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

Revised October 2021
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§

October 4, 2021

Abstract
We consider exclusive contracts 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, because of 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: L42, L12, F23, C72
Keywords: Exclusive dealing; Vertical relation; Antitrust policy; Multinational firms* We thank Akifumi Ishihara, Makoto Hanazono, and Tadashi Sekiguchi as well as the conference participants at
48th Annual Conference of the European Association for Research in Industrial Economics (University of Bergen)and the seminar participants at Okayama University and Sapporo Gakuin University. We gratefully acknowledge
the financial support from JSPS KAKENHI grant numbers JP15H05728, JP17H00984, JP18H00847, JP19H01483,
JP20K13485, and JP20H05631, and the program of the Joint Usage/Research Center for “Behavioral Economics” at
the ISER, Osaka University. Although Matsushima serves as the director of the Competition Policy Research Center(CPRC) at Japan Fair Trade Commission (JFTC), our paper does not reflect the view of JFTC. 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 considerable 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. For example, when India
opened its automotive industry in the 1980s, Bajaj Auto, the largest Indian manufacturer of motor
scooters, defended its market by building up its distribution network to fight Honda’s entry (Dawar
and Frost [1999]; Venugopal [2010]). When PepsiCo entered the bakery market in Mexico in
1991, Grupo Bimbo, the largest bakery product manufacturer in Mexico, strengthened its distribution network and maintained its leading market position (Dawar and Frost [1999]). As anotherexample, by forming a sales network of more than one million consultants, Natura Cosméticos,
a leading Brazilian cosmetics maker, defended its home market share against multinational rivals
such as L’Oréal, P&G, and Avon (Sanotos and Williamson [2015]). From these observations, somemultinational firms notice that their rivals are not other multinational firms but local firms (Sanotos
and Williamson [2015]).
Among business activities that can strengthen the distribution network, signing an exclusive
contract is a favored solution among local firms. For example, when Russia liberalized its economy, a Russian personal computer manufacturer, Vist, successfully defended its local markets byentering into exclusive distribution agreements with several key retailers in local markets in response to the entry of multinational firms such as Compaq, IBM, and Hewlett-Packard (Dawar andFrost [1999]). Moreover, such exclusive dealing can be an international issue. The US government and companies complained that exclusive distribution networks had been the entry barrier
into Japanese industries, such as flat glass, paper and paper products, passenger cars, automobile

1parts, and films (Subramanian [1995]; US Department of Justice [2000]). As a specific example,
in Eastman Kodak vs. Fuji, the former, a US photographic film firm, complained that Fuji, itsJapanese competitor, had established an exclusive relationship with several Japanese wholesalers(Nagaoka and Goto [1997]). Similar conflicts are also observed in ice cream markets in Europe;for example, Mars, a US firm, complained that Unilever’s subsidiaries in Ireland and Germany
entered into exclusive agreements with local retailers, becoming a barrier to entry (Motta [2004];
Cooke [2010]; Fumagalli, Motta, and Calcagno [2018]).1
Although exclusive contracts benefit local firms, those can be harmful from the perspective ofdomestic welfare because of the efficiency loss. More importantly, it is not obvious whether suchcontracts are attainable 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,
originating from the Chicago School argument in the 1970s, 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 inefficient competitive distributors, which are downstream competitive fringes. We consider the casein which, because of 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
1

See also Raff and Schmitt [2006] for other international conflicts over exclusionary vertical relationships in othercountries and industries. In addition to those publicly observable cases, there would be certain unobservable cases suchthat multinational firms actually consider entering a specific market but eventually relinquish the idea because of local
firms’ exclusive distribution networks, and subsequently those multinational firms instead choose another location.
Thus, exclusive dealing may become a crucial barrier to the entry of giant firms.

