multinational entry by incorporating rich switching options.
This study is also related to the substantial literature on the location decisions of multinationalfirms and on the boundaries of firms, which explores where multinational firms invest and havesubsidiaries (Helpman, Melitz, and Yeaple, 2004; Antràs and Helpman, 2004; Yeaple, 2009; Chen
4and Moore, 2010). For example, Chen and Moore (2010) explore location decisions using French
manufacturing firms’ data and find that more productive firms are more likely to enter a foreigncountry. They also analyze the impact of host countries’ attributes, such as entry cost, governance,
corporate tax, and market potential, on the probability of each firm’s entry into a foreign market.
Our study is related to this literature because exclusive business practices can also be a host country
attribute that influences the entry decisions of multinational firms. By interpreting this differently,
our analysis predicts that, since more productive firms have more options in terms of locating theireconomic activities, multinational firms with several options regarding where to invest can avoid
locations with high entry barriers.
Furthermore, this study is related to the literature on naked exclusion, in which the inefficientincumbent deters the entry of the efficient firm through exclusive contracts.3 This literature traces
its development to the Chicago School argument of the 1970s.4 By focusing on the contracting
party’s individual rationality, the Chicago School theory reveals that exclusive contracts are neversigned in a simple setting. In rebuttal to the Chicago School, post-Chicago economists find that
exclusive contracts can be used to deter efficient entrants in some situations.5 They show thatthe exclusion result is attainable in the cases where: the incumbent sets liquidated damages forthe case of entry (Aghion and Bolton, 1987), the entrant is capacity-constrained (Yong, 1996),
the entrant faces scale economies (Rasmusen, Ramseyer, and Wiley 1991; Segal and Whinston,2000),6 upstream firms compete à la Cournot (Farrell, 2005), downstream firms compete (Simpson
and Wickelgren, 2007; Abito and Wright, 2008),7 upstream firms can merge (Fumagalli, Motta,
3

Several studies focus on the fact that active firms may compete for exclusivity and explore its welfare effect(Mathewson and Winter, 1987; O’Brien and Shaffer, 1997; Bernheim and Whinston, 1998). Recently, Calzolari and
Denicolò (2013, 2015) and Calzolari, Denicolò, and Zanchettin (2020) have introduced asymmetric information.
4

For an analysis of the impact of this argument on antitrust policies, see Motta (2004), Whinston (2006), andFumagalli, Motta, and Calcagno (2018).
5

There are series of empirical studies that discuss whether exclusive dealing creates a barrier to entry. See, forexample, Nurski and Verboven (2016) and Fadairo, Yu, and Lanchimba (2017).
6

For an extended analysis, see Choi and Stefanadis (2018).

7

For extended models with downstream competition, see Wright (2008), Argenton (2010), Kitamura (2010),

5and Persson, 2009), the incumbent makes relationship-specific investments (Fumagalli, Motta, andRønde, 2012), and a dominant complementary input supplier exists (Kitamura, Matsushima, andSato, 2018a).8 In these studies, alternative distribution channels are out of scope; the contributionof this study to existing literature is to introduce an alternative exclusion mechanism such that
naked exclusion is attainable if we consider the efficient entrant’s outside option.
Among previous studies, this study is mostly related to Comanor and Rey (2000), who consider
a market in which a single supplier, downstream incumbent with inefficient external suppliers, anddownstream entrant exist. They assume that only the downstream incumbent has an outside option
to buy inputs from the external supplier. When each downstream firm has the bargaining power tooffer a wholesale price, the existence of an outside option diminishes the downstream incumbent’s
incentive to offer a higher wholesale price, which influences the efficient downstream entrant torefrain from offering a higher wholesale price. Therefore, the supplier cannot earn higher profits
even when downstream entry occurs, which leads to exclusion outcomes. In contrast to theirresearch, this study considers the entrant’s outside option, the source of which is the entrant’s
efficiency. More importantly, although the entrant’s efficiency does not play an essential role ininducing exclusion outcomes in their study, it does in this study; summarily, this study presents analternative exclusion mechanism.

3 ModelThis section describes the basic settings of the model. We first explain the players’ characteristics
and the timing of the game in Section 3.1. Section 3.2 introduces the design of the exclusive
contracts. For convenience, we consider the relationship between manufacturers and distributors,
DeGraba (2013), and Gratz and Reisinger (2013). Moreover, Fumagalli and Motta (2006) show that participation
fees to remain active in the downstream market play a crucial role in exclusion if buyers are undifferentiated Bertrand
competitors. See also Wright (2009), who further investigates the settings of Fumagalli and Motta (2006) in the caseof two-part tariffs.
8

See also Kitamura, Matsushima, and Sato (2017), who show that anticompetitive exclusive dealing can occur if
the downstream buyer bargains with suppliers sequentially.

6although this model is suitable for a more general application; for example, it can be applied to therelationship between input suppliers and final goods producers.

