Division of Research School of Business Administration October 1988 THE DESIGN AND DURATION OF CONTRACIS: STRATEGIC AND EFFICENCY CONSIDERATIONS Working Paper #589 Scott E. Masten and Edward A. Snyder The University of Michigan FOR DISCUSSION PURPOSES ONLY None of this material is to be quoted or reproduced without the expressed permission of the Division of Research Copyright 1988 University of Michigan School of Business Administration Ann Arbor, Michigan 48109

*Prepared for the Conference on the Law and Economics of Contracts, Duke University, April 8-9, 1988. To be published in a forthcoming issue of Law and Contemporary Problems. The authors would like to thank Deborah DeMott, Paul Godek, James Meehan, and participants at the conference and at seminars at the University of Michigan and the Antitrust Division, Department of Justice. **Associate Professor of Business Economics and Public Policy, The University of Michigan School of Business Administration. ***Assistant Professor of Business Economics and Public Policy, The University of Michigan School of Business Administration.

The Design and Duration of Contracts: Strategic and Efficiency Considerations I. Introduction. A vast body of economic theory is concerned with the ways in which parties design contracts to align incentives and promote efficient exchange. An alternate view, however, ascribes to contracts a more sinister purpose —that 2 of excluding or otherwise disadvantaging rival firms. Although the latter arguments have tended to target a specific set of suspect practices such as tie-in and exclusive dealing arrangements, recent efforts have begun to associate strategic objectives with more conventional pricing and incentive terms in contracts, including such common provisions as multi-part pricing schedules and stipulated damages clauses.3 In the course of developing and applying the antitrust laws, the courts have analyzed the effects of various contractual provisions on competition. The resulting body of law recognizes that contracts have the potential to exclude competitors but also that exclusion can serve efficiency purposes. The broadening of exclusion claims to include the strategic use of common contractual designs, and the corresponding potential to challenge a widely used class of contractual arrangements on antitrust grounds, stands to complicate rule-of-reason analyses of anticompetitive exclusion and raises broad public policy questions about the appropriate status of contracts in general. At a minimum, distinguishing situations in which contract provisions have strategic purpose from those in which such terms serve a more positive function becomes an important task.

2 Toward that end, we begin this paper by analyzing the efficiency and strategic roles of some common contractual provisions. In particular, we examine the assumptions underlying the results of both efficiency and strategic models of stipulated damage clauses and attempt to identify conditions conducive to using contracts for these conflicting purposes. To gain insight into the practical motives and processes involved in designing contract terms and, particularly, to see whether there is evidence that these terms played a strategic role in actual settings, we then examine a number of cases in which contracts governing the relationship between the transactors involved stipulated damage or similar provisions affecting the incentives of a buyer to switch to an alternative supplier. II. Stipulated Damages and the Economics of Contracting. The desire to design contract terms to promote efficient adaptation without the need for costly court intervention is the theme underlying most efficiency analyses of contracting. Given the substantial interval that often exists between the time a contract is entered and executed, significant changes in the environment surrounding the transaction are likely to occur, requiring adjustments in the behavior of the parties. Because contracts that stipulate the optimal response of each party to each conceivable contingency are too costly to write and enforce, transactors tend to rely on a combination of common law rules and relatively simple, easily-enforced contract clauses to accommodate change. Among a number of common contractual arrangements that have been interpreted in this light are two-part pricing schedules, stipulated damage provisions, andin bill contracts. Each perits the quantity provisions, and minimum bill contracts. Each permits the quantity

3 transacted under the contract to be adjusted in response to market conditions and, by relating the incremental price paid by the buyer to the seller's incremental cost, establishes incentives to respond efficiently. Moreover, compared to more elaborate arrangements, these schemes are easy to write and enforce, usually requiring only properly authorized orders and receipts to verify performance. From an efficiency perspective, the reason transactors enter contracts in the first place is to protect the relationship from strategic behavior in the form of either costly haggling over quasi-rents or free-riding on services or information provided by one of the transactors. The former problem arises where one or both parties have invested in reliance, or relationship-specific 8 assets, in support of the transaction. Because such investments have a higher value in their intended than next best use, parties have an incentive to engage in haggling or other forms of opportunism in hopes of influencing the distribution of the resulting quasi-rents. Contractual guarantees reduce the incidence of such behavior by restricting the ability of one party to extort concessions from the other by threatening not to perform. Freeriding, on the other hand, is a potential hazard, for example, where the cost of providing information or services associated with a purchase is included in the price of the product. If the unpriced service or information acquired from the original seller can be used with a competitor's product, the purchaser will have an incentive to avoid paying for the service by buying the product from a "no-frills" source. Contracts that restrict a purchaser's ability to use competing products can foster the development and provision of such services by suppliers.g