2and Kulatilaka [1994]; Tong and Reuer [2007]).2
By introducing nonlinear 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; thelocal incumbent manufacturer cannot offer an acceptable exclusive contract if the multinational
manufacturer is not efficient.
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.
The exclusion mechanism presented in this study provides important policy implications fromseveral perspectives. First, the results provide important policy implications for the invitationof multinational firms. Because multinational entry usually has a positive impact on host countries, such as technology transfer and physical capital inflows, the host country government often
removes official systems, including taxes and legal barriers, to promote multinational entry. More2

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

3

over, local firms seem to have difficulty using exclusive contracts as a survival strategy becauseof the high efficiency of multinational firms. However, let us consider the distribution options
available to multinational firms. It is possible that 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 development of information and communication technology helps firms establish alternative distribution
channels more easily (World Bank [2009]). Such development seemingly facilitates the entry ofhighly efficient firms. However, the results herein imply that such development may help local
manufacturers protect their local markets through exclusive contracts. From the perspective ofa multinational firm’s location strategy, 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
contracts.3
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 this3

In the Supplementary Appendix, we show that exclusion outcomes are attainable for the case of downstream
entry by inverting the vertical relationship.

4

study to 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 presents the literature review.
Section 3 constructs the model. Section 4 analyzes the existence of exclusion outcomes under
two-part tariffs and the welfare effect of exclusive dealing. Section 5 offers concluding remarks.

2 Literature Review
This study is related to the literature on naked exclusion, in which an inefficient incumbent deters
the entry of an efficient firm through exclusive contracts.4 This literature traces its development
to the Chicago School argument of the 1970s (see Posner [1976] and Bork [1978]. For surveys,
see Motta [2004], Whinston [2006], and Fumagalli, Motta, and Calcagno [2018]). Focusing on
the contracting party’s incentives, the Chicago School theory reveals that exclusive contracts arenever feasible in a three-player model with two suppliers and a buyer. In rebuttal to the Chicago
School, post-Chicago economists find that exclusive contracts can deter efficient entrants in somesituations.5 The seminal work by Aghion and Bolton [1987] shows the anticompetitive effect of a
private contract with liquidated damages between an incumbent seller and a buyer who anticipate
a potential seller whose efficiency is private information (see also Spier and Whinston [1995] andZiss [1996] for further discussions).6
The seminal works by Rasmusen, Ramseyer, and Wiley [1991] and Segal and Whinston [2000]
add multiple buyers and entry costs to the simple three-player setting in the Chicago School theory.
4

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]).
5

There are a 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

Although most studies on exclusive dealing assume perfect information, several studies consider the information asymmetry in this literature. Calzolari and Denicolò [2013, 2015] discuss three-player models with the private
information of the buyer’s valuation for the products of the two sellers. To investigate the effect of exclusive dealing,
Calzolari, Denicolò, and Zanchettin [2020] unify the previous different analytical frameworks (Mathewson and Winter[1987]; Bernheim and Whinston [1998]; Calzolari and Denicolò [2013, 2015]).

5

The entrant can enter the market only if it acquires the demands from more than one buyer. Then,the incumbent can deter entry even when not all of the buyers, but rather only some of them, accept
the exclusive dealing offers.7 By extending the multiple-buyer framework, Simpson and Wickelgren [2007] and Abito and Wright [2008] introduce downstream market competition, assumingthat buyers are competing firms.8 Competition in both upstream and downstream markets lowers
the profitabilities of the firms.9 Exclusive dealing between upstream and downstream firms is a
way to reduce competition in at least one of the markets.10 On the contrary, entry in our modelincreases total industry profits, but can reduce the total profits of the contracting party.
The model in this study shares some parts of equilibrium properties with those in the studies
that modify the competitiveness of the upstream market in a three-player model with two suppliers
and one buyer.11 Those studies show that anticompetitive exclusive dealing is attainable, and their
key feature is that the buyer does not benefit enough from the mild upstream competition, allowing
the incumbent supplier to offer an acceptable exclusive contract to the buyer.12 The buyer’s insuf7

Miklós-Thal and Shaffer [2016], Choi and Stefanadis [2018], and Chen and Shaffer [2014, 2019], respectively,
incorporate unobservable contracts (Hart and Tirole [1990]), sequential process innovation by the entrant, and market
share contracts into the frameworks in Rasmusen, Ramseyer, and Wiley [1991] and Segal and Whinston [2000].
8