3.1 Basic environment
The local upstream market consists of the incumbent manufacturer U I and the entrant manufacturer
U E . Notably, U I and U E produce an identical product with marginal costs cI and cE (cI > cE ≥ 0).
The cost difference captures the higher efficiency of a giant firm, such as a multinational firm.
In the downstream market, there is a downstream incumbent distributor DI who sells products
supplied by manufacturers to the final consumers. We assume that DI incurs a production cost wq
when purchasing q units of the product under the linear wholesale price w. In addition to supplying
the final product through DI , each manufacturer can supply it to the final consumers by incurring
an additional marginal cost ∆(> 0) through outside opportunities. We regard the opportunity as the
manufacturers’ outside options to use alternative distribution channels.
The demand system has the following properties. The demand function for the product is Q(p),where p is the unit price of the product. We assume that Q(p) is twice differentiable and Q′ (p) < 0.
For notational simplicity, we define Π(p, z), p∗ (z), and Π∗ (z) as follows:Π(p, z) ≡ (p − z)Q(p), p∗ (z) ≡ argmax Π(p, z), Π∗ (z) ≡ Π(p∗ (z), z),p≥zwhere z ≥ 0. To obtain the interior solution, we assume that cI < P(0), where P(Q) is the inverse
demand function of Q(p). We also assume that Π(p, z) is strictly and globally concave in p, and it
has a single peaked property; 2Q′ (p) + (p − z)Q′′ (p) < 0 for all p ≥ z and Q(p) + (p − z)Q′ (p) < 0
for sufficiently large p. By definition, we have ∂Π(p, z)/∂p R 0 for p ⋚ p∗ (z) and ∂Π(p, z)/∂z < 0.
In addition, the envelop theorem implies that ∂Π∗ (z)/∂z = −Q(p∗ (z)) < 0.
To clarify the role of upstream firms’ outside options, we assume that the marginal costs of U I ,U E , and DCF satisfy the following conditions:
Assumption 1.
cE < P(0) − ∆ ≤ cI ,7

(1)

The first inequality of condition (1) implies that U E can earn positive profits by using its outside
options if it is an upstream monopolist. Conversely, the second inequality implies that U I cannot
earn positive profits using its outside options even when it is the upstream monopolist under exclusive dealing; that is, U I needs to trade with DI to earn positive profits. In summary, condition (1)implies that U I ’s outside options are negligible before U E appears.
Note that exclusion occurs even when the second inequality of condition (1) does not hold.
This imposition in condition (1) simplifies the analysis, and it is the simplest way to explore how
the efficiency of U E affects the possibility of exclusion outcomes.
The model consists of four stages: In Stage 1, U I makes an exclusive offer to DI with fixedcompensation x ≥ 0.9 We assume that U E cannot make an exclusive offer because multinationalfirms usually spend some time to actually enter the markets after the news of their entry (Baoand Chen, 2018), which allows local firms to make exclusive offers before future entry occurs.
In addition, following the standard literature on naked exclusion, we assume that the exclusive
offer does not contain the wholesale price term.10 After observing the exclusive offer, DI decides
whether to accept the offer. If DI accepts the exclusive offer, it immediately receives x.
In Stage 2, after observing DI ’s decision, U E decides whether to enter the upstream market.
We assume that the fixed cost of entry F > 0 is sufficiently low such that entry into the upstream
market is profitable for U E if DI rejects the exclusive offer in Stage 1. In addition, to simplify
the analysis, we assume the following condition so that entry never occurs when DI accepts the
exclusive offer in Stage 1:
Assumption 2.
cE + ∆ ≥ cI

(2)

9

In this study, we assume that U E cannot make an exclusive offer. Kitamura, Matsushima, and Sato (2018b)
consider the case in which manufacturers can make exclusive offers and show that exclusion-offer competition leads
to exclusion outcomes. Our model setting eliminates the possibility that exclusion is attainable because of such aneffect, which allows us to clarify the role of an alternative distribution channel.
10

Several seminal studies such as Rasmusen, Ramseyer, and Wiley (1991) and Segal and Whinston (2000) indicatethat price commitment is unlikely if a precise prescription of the nature of the final goods is not available in advance.

8If condition (2) does not hold under the low fixed cost of entry, U E may enter the upstream market
to earn positive profits using its outside options even when DI accepts the exclusive offer in Stage
1 (See Section 5 for details).
In Stage 3, existing firms negotiate and make contracts for two-part tariffs, which consist of alinear wholesale price w and an upfront fixed fee ψ; the two-part tariff between Ui and DI when
DI accepts (rejects) the exclusive offer is (wai , ψai ) ((wri , ψri )), where i ∈ {I, E}. Following Fumagalli, Motta, and Rønde (2012) and Kitamura, Matsushima, and Sato (2018a), the industry profit
is allocated by bargaining with random proposers, and the process in Stage 3 is as follows: In thenegotiation between the distributor and the manufacturers, the players on one of the sides randomly
become proposers; DI has the proposer role with probability β ∈ (0, 1) and the manufacturers become proposers with probability 1 − β. We interpret β as the degree of the distributor’s bargaining
power over the manufacturers. In each event, U E can always use its outside options. For simplicity,
we assume that the proposers can choose how to offer two-part tariff contracts such that it maximizes their stage profits if possible; that is, they offer discriminatory two-part tariff contracts oroffer such contracts sequentially.11 We assume that if DI is indifferent between the two-part tariffs
of U I and of U E , the efficient manufacturer, U E , supplies its product to DI ; that is, we impose theso-called tie-breaking rule.
Finally, in Stage 4, DI orders products and sells them to consumers. Let πaUi (πrUi ) be Ui ’s
expected profit when DI accepts (rejects) the exclusive offer, where i ∈ {I, E}. In addition, let πaDI
(πrDI ) be DI ’s expected profit when it accepts (rejects) the exclusive offer.

3.2 Design of exclusive contracts
For an exclusion equilibrium to exist, the equilibrium transfer x∗ must simultaneously satisfy thefollowing two conditions:First, the exclusive contract must satisfy DI ’s participation constraint; that is, the amount of
11

When a restriction is imposed on the proposers to offer the same two-part tariffs, exclusion is more likely to beattainable; however, the analysis becomes considerably complicated. The results are available upon request.

9

compensation x∗ induces DI to accept the exclusive offer:
πaDI + x∗ ≥ πrDI or x∗ ≥ πrDI − πaDI .

(3)

Second, the exclusive contract must satisfy U I ’s participation constraint; that is, U I earns higher
profits under exclusive dealing.
πaU I − x∗ ≥ πrU I or x∗ ≤ πaU I − πrU I .