4 The notion that contracts, rather than deterring strategic behavior, are themselves strategic devices stands in sharp contrast to this view. Instead of constraining free-riding or haggling between the parties to an exchange, contracts are perceived as a means of restricting the actions of third parties, usually suppliers seeking to enter the market. Thus, two-part prices and stipulated damage provisions, instead of promoting efficient adjustment, establish entrance fees for rival firms, with the result that some low-cost firms are foreclosed from competing for business or deterred from entry. In the remainder of this section, we examine how these competing theories interpret the use of stipulated damages. For purposes of analysis, stipulated damage provisions have the advantage of having received detailed attention from both the strategic and efficiency perspectives and also of being analytically tractable. The equivalence between stipulated damages and two-part pricing schemes in many settings also permits us to generalize our results to a broader class of contracts. A. Stipulated damages and efficient breach. In models of efficient breach,0 parties to a contract face uncertainty about some dimension of the transaction that makes it possible that actual performance will not in fact be desirable ex post. The uncertainty may be about the seller's costs, the buyer's valuation, or the availability of alternative buyers or sellers.ll The critical element is that in some states of the world the joint surplus between contracting parties may be larger if they do not perform the contract as originally intended.

5 Recognizing this possibility, the courts generally permit one party to discharge his obligation by compensating the other for lost profits. To see that the lost-profit or "expectation" measure of damages leads to efficient breach, consider a setting in which the buyer's valuation, v, and the supplier's cost of production, c, of a particular input are determinate, but there is uncertainty about the cost, s(e), of acquiring supplies from an alternative source. If the cost of the alternative supplies falls below the price, p, agreed to in the contract (that is, s(e) < p), the buyer will wish to breach the contract with the original seller. Efficiency, however, requires that the buyer honor the contract with the original producer unless the cost of alternative supplies falls below the seller's opportunity cost, or s(e) < c. Thus, for values of s(e) that fall between the original seller's costs and the contract price (c < s(e) < p), the buyer will wish to breach even though breach is inefficient. If the courts set damages, 8, equal to the seller's lost profits in the event of breach, or p - c, then the buyer would be encouraged to perform the contract when it is efficient to do so. Specifically, the buyer would breach only if v - s(8) - 6 > v - p or, equivalently, when s(e) < p - 6. Setting damages, 6, equal to the seller's lost profits would induce the buyer to breach when s(e) < c (see figure 1). As illustrated, the buyer is given the efficient efficient breach performance I I. I > s(e) c p 6* Figure 1

6 incentive to buy from the low cost supplier, which is, of course, efficient. More importantly for the issue at hand, the level of damages that would maximize expected joint-profits were the parties to choose to stipulate damages in the contract rather than rely on the courts is also lost 12 profits. The reason that parties might choose to stipulate damages is to avoid the costly process of establishing court determined awards where the seller's costs may be difficult for the courts to assess but are reasonably stable and recognized by the parties at the time they enter the contract: "The advantages of stipulating in advance a sum payable as damages are manifold. For both parties, it may facilitate the calculation of risks and reduce the cost of proof. For the injured party, it may afford the only possibility of compensation for loss that is not susceptible of proof with sufficient certainty. For society as a whole, it may save the time of judges, juries, and witnesses, was well as the parties, and may cut the expense of litigation."13 Finally, notice that the difference between the amount the buyer pays if he performs the contract and the amount if he breaches is p - (p - c) = c. In other words, expectation damages make the incremental cost of acquiring supplies from the seller equal to the seller's marginal cost. An equivalent way of writing the contract would be to adopt a two-part pricing schedule stipulating a fixed component equal to the damage level identified above and a per unit price equal to the seller's marginal cost. Hence, the generalization of the current analysis to that of two-part prices is straightforward. Overall, circumstances in which there is (i) uncertainty about the buyer's alternatives and (ii) relatively stable, though possibly unverifiable, costs of production are consistent with the efficient use of stipulated damages.