In the literature on exclusion with downstream competition, 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.
9

Ulsaker [2020] introduces an upstream exclusion model with the differences in input qualities. His model allows
the possibility that entry increases industry profit, in contrast to the previous models with downstream competition.
10

There are extended models with downstream competition: interbrand competition with homogeneous retailers(Wright [2008]), vertical differentiation (Argenton [2010]), multiple entrants (Kitamura [2010]), allowing imperfectexclusion (DeGraba [2013]), and allowing a higher degree of horizontal product differentiation (Gratz and Reisinger[2013]).
11

Fumagalli, Motta, and Rønde [2012] extend the three-player model in a different direction by introducing theincumbent’s relationship-specific investments.
12

Based on the Chicago School three-player model, Kitamura, Matsushima, and Sato [2018a] introduce a complementary input supplier and show that exclusion is attainable when the complementary input supplier has market
power. In addition, Kitamura, Matsushima, and Sato [2018b] consider the case in which symmetric manufacturers canmake exclusive offers based on the three-player model and show that exclusive-offer competition leads to exclusion
outcomes.

6

ficient benefit from entry is similar to ours,13 although the source of such an insufficient benefit
in those studies (milder upstream competition) differs from ours (the entrant’s rent extraction in
negotiation). Yong [1996] incorporates a capacity constraint of the upstream entrant, mitigating
upstream competition. Farrell [2005] considers upstream quantity competition, which is milder
than Bertrand competition. Fumagalli, Motta, and Persson [2009] allow a horizontal merger between the incumbent supplier and a potential supplier under inspection by the antitrust authority
after signing an exclusive dealing between the incumbent and the buyer. The merger escapes upstream competition. Kitamura, Matsushima, and Sato [2017] assume Nash bargaining between
the buyer and the entrant supplier with potential subsequent bargaining between the buyer and theincumbent supplier. The bargaining process mitigates upstream competition. Alternative distribution channels are beyond the scope of these studies; the contribution of this study to the 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 most closely related to Comanor and Rey [2000], who
consider a market with a single supplier, a downstream incumbent with inefficient external suppliers, and a downstream entrant.14 They assume that only the downstream incumbent has an outside
option to buy inputs from the external supplier, although an efficient upstream entrant can use inefficient downstream distributors in our model. When each downstream firm has full bargaining
power to offer a wholesale price, the existence of inefficient external suppliers lowers the downstream incumbent’s wholesale price offer, which induces the efficient downstream entrant to offer
a lower wholesale price. Therefore, the supplier cannot earn higher profits even when downstream
entry occurs, which leads to exclusion outcomes. The key feature of their study is that, because of13

Liu and Meng [2021] introduce the fixed cost of the incumbent to stay in the market. If the entrant enters, thefixed cost forces the incumbent to exit the market, lowering the buyer’s benefit from the new entry.
14

Kitamura, Matsushima, and Sato [2021] consider a three-player model with a single supplier, a downstream
incumbent, and a downstream entrant. The key feature of their model is that the entrant is efficient in terms of thenecessary amount of input produced by the supplier. The lower input demand by the entrant can be a source of the
exclusion outcome if the supplier employs nondiscriminatory linear wholesale pricing.

7the existence of the external supplier, downstream entry generates competition throughout the vertical structure, which induces final consumers to extract the benefit from the entry.15 In contrast to
their research, this study considers the entrant’s outside option, the source of which is the entrant’s
efficiency. Furthermore, the entry in our model increases total industry profit. More importantly,
although the entrant’s efficiency is irrelevant in inducing exclusion outcomes in Comanor and Rey[2000], it is critical in our study; by facilitating rent extraction from the downstream firm, an efficiency improvement of the upstream entrant is more likely to induce exclusion, which is the novel
feature of our result.16 In sum, this study presents an alternative exclusion mechanism with themodifications of Comanor and Rey [2000].
This study is also related to the literature on exclusive contracts in an international context.
There are few studies in this field. 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 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 weinvestigate local firms’ exclusive offers to construct a barrier to foreign multinational entry byincorporating rich switching options.
Finally, this study is related to the substantial literature on the location decisions of multinational firms and on the boundaries of firms, which explores where multinational firms investand have subsidiaries (Helpman, Melitz, and Yeaple [2004]; Antràs and Helpman [2004]; Yeaple[2009]; Chen and Moore [2010]). For example, Chen and Moore [2010] explore location deci15