(4)From the aforementioned conditions, it is evident that an exclusion equilibrium exists if andonly if inequalities (3) and (4) hold simultaneously. This is equivalent to the following condition:
πaU I + πaDI ≥ πrU I + πrDI .

(5)

Condition (5) implies that the inefficient incumbent manufacturer can use exclusive contracts toprotect the local market if exclusive contracts increase the joint profits of U I and DI . Thus, in theremainder of this study, we mainly focus on the joint profits of the contracting party.

4 Analysis
In this section, the existence of exclusive outcomes is analyzed. First, in Section 4.1, we explore thecase in which U E is not so efficient such that its outside options are ineffective, that is, p∗ (cI ) − ∆ ≤cE . Second, we explore the case in which U E is efficient such that its outside options are effective,that is, cE < p∗ (cI ) − ∆, in Section 4.2.

4.1 When U E is not so efficientFirst, we consider the case in which U E cannot use its outside options effectively when DI sells
U I ’s product, that is, p∗ (cI ) − ∆ ≤ cE . To derive the equilibrium outcomes, we solve the game using
backward induction.
First, we consider the case in which DI accepts the exclusive offer in Stage 1. In this case,
U E does not enter the upstream market in Stage 2, and U I supplies products to DI . In Stage 3, DI
10becomes the proposer and offers (cI , 0) to U I with probability β, and U I becomes the proposer andoffers (cI , Π∗ (cI )) to DI with probability 1 − β. The resulting expected profits, excluding the fixedcompensation x, are as follows:
πaDI = βΠ∗ (cI ), πaU I = (1 − β)Π∗ (cI ), πaU E = 0.

(6)

Second, we consider the case in which DI rejects the exclusive offer in Stage 1. In this case, U E
enters the upstream market in Stage 2 and supplies the product to DI . The industry profit allocationin Stage 3 is derived as follows: DI becomes the proposer with probability β and offers (cI , 0) and(cE , 0) to U I and U E , respectively, to extract all the industry profits.12 Conversely, U I and U E are
the proposers with probability 1 − β, and then they offer (cI , 0) and (cE , Π∗ (cE ) − Π∗ (cI )) to DI ,respectively. Consequently, the resulting expected profits are:πrDI = βΠ∗ (cE ) + (1 − β)Π∗ (cI ), πrU I = 0, πrU E = (1 − β)(Π∗ (cE ) − Π∗ (cI )).

(7)

Finally, we consider the game in Stage 1. By substituting equations (6) and (7) into both sidesof condition (5), we check the difference between the two sides as follows:
πaU I + πaDI − (πrU I + πrDI ) = −β(Π∗ (cE ) − Π∗ (cI )) < 0,for all β ∈ (0, 1), which implies that condition (5) never holds. Thus, we have the following
proposition:
Proposition 1. Suppose that p∗ (cI ) − ∆ ≤ cE ; U E ’s outside options are not effective. In this case,
U I cannot protect the local upstream market from the entry of U E through exclusive contracts forany β ∈ (0, 1).
The intuition behind Proposition 1 is as follows: When DI rejects the exclusive offer in Stage 1,
U E enters the upstream market in Stage 2. The entry of U E allows DI to earn considerably higher
12

Although we consider the case in which DI offers discriminatory two-part tariff contracts to U I and U E simultaneously to extract all industry profits Π∗ (cE ), DI can achieve the same profit allocation by using sequential offers; thatis, DI first offers (cE , 0) to U E and thereafter offers (cI , 0) to U I if U E rejects the first offer, which prevents U E from
earning positive profits from outside options by using alternative distribution channels.

11

profits. U I cannot profitably compensate DI for such high profits through an exclusive contract.
Thus, U I cannot protect the local upstream market from the entry of U E using exclusive contracts.

4.2 When U E is efficient
We consider the case in which U E can use its outside options effectively when DI sells U I ’s product,that is, cI − ∆ ≤ cE < p∗ (cI ) − ∆.
First, we consider the case in which DI accepts the exclusive offer in Stage 1. The subsequent
outcomes in the remaining stages are the same as those in Section 4.1.
Second, we consider the case in which DI rejects the exclusive offer in Stage 1. In this case, U E
enters the upstream market in Stage 2 and supplies the product to DI . In Stage 3, DI becomes the
proposer with probability β and offers (cI , 0) and (cE , 0) to U I and U E , respectively, and U E accepts
and becomes the manufacturer trading with DI . Conversely, U I and U E become the proposers withprobability 1−β, and then U I and U E offer (cI , 0) and (cE , Π∗ (cE )−Π(cE +∆, cI )) to DI , respectively.
The latter contract term differs from that in Section 4.1 because U E can use its outside options as
a competitive threat to the pair of U I and DI in the case whereby DI rejects U E ’s offer and accepts
U I ’s offer. Notably, Π∗ (cE ) − Π(cE + ∆, cI ) in this section is strictly larger than Π∗ (cE ) − Π∗ (cI ) in
Section 4.1. Such a competitive threat by U E gives it an advantage over DI in the proposal stage.
The resulting expected profits are summarized as follows.
πrDI = βΠ∗ (cE ) + (1 − β)Π(cE + ∆, cI ), πrU I = 0,
πrU E = (1 − β)(Π∗ (cE ) − Π(cE + ∆, cI )).