7 As noted earlier, the desire to protect investments from free-riding or costly opportunistic haggling motivates the adoption of explicit contractual agreements in the first place. The duration of those agreements is likely to reflect the longevity of the investments and, where the distribution of rents is at issue, the degree to which the assets are specific to the relationship. 14 B. Stipulated damages as a barrier to entry. A recent article by Philippe Aghion and Patrick Bolton raises the possibility that contracts containing precisely the type of incentive provisions discussed above can be used strategically to create a barrier to entry.15 Indeed, the setting in which Aghion and Bolton develop their results is remarkably similar to the one associated with the efficient use of stipulated damages in the preceding 16 section.1 Specifically, the costs of the incumbent seller, c, are determinate and known, as is the buyer's reservation price, v. But there is uncertainty about the costs, s(G), of acquiring supplies from an alternative source. Again, the parties face a choice of contract terms including the price and the level of damages to be stipulated in the contract. Unlike the efficient breach models, parties in the strategic model optimally choose a damage provision in excess of the seller's lost profits. As a result, the buyer is induced to deal with the incumbent seller too often relative to the optimum, thereby deterring entry by the rival for a range of costs over which entry would be efficient. Thus, despite similarities in the underlying environment, damage provisions, rather than promoting efficient breach, serve as a barrier to entry.

8 A closer inspection of the Aghion-Bolton model reveals the source of this disparity. As in the efficient breach model, the seller receives p - c when the contract is performed and S when the buyer breaches. The buyer also nets v - p when he buys from the original supplier. But, unlike the previous model, the buyer cannot obtain supplies from an alternative source at their cost, s(e), and instead pays a price above this level. The ability of the "entrant" to earn excess profits, that is, to set p > s(O), creates the incentive for the original transactors to engage in strategic behavior. Since the new seller must charge a price below p - S to induce the buyer to switch, stipulated damages determine the maximum price that the entrant can charge. Assuming the new supplier charges the highest price sufficient to induce the buyer to switch (i.e., pe = p - 6), the level of stipulated damages that maximizes the expected joint profits of the original contractors satisfies P = p - c + 17 where the probability of breach, P, is Pr[s(9) < p - 6], and P' is the marginal probability of P with respect to a change in p - 6.18 Thus, the strategic model implies that the optimal penalty from the point 19 of view of the parties is one that exceeds the lost profit measure by P/P'. Given a contract price, p, permitting some entry gives the seller a positive probability (P > O) of receiving an amount in damages, 6, greater than his 20 profits if the buyer performed, p - c.2 In designing the contract, the original transactors trade off the gains foregone when an efficient entrant is excluded against the lower price the new supplier must accept when entry does in fact occur. The result is that the buyer is.induced to switch to the alternative seller too infrequently relative to the social optimum (see

9 entry deterred | ---— I I --- — I 1- — > s(e) s c p -- V 6' Figure 2 figure 2). Unable to supply the buyer, a rival with costs between s and c is discouraged from entering. The role of contracts in the strategic model is to create an entry barrier that extracts part of the potential gains from trade from rival firms. Using damages, this is accomplished by setting a penalty for breach in excess of the efficient level; with a two-part pricing schedule, the same effect is achieved by setting a per unit price below the incumbent's marginal cost. The duration of contracts, meanwhile, is limited only by the desire of the incumbent to signal the probability of entry. If the incumbent perceives a high probability of entry, he will want to protect himself by writing a longer term contract, which the buyer will only agree to if the contract price is low; if the probability of entry is low, then the seller adopts shorter term but higher price agreements.21 III. Requirements for the Strategic Use of Damage Provisions The source of the disparity in the results of the strategic and efficiency models of stipulated damages is readily apparent. Whereas the efficiency model presumes that new supplies are available at their true opportunity cost, the strategic model assumes the new supplier charges a price just