Using a two-period model, Fumagalli and Motta [2020] point out that to avoid the coexistence of upstream anddownstream competition, the possibility of an efficient upstream firm’s entry in the future may facilitate the current
exclusion of an efficient downstream entrant by a vertically integrated incumbent.
16

In the extended model in Comanor and Rey [2000], the entrant’s efficiency improvement makes exclusion lessachievable, which contrasts our novel feature. Note that an efficiency improvement by inefficient external suppliers
makes exclusion more achievable in Comanor and Rey [2000]. This property aligns with that in our model in whichan efficiency improvement of competitive fringe distributors makes exclusion more achievable.

8sions using French manufacturing firms’ data and find that more productive firms are more likely
to enter a foreign country. 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 canalso be a host country attribute that influences the entry decisions of multinational firms. By interpreting this differently, our analysis predicts that because more productive firms have more optionsin terms of locating their economic activities, multinational firms with several options regarding
where to invest can avoid locations with high entry barriers.

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,
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),
respectively. 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. To simplify the analysis, we assume that DI ’s
resale cost is zero; 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 through competitive fringe distributors that are less efficient9than DI . Each of the fringe distributors incurs the per unit resale cost ∆(> 0); it incurs a production
cost (w + ∆)q when purchasing q units of the product under the linear wholesale price w.
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 is single-peaked; 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 envelope theorem implies that ∂Π∗ (z)/∂z = −Q(p∗ (z)) < 0.
To clarify the role of manufacturers’ outside options, we assume that the marginal costs offirms satisfy the following conditions:
Assumption 1.
cE < P(0) − ∆ ≤ cI .

(1)

The first inequality of condition (1) implies that U E can earn positive profits 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 always negligible.
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. We assume that U E cannot make an exclusive offer because multinational10

firms usually spend some time to actually enter the markets after the news of their entry (Bao andChen [2018]), which allows local firms to make exclusive offers before future entry occurs.17 In
addition, following the standard literature on naked exclusion, we assume that the exclusive offer
does not contain the trading term.18 After observing the exclusive offer, DI decides whether toaccept 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)

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
1.19
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 isallocated by bargaining with random proposers, and the process in Stage 3 is as follows. In the negotiation between the distributors and the manufacturers, the players on one of the sides randomly17

If we consider the case in which every manufacturer can make exclusive offers, exclusive-offer competition leads
to exclusion outcomes as in Kitamura, Matsushima, and Sato [2018b]. Our model setting eliminates the possibility
that such an effect makes exclusion attainable, which allows us to clarify the role of an alternative distribution channel.
18

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.
19

In the Supplementary Appendix, we explore the case in which condition (2) does not hold. We show that exclusion
is attainable even when U E ’s marginal cost is sufficiently low if the fixed cost of entry is adequately high.

11become proposers; the distributors become proposers with probability β ∈ (0, 1), and the manufacturers become proposers with probability 1 − β. We interpret β as the degree of the distributors’
bargaining power over the manufacturers. In each event, only U E can always use its outside option
to trade with a competitive fringe distributor (CF) under the term (wrE|CF , ψrE|CF ) = (cE , 0).20 For
simplicity, we assume that the proposers can choose how to offer two-part tariff contracts such thatthe contracts maximize their stage profits if possible; that is, they offer discriminatory two-parttariff contracts or offer such contracts sequentially.21 We assume that if DI is indifferent between
the two-part tariffs of U I and U E , the efficient manufacturer, U E , supplies its product to DI ; that is,
we impose the so-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 ofcompensation 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
20

Note that in each event, the pair of U E and a competitive fringe distributor cannot earn positive profits because
they cannot win the competition with the pair of U I and DI under condition (2). Hence, regardless of the proposerrole, ψrE|CF = 0 holds, although the competition among competitive fringe distributors usually benefits manufacturers.
21

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.