(8)

We consider the game in Stage 1. By substituting equations (6) and (8) into condition (5), we findthat condition (5) holds if and only if:
cI − ∆ ≤ cE < p∗ (cI ) − ∆ andβ ≤ β̂(cE , cI , ∆) ≡Π∗ (cI ) − Π(cE + ∆, cI ).
Π∗ (cE ) − Π(cE + ∆, cI )Note that we have β̂(cE , cI , ∆) ∈ (0, 1), β̂(cE , cI , ∆) → 0 as cE → p∗ (cI ) − ∆, and β̂(cE , cI , ∆) →Π∗ (cI )/Π∗ (cE ) < 1 as cE → cI − ∆. The following proposition summarizes the results:
12

Proposition 2. Suppose that cI − ∆ ≤ cE < p∗ (cI ) − ∆; U E ’s outside options are effective. U I
can protect the local upstream market from the entry of U E through exclusive contracts if DI has aweak bargaining power (i.e., β ≤ β̂(cE , cI , ∆)).
The results in Propositions 1 and 2 imply that in the presence of an outside option, the giant
manufacturer cannot enter the market because of the incumbent’s exclusive contracts if the giant
manufacturer has high efficiency. The change in U E ’s efficiency has two opposite effects on thepossibility of exclusion outcomes. First, as U E becomes efficient, the industry profit in the caseof entry increases, which allows DI to earn higher profits when DI becomes the proposer; thus,
exclusion becomes more difficult. Second, as U E becomes efficient, it can earn higher profits
because its outside options work more effectively for bargaining over DI when the manufacturers
become proposers; therefore, DI cannot earn higher profits even in the case of entry. Since β
represents the probability that DI becomes the proposer, the second effect is dominant for lowerβ; thus, exclusion is attainable. In this case, we obtain the seemingly counterintuitive results thatthe inefficient incumbent manufacturer can protect the local market from the entrant manufacturer
through exclusive contracts when the entrant manufacturer is sufficiently efficient rather than when
it is rather inefficient.
We believe that the exclusion mechanism presented herein captures the negotiation on profit
allocation that multinational firms often conduct when they have rich distribution options. Thus,
the results here imply that we cannot ignore such distribution options if we consider local firms’
survival strategies in response to the entry of giant multinational firms.
We also explore the relationship between the existence of an exclusion equilibrium in Proposition 2 and DCF ’s efficiency under the general demand function with standard properties. By
differentiating β̂(cE , cI , ∆) with respect to ∆, we obtain∂β̂(cE , cI , ∆)Π∗ (cE ) − Π∗ (cI )∂Π(cE + ∆, cI )
=− ∗
< 0,
∂∆
{Π (cE ) − Π(cE + ∆, cI )}2∂∆13

for all ∆ ∈ (cI − cE , p∗ (cI ) − cE ). Thus, we have the following proposition.13
Proposition 3. Suppose that conditions (1) and (2) hold. U I can protect the local upstream market
from the entry of U E through exclusive contacts as the outside options become efficient; that is,∂β̂(cE , cI , ∆)/∂∆ < 0 always holds.
Proposition 3 shows that entry is less likely as the outside option becomes efficient for cI − ∆ <cE < p∗ (cI ) − ∆. An increase in the efficiency of alternative distribution channels benefits U E after
entry, and U E has a strong incentive for entry. However, from the viewpoint of DI , the entry of U E
in such a situation is harmful because DI earns lower profits when U E ’s entry occurs. Thus, DI ismore likely to have an incentive to choose exclusive dealing with U I .
The results herein provide important implications for the relationship between the likelihoodof multinational entry and the progress of information and communication technology and globalization. The advancement of informatization and globalization seemingly enhances multinational
entry because such development facilitates not only finding new trading partners easily but also reducing transaction costs; in other words, the entrant manufacturer can use alternative distribution
channels more effectively for negotiations on industry profit allocation after entry. Therefore, theadvancement of informatization and globalization may help local manufacturers protect the local
market from multinational entry.

5 Discussion
This section briefly introduces the extension analyses and discussions on a market protection strategy against multinational entry and our model’s validity. Section 5.1 extends the analysis to thecase in which U E is highly efficient. Section 5.2 briefly discusses a reversal setting in which entry
can occur in the downstream market. Section 5.3 discusses the validity of our model by capturing
the features of multinational entry.
13

The partial differential ∂β̂(cE , cI , ∆)/∂ci (i = I, E) does not have clear-cut properties.

145.1 When U E is highly efficientThis subsection explores the case in which condition (2) does not hold. In this subsection, we
assume that the fixed cost of entry satisfies the following conditions:
F < F < F,

(9)

where
F ≡

(

Π(cI , cE + ∆)
Π∗ (cE + ∆)F ≡((1 − β)Π∗ (cE ) + βΠ(cI , cE + ∆)(1 − β)Π∗ (cE ) + βΠ∗ (cE + ∆)if cE + ∆ ≤ cI < p∗ (cE + ∆),if cE + ∆ < p∗ (cE + ∆) ≤ cI ,if cE + ∆ ≤ cI < p∗ (cE + ∆)if cE + ∆ < p∗ (cE + ∆) ≤ cI .

If the first inequality in condition (9) holds, entry into the local upstream market by using its
outside options is not profitable for U E when DI accepts the exclusive offer in Stage 1. That is,
the exclusive offer is effective in completely excluding U E . However, if the second inequality
in condition (9) holds, entry into the upstream market is profitable for U E when DI rejects the
exclusive offer in Stage 1.14
Note that when DI accepts the exclusive offer in Stage 1, the equilibrium outcomes coincidewith equations (6) as long as condition (1) holds. Therefore, as presented in the previous section,
the rest of this section only focuses on the equilibrium outcomes after DI rejects the exclusive offer
in Stage 1.
When DI rejects the exclusive offer in Stage 1, U E trades with DI . To derive equilibriumoutcomes, we consider two possible cases: (i) cE + ∆ ≤ cI < p∗ (cE + ∆) and (ii) cE + ∆ <p∗ (cE + ∆) ≤ cI .
We first consider the case of cE +∆ ≤ cI < p∗ (cE +∆). DI becomes the proposer with probability
β and offers (cI , 0) and (cE , Π∗ (cE ) − Π(cI , cE + ∆)) to U I and U E , respectively. The fixed payment
in the latter term reflects the fact that U E can earn Π(cI , cE + ∆) by using its outside options forthe case in which it rejects DI ’s offer. Consequently, U I earns nothing, U E earns Π(cI , cE + ∆), and14

When condition (2) and cE < p∗ (cI ) − ∆ hold, F = 0 and F = (1 − β)(Π∗ (cE ) − Π∗ (cE + ∆, cI )).