10 sufficient to get the buyer to switch. In the latter case, the original transactors can extract some of the entrant's expected rents by stipulating "excessive" damage levels that "commit" the buyer to rejecting bids above s. The potential inefficiency of excluding an entrant with costs between s and c arises because the original transactors cannot discriminate between a highcost and low-cost entrant. For this strategy to be successful, two factors are critical: First, the contract must credibly commit the parties to not dealing with the entrant except on the terms of the contract. And second, the entrant must be able to earn positive rents. In this section, we evaluate these two requirements in turn. A. Commitment and the law of contracts. The importance of commitment in the strategic model can been seen by examining the original transactors' optimal response to entry in the absence of a binding agreement. Before an entrant made a bid, the original transactors would have no specific information about the entrant's actual costs, leaving the parties in the position of a nondiscriminating monopolist. Thus, it would be in the interest of the parties to announce their intention to reject bids below s. Once a bid was made, however, the parties' incentives to accept or reject that bid would change. An entrant who met the transactor's reserve price would reveal, by his action, that his costs were no higher than s and were probably lower. The original transactors could exploit this information to appropriate a larger share of the entrant's expected rents by demanding further price concessions. On the other hand, if no bid was made given the

11 reserve price set by the transactors, the incentive would be to raise the minimum acceptable price.2 Thus, although a take-it-or-leave-it offer would maximize the expected profits of the original transactors, their ex post incentive to alter the terms exposes the need for a mechanism to discourage deviations from the original terms. If take-it-or-leave-it offers lack sufficient commitment, then bargaining processes will determine between whom and at what price exchange will take place.23 The mechanism ostensibly serving to commit the parties to their best takeit-or-leave-it offer in the strategic model is contracting. Indeed, as long as the damage provision described in the model is enforceable, the buyer will be prevented from switching to the new supplier at bids above s. Notice, however, that constraining the buyer's ability to accept price offers is not enough. Since the incumbent can avoid his own production costs, c, by procuring supplies from the lower-cost entrant, subcontracting produces gains whenever s(G) < c. Thus, for the contract successfully to deter entry, it must also limit the ability of the seller to deal with the entrant. A crucial issue then becomes whether contracts in fact serve the commitment function postulated in the strategic model. An examination of applicable laws governing contracts suggests they may not. First, contracts generally permit a supplier to meet his contractual obligations by offering substitute performance. The Uniform Commercial Code, for example, describes "both delegation of performance and assignability as normal and permissible incidents of a contract for the sale of goods."24 Thus, the incumbent seller is normally at liberty to delegate performance or, alternatively, to procure supplies fro a third party.25 In this respect, a contract can be thought of supplies from a third party. In this respect, a contract can be thought of

12 as mainly affecting who negotiates with the low-cost supplier rather than whether or not such negotiation can take place.26 Second, the law confers on the parties to a contract the right to modify 27 or rescind the terms of their agreement by mutual consent. By splitting the gains from dealing with the entrant three ways instead of two, the position of both parties to the contract can be improved relative to the status quo, satisfying a necessary condition for a modification to be negotiated and accepted. The incentive to renegotiate once an entrant has made a bid weakens the credibility of take-it-or-leave-it offers by the incumbents. Thus, even a "no substitute performance" clause is likely to fall to the ex post mutual interests of the parties. Finally, although the common law gives the parties the latitude to stipulate damages, it is an established rule of law that damages must be reasonable in "in light of the anticipated or actual loss caused by the 28 breach."28 Stipulated damages in excess of this level are regarded as 29 penalties and therefore unenforceable.9 If the courts restrict damages to the efficient level, supply by the low-cost provider will occur no matter what share of the gains from trade the entrant can command for his product. Thus, in principle, the common law would not support restrictions on even the buyer's ability to deal with a more efficient entrant. In practice, of course, these common law impediments to strategic contracting do not make moot the issue of anti-competitive foreclosure. Challenging the legality of stipulated damages, as with any legal action, is certain to impose some nonrecoverable enforcement costs on the plaintiff. These costs include the obvious such as witness time and attorney's fees, but may also include reputation effects that raise the pl-aintiff's future costs