12

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 focus mainly on the joint profits of the contracting party.
Moreover, if U I and D sign exclusive contracts to satisfy condition (5), the global total surplus
decreases; the exclusive contracts we consider here are harmful. We provide a precise discussionof the welfare analysis in Section 4.4.

4 Analysis
In this section, the existence of exclusive outcomes is analyzed. First, in Section 4.1, we explore
the case in which the pair of U E and a competitive fringe distributor cannot be a competitive threat
to the pair of U I and DI in the off-path event whereby DI rejects U E ’s offer and accepts U I ’s
offer in Stage 3; concretely, p∗ (cI ) − ∆ ≤ cE . This means that the pair of U I and DI can set themonopoly price p∗ (cI ) even when the pair of U E and a competitive fringe distributor exist as acompetitor in the downstream market. Second, we explore the case in which the pair of U E and thecompetitive fringe distributor can be a competitive threat to the pair of U I and DI in the off-path
event mentioned above; concretely, cI − ∆ ≤ cE < p∗ (cI ) − ∆, in Section 4.2. Third, we introduce
comparative statics in Section 4.3. Finally, we explore the welfare effect of exclusive dealing in
Section 4.4.

13

4.1 When U E is not so efficient
We consider the case in which the pair of U E and a competitive fringe distributor cannot be acompetitive threat to the pair of U I and DI in the off-path event whereby DI rejects U E ’s offer andaccepts U I ’s offer in Stage 3; concretely, p∗ (cI ) − ∆ ≤ cE . To derive the equilibrium outcomes, wesolve 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 .22 In Stage 3, DI
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 in the equilibrium, although
it can trade with a competitive fringe distributor under the term (cE , 0) off the equilibrium path.
The industry profit allocation in Stage 3 is derived as follows. DI becomes the proposer withprobability β and offers (cI , 0) and (cE , 0) to U I and U E , respectively, to extract all the industry
profits.23 Conversely, U I and U E are the proposers with probability 1 − β, and then they offer (cI , 0)22

Because U I cannot earn positive profits by selling its products through competitive fringe distributors undercondition (1), the existence of competitive fringe distributors is negligible under exclusive dealing regardless of the
proposer role.
23

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 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 using competitive fringe distributors under the term (cE , 0). This is because the per production cost of U E ’s product in such a case is strictly higher than that of U I ’s product using DI (i.e.,cE + ∆ > cI ).

14and (cE , Π∗ (cE ) − Π∗ (cI )) to DI , respectively.24 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 is not so efficient. In this case, U I cannot protect
the local upstream market from the entry of U E through exclusive contracts for any 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
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 the pair of U E and a competitive fringe distributor can be a competitive threat to the pair of U I and DI in the off-path event whereby DI rejects U E ’s offer and accepts
U I ’s offer in Stage 3; 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; then, the resulting expected
profits are presented in equation (6).
24

U E ’s offer is derived as follows. If DI rejects U E ’s offer, U E trades with a competitive fringe distributor under
the term (cE , 0) off the equilibrium path. Under this term, the per unit production cost of the chosen competitive fringe
distributor selling U E ’s product becomes cE + ∆, which is not lower than p∗ (cI ); namely, by trading with U I , DI setsp∗ (cI ), earning Π∗ (cI ) off the equilibrium path. Thus, U E needs to compensate DI for this profit in the equilibrium.