15

DI earns Π∗ (cE ) − Π(cI , cE + ∆). In addition, U I and U E become the proposers with probability
1 − β and offer (cI , 0) and (cE , Π∗ (cE )) to DI , respectively. DI obtains nothing by accepting U I ’s
offer because U E defeats the pair of DI and U I in the downstream competition by using its outside
options owing to the cost advantage of U E . Hence, U E earns Π∗ (cE ), while U I and DI earn nothing.
Next, we consider the case of cE + ∆ < p∗ (cE + ∆) ≤ cI . DI is the proposer with probability
β and offers (cI , 0) and (cE , Π∗ (cE ) − Π∗ (cE + ∆)) to U I and U E , respectively. The fixed payment
in the latter term reflects the fact that U E can earn Π∗ (cE + ∆) by using its outside options for thecase in which it rejects DI ’s offer. Therefore, when DI becomes the proposer, U I earns nothing, U E
earns Π∗ (cE + ∆), and DI earns Π∗ (cE ) − Π∗ (cE + ∆). Furthermore, U I and U E become the proposers
with probability 1 − β and offer (cI , 0) and (cE , Π∗ (cE )), respectively. Consequently, in this event,U E earns Π∗ (cE ), while U I and DI earn nothing. The resulting expected profits are summarized asfollows:
πrDI =(β(Π∗ (cE ) − Π(cI , cE + ∆))β(Π∗ (cE ) − Π∗ (cE + ∆))if cE + ∆ ≤ cI < p∗ (cE + ∆),if cE + ∆ < p∗ (cE + ∆) ≤ cI ,πrU I =0,(
(1 − β)Π∗ (cE ) + βΠ(cI , cE + ∆)r
πU E =(1 − β)Π∗ (cE ) + βΠ∗ (cE + ∆)(10)∗

if cE + ∆ ≤ cI < p (cE + ∆)if cE + ∆ < p∗ (cE + ∆) ≤ cI .

Finally, using the subgame outcomes derived above, we consider the game in Stage 1. By substituting equations (6) and (10), we find that condition (5) holds if and only if both β ≤ β̂(cE , cI , ∆)hold, where




(
)



Π∗ (cI )
min 1, ∗Π (cE ) − Π(cI , cE + ∆)β̂(cE , cI , ∆) ≡ 



(
)




Π∗ (cI ) min 1, Π∗ (c ) − Π∗ (c + ∆)E
E

if cE + ∆ ≤ cI < p∗ (cE + ∆),if cE + ∆ < p∗ (cE + ∆) ≤ cI .

Note that β̂(cE , cI , ∆) > 0 holds for all cE + ∆ ≤ cI , which implies that exclusion can always beobserved even when U E is sufficiently efficient and the fixed entry cost F is not overly small suchthat condition (9) holds. The following proposition summarizes these results:
16

Proposition 4. Suppose that condition (2) does not hold; When the fixed cost of entry satisfies
condition (9), U I can protect the local upstream market from the entry of U E through exclusive
contracts if and only if DI has weak bargaining power (i.e., β ≤ β̂(cE , cI , ∆)).
The results in Proposition 4 imply that U I can protect the local upstream market from theentry of U E using exclusive contracts even when U E is highly efficient if the fixed cost of entry
is sufficiently high, which confirms the robustness of the exclusion mechanism presented in thisstudy. Moreover, because Π(cI , cE + ∆) and Π∗ (cE + ∆) strictly decrease in ∆, β̂(cE , cI , ∆) strictly
decreases in ∆ for all β̂(cE , cI , ∆) < 1. Thus, as described in the previous section, as the alternative
distribution channel becomes efficient, U E is more likely to have difficulties entering the upstream
market.

5.2 Downstream exclusion
We briefly introduce the results in the case of exclusive supply contracts by inverting the vertical
relationship in Section 4. We provide a precise analysis in Appendix A. In this extension analysis,
we consider the following case. The upstream market comprises an upstream input supplier, U I ;conversely, the downstream market consists of an incumbent manufacturer DI and an entrant manufacturer DE . In addition to procuring the input from U I , each manufacturer can procure it fromalternative supply chains by incurring an additional marginal cost. We regard the opportunity as
an outside option for manufacturers. As in Section 4, we consider the case in which, owing to its
efficiency, only DE can use the outside option for simplicity.
In this setting, we introduce two measures of DE ’ s efficiency. First, we consider the case inwhich manufacturers differ in exogenous marginal costs by inverting the cost structure in Section
4. Second, we consider the case in which manufacturers differ in the transformational technology
of input supplied by suppliers.
In both settings, we show that DI can protect the local downstream market from the entry of
DE if DE is sufficiently efficient and downstream manufacturers have strong bargaining powers.
17

As demonstrated in Section 4, DI cannot protect the local downstream market when the alternative
supply chain is too inefficient or DE is marginally more efficient than DI .15 Thus, the exclusion
mechanism in this study remains valid in various settings.

5.3 Survival strategies for multinational entry in emerging markets
We briefly introduce several cases whereby multinational firms struggle in emerging markets andexplain why the model setting adopted in this study is suitable for the case of multinational entry.