15

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 using its outside option
to trade with a competitive fringe distributor under the term (cE , 0). 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
with probability 1 − β, and then U I and U E offer (cI , 0) and (cE , Π∗ (cE ) − Π(cE + ∆, cI )) to DI ,respectively.25 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 thanΠ∗ (cE ) − Π∗ (cI ) in Section 4.1. U E ’s outside option 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)

Finally, we consider the game in Stage 1. By substituting equations (6) and (8) into condition(5), we find that 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). The following proposition summarizes the results:
Proposition 2. Suppose that cI − ∆ ≤ cE < p∗ (cI ) − ∆; U E is efficient. U I can protect the local
upstream market from the entry of U E through exclusive contracts if DI has weak 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
25

U E ’s offer is derived as follows. If DI rejects U E ’s offer, U E trades with a competitive fringe distributor under
the term (cE , 0) off the equilibrium path. Under this term, the chosen competitive fringe distributor sells U E ’s productat p = cE + ∆, which is lower than p∗ (cI ). By trading with U I , DI matches this price, earning Π(cE + ∆, cI ) off theequilibrium path. Thus, U E needs to compensate DI for this profit in the equilibrium.

16

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. Because 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 result 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.

Remark (The inverted vertical relationship)

Inverting the vertical relationship, we obtaincompanion results of Propositions 1 and 2 for downstream entry (available in the Supplementary
Appendix). The results under downstream entry imply that abundant options of input suppliers may
facilitate downstream exclusion through exclusive supply contracts. Moreover, under the inverted
relationship, we can apply our exclusion mechanism to situations where a multinational downstream entrant needs a local firm, such as a local manufacturer or logistics company, to procure acomplementary input.

17

4.3 Comparative statics
From now on, we explore the relationship between the existence of an exclusion equilibrium in
Proposition 2 and the efficiencies of U E and competitive fringe distributors, cE and ∆. Although
we cannot obtain a clear-cut property of the partial differential ∂β̂(cE , cI , ∆)/∂cE , we obtain thefollowing result as a corollary of Proposition 2:
Corollary 1. β̂(cE , cI , ∆) → 0 as cE → p∗ (cI ) − ∆, and β̂(cE , cI , ∆) → Π∗ (cI )/Π∗ (cE ) < 1 as
cE → cI − ∆; that is, β̂(cE , cI , ∆) is higher for lower cE within cI − ∆ ≤ cE < p∗ (cI ) − ∆.
Next, for ∂β̂(cE , cI , ∆)/∂∆, we obtainΠ∗ (cE ) − Π∗ (cI )∂Π(cE + ∆, cI )∂β̂(cE , cI , ∆)
=− ∗
< 0,
∂∆
{Π (cE ) − Π(cE + ∆, cI )}2∂∆
for all ∆ ∈ (cI − cE , p∗ (cI ) − cE ). Thus, we have the following proposition.
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 contracts as the alternative distribution channels become
efficient; that is, ∂β̂(cE , cI , ∆)/∂∆ < 0 always holds.
Corollary 1 and Proposition 3 show that entry is less likely as the efficiencies of U E and thecompetitive fringe distributors improve for cI − ∆ < cE < p∗ (cI ) − ∆. An increase in the efficiencies
benefits U E after entry because U E ’s outside options work more effectively, and U E has a strong
incentive for entry. However, from the perspective of DI , the entry of U E in such a situationis harmful because DI earns lower profits when U E enters. Thus, DI is more 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
18

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.

4.4 Welfare
We examine the effect of exclusive contracts satisfying condition (5) on global welfare. For simplicity, we assume that the fixed cost of entry is negligible.
We first consider the consumer surplus, which is defined as
Z Q(p∗ (z))∗
CS (p (z)) ≡P(s)ds − p∗ (z)Q(p∗ (z)).
0Consumer surplus under exclusive dealing (entry) is CS a ≡ CS (p∗ (cI )) (CS r ≡ CS (p∗ (cE ))).
Using the first-order condition of D’s profit maximization problem, the implicit function theorem
implies that
Q′ (p∗ (z))> 0,p (z) =
2Q′′ (p∗ (z)) + (p∗ (z) − z)Q′′ (p∗ (z))∗′

where the inequality follows the second-order condition. Thus, exclusive dealing increases theequilibrium price; p∗ (cI ) > p∗ (cE ). Because CS (p∗ (z)) is decreasing in p∗ (z), we have CS a < CS r ;exclusive dealing is harmful for consumers.
We next consider the global producer surplus, PS ω ≡ πωDI + πωU I + πωU E , where ω ∈ {a, r}. Fromequations (6) and (8), we have PS a = Π∗ (cI ) < Π∗ (cE ) = PS r ; exclusive dealing reduces global
producer surplus.
Finally, we consider global total surplus, T S ω ≡ CS ω + PS ω . From the discussion presented
above, exclusive dealing reduces global total surplus; i.e., T S a < T S r .
Proposition 4. Exclusive dealing to deter the entry of U E is not desirable from the perspective ofglobal welfare.
Note that global total surplus here coincides with domestic total surplus when U E is a domestic
supplier. We can also consider domestic total surplus when U E is a foreign supplier, T S dω . The
19

difference from global total surplus arises in domestic producer surplus, PS dω ≡ πωDI + πωU I . If
condition (5) holds, we have PS da ≥ PS dr , which implies that exclusive dealing does not reduce
domestic producer surplus. Thus, there exists a possibility that exclusive dealing is desirable fromthe perspective of domestic total surplus. The result depends highly on the level of β. Whenβ = β̂(cE , cI , ∆), we have PS da = PS dr , which leads to T S da < T S dr ; exclusive dealing reduces
domestic total surplus. Conversely, as β → 0 and cE → cI − ∆, we have PS dr → 0; the entry of
U E does not benefit DI because U E extracts a large part of industry profits. In this case, exclusive
dealing can increase domestic total surplus. We can derive such a result under a linear demandsystem.26 These results provide important insight for competition policy. Prohibiting exclusive
dealing for entry deterrence purposes may not always be desirable for the case of multinational
entry. Even when a foreign multinational entrant is considerably efficient, the antitrust authority
may allow exclusive dealing to protect domestic total surplus.

5 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 situation inwhich signing exclusive contracts is achievable, 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 a multinational 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; in other 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 entry26

The results are available upon request.

20

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.
Besides, we show that such exclusion harms global total surplus.
Note that this study’s exclusion mechanism works well if the entrant manufacturer is 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 features ofmultinational 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 perspective 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.
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 suitable
21

for exclusive dealing when an efficient giant firm tries to enter a new market in other countries orregions.
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.

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29

A Supplementary Appendix for “Defending Homeagainst Giants: Exclusive Dealing as a Survival Strategy
for Local Firms”
Hiroshi Kitamura*

Noriaki Matsushima†

Misato Sato‡

October 3, 2021

Abstract
This appendix provides an extension analysis of Kitamura, Matsushima, and Sato (2021a).
Appendix A extends the analysis to the case in which U E is highly efficient. Section B briefly
discusses a reversal setting in which entry can occur in the downstream market.

JEL classification codes: L42, L12, F23, C72
Keywords: Exclusive dealing; Vertical relation; Antitrust policy; Multinational firms* 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

A When U E is highly efficientThis subsection explores the case in which condition (2) in Kitamura, Matsushima, and Sato
(2021a) does not hold. In this subsection, we assume that the fixed cost of entry satisfies thefollowing conditions:
F < F < F,

(1)
where
F ≡
F ≡

(
(

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

If the first inequality in condition (1) 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 (1) holds, entry into the upstream market is profitable for U E when DI rejects the
exclusive offer in Stage 1.1
Note that when DI accepts the exclusive offer in Stage 1, the equilibrium outcomes coincidewith equations (6) as long as condition (1) holds in Kitamura, Matsushima, and Sato (2021a).
Therefore, as presented in Kitamura, Matsushima, and Sato (2021a), 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
1

When condition (2) in Kitamura, Matsushima, and Sato (2021a) and cE < p∗ (cI ) − ∆ hold, F = 0 and F =(1 − β)(Π∗ (cE ) − Π∗ (cE + ∆, cI )).

1

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 + ∆), andDI 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 ), whereas U I and DI earnnothing.
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 ), whereas U I and DI earn nothing. The resulting expected profits are summarized
as follows:
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 + ∆)(2)

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) in Kitamura, Matsushima, and Sato (2021a) and (2), we find that condition(5) in Kitamura, Matsushima, and Sato (2021a) 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
E2

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 (1) holds. The following proposition summarizes these results:
Proposition A.1. Suppose that condition (2) in Kitamura, Matsushima, and Sato (2021a) does nothold; When the fixed cost of entry satisfies condition (1), 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 A.1 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.