Multinational entry struggling in emerging markets

In addition to the case of Vist, as de-scribed in the Introduction, we briefly introduce three cases in which multinational firms are struggling in emerging markets, and some of them decide to withdraw from the market. First, theHonda Motor Company, a Japanese manufacturer of automobiles, motorcycles, and so on, entered the motor scooter market in India in the mid-1980s. Notwithstanding its superior technology,
Honda failed to compete with Bajaj Auto, the largest manufacturer of motor scooters in India, andabandoned the Indian market in 1998 (Dawar and Frost, 1999; Venugopal, 2010). Second, when
PepsiCo entered the bakery market in Mexico in 1991, Grupo Bimbo, the largest bakery productmanufacturer in Mexico, strengthened its distribution network and maintained its leading market
position (Dawar and Frost, 1999). Third, Natura Cosméticos, a leading Brazilian cosmetics maker,
also defended its home market share in Brazil against multinational rivals such as L’Oréal, P&G,
and Avon (Sanotos and Williamson, 2015).16
A common factor in these three examples is that local firms have strong distribution networks(plus a widespread local supply chain in Natura’s case), which works as a key element in theirdefense strategies against multinational rivals.17 If local firms have had strong ties with local man15

Kitamura, Matsushima, and Sato (2020) consider the second case in the absence of alternative supply chains andshow that exclusion can be an equilibrium outcome under linear wholesale pricing.
16

Some survival strategies of local firms can protect a certain area of the local country from multinational entry orlead to compartmentalization in a local market.
17

In the business literature, studies typically are interested in why local firms win the competition against foreign18

ufacturers or distributors as a result of the first-mover advantage, it could work as a sort of barrier
to entry when multinational firms choose which location to invest in. Notably, some multinational firms in emerging markets notice that their rivals are not other multinational firms, but local
firms (Sanotos and Williamson, 2015). More importantly, we expect that there would be certain
unobservable cases such that multinational firms actually consider entering a specific market but
eventually relinquish the idea due to local firms’ strong distribution network, and subsequently,
those multinational firms rather choose another location from their candidates. Thus, constructing
strong distribution channels in the local market, including exclusive dealing, may become a crucialbarrier to the entry of giant firms.18

Linkage between the model and multinational entry

We believe that signing exclusive con-tracts against multinational entry is one of the most suitable situations that this study focuses on
because of the following reasons: First, multinational firms usually have high productivity (Helpman, Melitz, and Yeaple, 2004); second, multinational firms usually have a network of switching
options that is unavailable to locally operating domestic firms (Kogut and Kulatilaka, 1994; Tongand Reuer, 2007); third, multinational entry usually takes some time for full establishment after the
initial news of the entry, and domestic firms thereby have an opportunity to respond to the threat offuture entry (Bao and Chen, 2018); and fourth, the recent development of information and communication technology allows multinational firms to find trading partners more easily because suchtechnology reduces communication, search, and variable trade costs (World Bank, 2009). These
giants (Dawar and Frost, 1999; Bhattacharya and Michael, 2008). One of the crucial factors in multinational firms’
survival in emerging markets is the integration of economic activities with local commercial networks. Sanotos andWilliamson (2015), for example, discuss the importance of the “home team” advantage of local firms through local
integration; partnership with local manufacturers or distributors are vital to the success of local firms in the local
market. In particular, a tie with distributors gives local firms a channel for interactions with customers. See also
Johanson and Vahlne (2009) and Monaghan, Gunnigle, and Lavelle (2014) for further examples. They discuss theimportance of “insidership” in the business network for successful foreign market entry.
18

Heide, Dutta, and Bergen (1998) empirically report that the use of exclusive contracts against new entry is lesslikely to be observed. However, the existence of such contracts can reduce the possibility of new entry (Whinston,
2006, p.192), which is similar to our argument.

19four features play essential roles in the exclusion mechanism presented in this study. Therefore,
we predict that exclusive contracts can be effectively used as a survival strategy against foreign
firms’ entry.
Notably, we can apply the exclusion mechanism presented in this study to not only the entry ofmultinational firms but also that of giant domestic firms. For example, we can apply our concept
to a situation in which a locally dominant firm tries to enter the market in other regions to expand
its business, because the development of information and communication technology also helps
local firms find several trading partner candidates in other regions. Thus, this study is also suitablefor exclusive dealing when an efficient giant firm tries to enter a new market in other countries orregions.

6 Conclusion
This study considers a survival strategy for defending a home market facing multinational entry.
Notwithstanding their high efficiency, multinational firms sometimes struggle to enter emerging
markets because a local dominant manufacturer develops strong connections with local distributors to safeguard against multinational entry. To consider such situations, we discuss the effectiveness of signing exclusive contracts, one of the primary solutions to protect the local market. In
our model, a local manufacturer makes an exclusive offer to a local dominant distributor against amultinational firm’s entry. Our model’s key feature is that because of its efficiency, only the multinational entrant can use alternative distribution channels as one of the rich switching options; inother words, the entrant in this study is stronger than those in previous studies on naked exclusion.
Seemingly, it is difficult to close exclusive contracts with the local distributor when existing firms
anticipate the entry of a strong multinational firm. However, multinational entry may not necessarily benefit the local distributor when multinational entrants have rich outside options. Thus, there
is room for exclusive dealing between local manufacturers and distributors.
Note that this study’s exclusion mechanism works effectively if the entrant manufacturer is20

more efficient than the local incumbent manufacturer, which is different from the exclusion mechanism in previous studies on naked exclusion. This implies that our model provides a new rationale for exclusion, caused by an entrant’s high efficiency, which is one of the important featuresof multinational firms. Although the results obtained here are seemingly counterintuitive, we can
explain them based on common commercial practice, which we frequently observe in commerceand business settings; a giant firm takes an aggressive attitude toward negotiation with a local
distributor based on its rich outside options.
The findings of this study have important implications. From the perspective of entry strategies,
we predict that a strong entrant may not necessarily succeed in entering a new market with a lessefficient incumbent. Although the development of information and communication technology
helps multinational firms find trading partners for entry, it allows the local firm to protect the local
market from entry through exclusive contracts. In addition, from the viewpoint of competition
policy, the Chicago School argument may be inapplicable when the entrant has rich switching
options; naked exclusion is achievable if the entrant has high efficiency, rich switching options, andstrong bargaining power. When antitrust agencies consider the situation in which naked exclusion
occurs, they cannot neglect the possibility that the entrant has an option to use alternative but
inefficient distribution channels.
Notwithstanding these contributions, several issues require further research. First, the present
study’s analysis assumes that industry profit is allocated by bargaining with random proposers, toclarify the exclusion mechanism in this study easily. We predict that the exclusion result may also
remain valid under more general bargaining structures. Second, we assume that manufacturers
produce homogeneous products. For a small degree of product differentiation, the exclusion result
remains valid. We hope that this study will help researchers address these issues.

21

A Downstream Exclusion
This appendix introduces the case of exclusive supply contracts by inverting the vertical relationin Section 4. In this appendix, the upstream market is composed of a supplier U I , while thedownstream market, by contrast, is composed of a downstream incumbent DI and a downstream
entrant DE .
In the remainder of this appendix, we introduce two efficiency measures for downstream firms
to clarify the robustness of the exclusion mechanism reported in this study. We first consider thecase in which downstream firms differ in exogenous marginal costs in A.1. Thereafter, we consider
the case in which downstream firms differ in the transformational technology of input supplied bysuppliers in A.2.

A.1

When downstream firms differ in marginal costs

U I produces an input at a marginal cost of 0 ≤ c < P(0). To simplify the analysis, we assume thatc = 0. In this subsection, we assume that DI and DE sell the products supplied by the suppliers.
In terms of exogenous marginal costs, DE is more efficient than DI , with a marginal cost of 0 ≤dE < dI . In addition to procuring the input from U I , each manufacturer can procure identical inputs
by incurring an additional marginal cost c0 ∈ (0, P(0)). We regard this opportunity as an outside
option for manufacturers to use alternative supply chains.
As in Section 4, we assume that only DE can earn positive profits by using the outside options if
it is able to monopolize the downstream market and that DE does not enter the downstream market
if U I accepts the exclusive offer.
Assumption A.1. dE satisfies the following properties:
dE < P(0) − c0 ≤ dI .

(11)

dE + c0 ≥ dI

(12)

22

As in Section 4, the model contains four stages: In Stage 1, DI makes an exclusive supply
offer to U I with fixed compensation x ≥ 0. Thereafter, U I decides whether to accept the offer.
If U I accepts the exclusive supply offer, it immediately receives x. In Stage 2, after observing
U I ’s decision, DE decides whether to enter the downstream market. We assume that the fixed
cost of entry is sufficiently low such that DE can earn positive profits.19 In Stage 3, existing firms
negotiate and make contracts for two-part tariffs. As in Section 4, the industry profit is allocatedby bargaining with random proposers. In Stage 4, the manufacturer(s) orders inputs and sells the
final goods to consumers. U I ’s profit when it accepts (rejects) the exclusive offer is denoted by πaU I(πrU I ). Conversely, Di ’s profit when U I accepts (rejects) the exclusive offer is denoted by πaDi (πrDi ),where i ∈ {I, E}.
Henceforth, we explore the existence of exclusion outcomes. The equilibrium outcomes in thesubgame following U I ’s decision in Stage 1 are derived as follows: When the exclusive supply
offer is accepted in Stage 1, DI offers (0, 0) to U I with probability β, and U I offers (0, Π∗ (dI )) toDI with probability 1 − β. The resulting expected profits, excluding the fixed compensation x, aregiven as follows:
πaU I = (1 − β)Π∗ (dI ), πaDI = βΠ∗ (dI ), πaDE = 0.

(13)

By contrast, when the exclusive supply offer is rejected in Stage 1, DE sells U I ’s inputs on theequilibrium path. There are two possible equilibrium outcomes: We first consider the case in which
DE is not too efficient (dI < p∗ (dI ) ≤ dE + c0 ). When U I becomes the proposer with probability
1 − β, it offers two-part tariff contracts sequentially to extract all industry profits; it first offers(0, Π∗ (dE )) to DE and then it offers (0, Π∗ (dI )) to DI if DE rejects the first offer. At equilibrium, DE
accepts the first offer.20 By contrast, when manufacturers become proposers with probability β, DI
19

Similar to the discussion in Section 5.1, we have exclusion results even when condition (12) does not hold. The
results are available upon request.
20

In contrast to the upstream exclusion in Section 4, U I cannot extract all industry profits Π∗ (dE ) by offering
discriminatory two-part tariff contracts to DI and DE simultaneously. If U I is restricted to offering discriminatory
two-part tariff contracts simultaneously, exclusion is more likely to be attainable because U I earns a lower profit when
it rejects the exclusive offer. Moreover, the analysis becomes considerably complicated with such offers. The results

23and DE offer (0, Π∗(dI )) to U I and U I accepts DE ’s offer.
Next, we consider the case in which DE is efficient (dI ≤ dE + c0 < p∗ (dI )). When U I becomesthe proposer with probability 1 − β, it offers two-part tariff contracts sequentially; it first offers(0, Π∗ (dE )) to DE and then offers (0, Π(dE +c0 , dI )) to DI if DE rejects the first offer. At equilibrium,
DE accepts the first offer. Conversely, when manufacturers become proposers with probability β,
DI and DE offer (0, Π(dE + c0 , dI )) to U I , and U I accepts DE ’s offer. Consequently, the resulting
expected profits are as follows:(βΠ∗ (U I ) + (1 − β)Π∗ (dE )r
πU I =
βΠ(dE + c0 , dI ) + (1 − β)Π∗ (dE )πrDI =0,(β(Π∗ (dE ) − Π∗ (dI ))rπDE =β(Π∗ (dE ) − Π(dE + c0 , dI ))if dI < p∗ (dI ) ≤ dE + c0 ,if dI ≤ dE + c0 < p∗ (dI ),(14)

if dI < p∗ (dI ) ≤ dE + c0 ,if dI ≤ dE + c0 < p∗ (dI ).