B Downstream exclusion
This appendix introduces the case of exclusive supply contracts by inverting the vertical relationin Kitamura, Matsushima, and Sato (2021a). 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 from alternative supply chains by
incurring an additional marginal cost. We regard the opportunity as an outside option for manufacturers. As in Kitamura, Matsushima, and Sato (2021a), 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 in3

which manufacturers differ in exogenous marginal costs by inverting the cost structure in Kitamura,
Matsushima, and Sato (2021a). Second, we consider the case in which manufacturers differ in thetransformational technology of input supplied by suppliers, following Kitamura, Matsushima, andSato (2021b).2
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. As
demonstrated in Kitamura, Matsushima and Sato (2021a), DI cannot protect the local downstream
market when the alternative supply chain is too inefficient or DE is marginally more efficient than
DI . Thus, the exclusion mechanism in this study remains valid in various settings.
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 B.1. Thereafter, we consider
the case in which downstream firms differ in the transformational technology of input supplied bysuppliers in B.2.

B.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 Kitamura, Matsushima, and Sato (2021a), 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.
2

Kitamura, Matsushima, and Sato (2021b) consider the second case in the absence of alternative supply chains
and show that exclusion can be an equilibrium outcome under linear wholesale pricing.

4Assumption B.1. dE satisfies the following properties:(3)dE < P(0) − c0 ≤ dI .

(4)

dE + c0 ≥ dI
As in Kitamura, Matsushima, and Sato (2021a), 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.3 In
Stage 3, existing firms negotiate and make contracts for two-part tariffs. As in Kitamura, Matsushima, and Sato (2021a), the industry profit is allocated by 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:(5)

πaU I = (1 − β)Π∗ (dI ), πaDI = βΠ∗ (dI ), πaDE = 0.
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
3

Similar to the discussion in Appendix A, we have exclusion results even when condition (4) does not hold. The
results are available upon request.

5

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.4 By contrast, when manufacturers become proposers with probability β, DI
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 )(6)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 ),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 Kitamura, Matsushima, and Sato (2021a), there is an exclusion equilibrium if andonly if condition (5) in Kitamura, Matsushima, and Sato (2021a) holds. By substituting equations(5) and (6), 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.
4

In contrast to the upstream exclusion in Kitamura, Matsushima, and Sato (2021a), 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 tooffering 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 withsuch offers. The results are available upon request.

6

Proposition B.1. Suppose that conditions (3) and (4) 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 )).

B.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
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.
7

Assumption B.2. k satisfies the following properties:(7)

kc0 < P(0) ≤ c0 .

(8)

kc0 ≥ c.
We also assume that, as stated in Section B.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 1.5
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:(9)

πaU I = (1 − β)Π∗ (c), πaDI = βΠ∗ (c), πaDE = 0.
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,
5Similar to the discussion in Appendix A, we have exclusion results even when condition (8) does not hold. The
results for the case of low k and high c are available upon request.

8

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))(10)

if c < p∗ (c) ≤ kc0 ,if c ≤ kc0 < p∗ (c),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 (9) and (10), we find that condition (5) in Kitamura, Matsushima, andSato (2021a) 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)Note that we have β̃(k, c, c0 ) ∈ (0, 1). The following proposition summarizes the result.
Proposition B.2. Suppose that conditions (7) and (8) 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 )).

References
Kitamura, H., Matsushima, N., and Sato, M., 2021a. Defending Home Against Giants: Exclusive
Dealing as a Survival Strategy for Local Firms. ISER Discussion Paper No. 1122, Available
at SSRN: https://ssrn.com/abstract=3799791.
Kitamura, H., Matsushima, N., and Sato, M., 2021b. How Does Downstream Firms’ Efficiency Affect Exclusive Supply Agreements? ISER Discussion Paper No. 878, Available at SSRN:
http://ssrn.com/abstract=2306922.

9