Using the subgame outcomes derived above, we now consider the game in Stage 1. Note that,as presented in Section 4, there is an exclusion equilibrium if and only if condition (5) holds. By
substituting equations (13) and (14), we find that condition (5) holds if and only if dI ≤ dE + c0 <p∗ (dI ) and β ≥ β(dE , dI , c0 ) hold simultaneously, whereβ(dE , dI , c0 ) ≡Π∗ (dE ) − Π∗ (dI ).
Π∗ (dE ) − Π(dE + c0 , dI )Note that we have β(dE , dI , c0 ) ∈ (0, 1). The following proposition summarizes the result.
Proposition A.1. Suppose that conditions (11) and (12) hold. DI can protect the local downstream
market from the entry of DE through exclusive supply contracts if DE is sufficiently efficient (dI −c0 ≤ dE < p∗ (dI ) − c0 ) and U I has weak bargaining power (β ≥ β(dE , dI , c0 )).

A.2

When downstream firms differ in transformational technology

In contrast to the previous subsection, we consider a case in which manufacturers differ in termsof transformational technology. In addition, we assume that c ≥ 0 in this appendix. Here, DI
are available upon request.

24

produces a unit of final goods using a unit of input. The transformational technology of DI is givenby:
QI = qI ,where QI (qI ) is the amount of output (input) for DI . The per unit production cost of DI , given thelinear wholesale price w, cI , is denoted by:
cI = w.
Conversely, DE produces a unit of final goods using k units of input, where k is a positive constant.
The transformational technology is denoted by:
QE = qE
where QE (qE ) is the amount of output (input) for DE . Thereafter, the per unit production cost of
DE , given linear wholesale price w, cE , is denoted by:
cE = kw.
By assuming 0 < k < 1, DE is more efficient than DI in terms of the per unit production cost.
As provided in the previous analyses, we assume that only DE can earn positive profits using
outside options if it is able to monopolize the downstream market and that DE does not enter thedownstream market if U I accepts the exclusive offer.
Assumption A.2. k satisfies the following properties:
kc0 < P(0) ≤ c0 .

(15)

kc0 ≥ c.

(16)

We also assume that, as stated in Section A.1, the model contains four stages and that the
fixed cost of entry is sufficiently low such that DE can earn positive profits if the exclusive offer isrejected in Stage 1.21
21

Similar to the discussion in Section 5.1, we have exclusion results even when condition (16) does not hold. The
results for the case of low k and high c are available upon request.

25

Hereinafter, we explore the existence of exclusive outcomes. The equilibrium outcomes in thesubgame following U I ’s decision in Stage 1 are derived as follows: When the exclusive supply
offer is accepted in Stage 1, DI offers (c, 0) to U I with probability β, and U I offers (c, Π∗ (c)) to DI
with probability 1 − β. The resulting expected profits, excluding the fixed compensation x, are:πaU I = (1 − β)Π∗ (c), πaDI = βΠ∗ (c), πaDE = 0.

(17)

By contrast, when the exclusive supply offer is rejected in Stage 1, DE sells U I ’s inputs on
the equilibrium path. There are two possible equilibrium outcomes: We first consider the case inwhich DE is not too efficient (c < p∗ (c) ≤ kc0 ). When U I becomes the proposer with probability
1 − β, it offers two-part tariff contracts sequentially to extract all industry profits; it first offers(0, Π∗ (kc)) to DE and then offers (0, Π∗ (c)) to DI if DE rejects the first offer. At equilibrium, DE
accepts the first offer. Contrariwise, when manufacturers become proposers with probability β, DI
and DE offer (c, Π∗ (c)) to U I and U I accepts DE ’s offer with probability β.
Next, we consider the case in which DE is efficient (c ≤ kc0 < p∗ (c)). When U I becomesthe proposer with probability 1 − β, it offers two-part tariff contracts sequentially. It first offers(0, Π∗ (kc)) to DE and thereafter offers (0, Π(kc0 , c)) to DI if DE rejects the first offer. At equilibrium,
DE accepts the first offer. Conversely, when manufacturers become proposers with probability β,
DI and DE offer (c, Π(kc0 , c)) to U I , and U I accepts DE ’s offer. Consequently, the resulting expected
profits are:πrU I =(βΠ∗ (c) + (1 − β)Π∗ (kc)βΠ(kc0 , c) + (1 − β)Π∗ (kc)πrDI =0,(β(Π∗ (kc) − Π∗ (c))
rπDE =β(Π∗ (kc) − Π(kc0 , c))

if c < p∗ (c) ≤ kc0 ,if c ≤ kc0 < p∗ (c),(18)

if c < p∗ (c) ≤ kc0 ,if c ≤ kc0 < p∗ (c).

Using the subgame outcomes derived above, we now consider the game presented in Stage 1.
By substituting equations (17) and (18), we find that condition (5) holds if and only if c ≤ kc0 <p∗ (c) and β ≥ β̃(k, c, c0 ) hold simultaneously, whereβ̃(k, c, c0 ) ≡Π∗ (kc) − Π∗ (c).
Π∗ (kc) − Π(kc0 , c)26

Note that we have β̃(k, c, c0 ) ∈ (0, 1). The following proposition summarizes the result.
Proposition A.2. Suppose that conditions (15) and (16) hold. DI can protect the local downstream
market from the entry of DE through exclusive supply contracts if DE is sufficiently efficient (c ≤kc0 < p∗ (c)) and DI has a strong bargaining power (β ≥ β̃(k, c, c0 )).

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