13 of contracting with other parties. The need to incur such costs may deter a breaching party from filing suit to reduce damages. In addition, courts may choose to err in favor of the contract where the incumbent's costs are particularly difficult to ascertain, as is likely to be the case where 30 damages were indeed stipulated for efficiency reasons. Nevertheless, several factors mitigate against the survival of the penalty: First, the reality that strategic damages exceed lost profits where the provisions were chosen strategically favors the complainant in a trial of fact. Second, the savings to a buyer from dealing with a low-cost supplier provide the buyer with the incentive to seek relief from contractual penalties; the greater the inefficiency, the greater the gains to successful litigation and the larger the incentive to sue. Finally, litigation represents the last and probably least likely process though which to achieve a reduction in the penalty given the mutual gains to a negotiated modification. In sum, the ability to use contracts strategically may be undermined in any of several ways. The presumed legality of delegated performance, the illegality of penalties, and the potential for ex post agreements to either raise or lower the entry fee, each tends to undermine the credibility of the threat not to deal with the entrant except on the terms of the contract. In practice, the use of contracts as a barrier to entry must be accompanied (i) by restrictions on the delegation of performance imposed by either the nature of the work or explicit provision to prevent the seller from dealing with the entrant, and (ii) by high litigation and bargaining costs to prevent a legal or negotiated adjustment to the contract. Raising the costs of switching will deter some switching, but the resulting inefficiencies represent as much a failure in negotiations as market foreclosure. Indeed, the economic

14 literature on incentive compatibility sometimes refers to the type of inefficiency generated in the present model as a "cost of information," suggesting the irremediability of the problems identified by Aghion and Bolton.31 B. Entry and economic rents. In addition to these commitment requirements, the ability to use contracts strategically depends on the extent to which the damage provisions alter the entrant's price. The less power the entrant has to set price, the less the advantage to stipulating an excessive damage. To the extent, for example, that the buyer wields pure bargaining power to some degree over the new supplier, the incentive to use contracts for strategic purposes is mitigated. In the extreme, if the new supplier is unable to charge a price above his costs, the optimal damage becomes the efficient 32 one. The latter would occur, for instance, if the uncertainty about s(G) represented fluctuations in the price of a market substitute. In that case, competition would keep the entrant's price at marginal cost and thereby eliminate the incentive to design contracts strategically.33 In the Aghion-Bolton model, there is only a single entrant who has, in effect, full power to set price at the buyer's reservation value. This raises a basic question about the nature of entry. Since the entrant expects positive profits, why are other firms not attracted to the market? If the costs of entry are the same for all firms and it makes sense for one firm to enter, then it would also make sense for any firm. Competition for contracts to serve the buyer would guarantee that all expected rents accrue to the buyer.

15 For an entrant to expect an above normal return requires differential barriers to entry.3 In other words, the entrant must have a discrete advantage over other potential suppliers, generating the possibility of earning economic rents. If the source of that advantage also reveals the identity of the firm best situated to enter, however, the buyer has an incentive to integrate that supplier and produce his inputs needs internally. By internalizing the rents accruing to "entry," integration eliminates the complicity of the buyer, who would not sign a contract with the incumbent designed to extract rents from himself. At a minimum, the possibility of internal production limits the potential rents of an outside supplier. In general, the existence of competition to supply the buyer undermines the ability to use contracts strategically. Thus, in addition to the commitment requirements discussed above, a necessary condition for stipulated damages to serve strategic purposes becomes some form of differential barriers to entry. Even then, bargaining power on the part of the buyer reduces both the incentive to set excessive penalties and the amount of entry actually deterred. IV. Evidence of the strategic use of damages. A number of studies have examined actual contracting practices and offered 35 plausible efficiency rationales for observed provisions.35 Studies scrutinizing contracts for strategic effect, however, are relatively scarce. To get a sense for whether the conditions necessary for strategic use of contracts are common in practice, we examined a sample of antitrust cases in which the design and duration of the contracts played a role. Such a sample

16 is probably not representative of contracting practices in general but, if anything, is biased toward a finding of strategic effect. Our search revealed only five reported decisions in which stipulated damage provisions or multi-part pricing schemes were alleged to exclude 36 efficient rivals. The fewness of cases may reflect a variety of factors, one of which is the recent vintage of the literature on strategic use of these provisions. With respect to stipulated damages, the lack of enforceability of penalties may also be a significant factor. On the other hand, the infrequency may indicate that the underlying conditions required for anti-competitive exclusion to occur (the ability of entrants to earn positive profits, the reliance on non-discriminatory commitments by incumbents, the inability to verify the entrant's costs) are in fact uncommon. Although the cases often involved additional concerns, in keeping with our preceding analysis, our discussion concentrates on whether the circumstances of each case permit a strategic interpretation of the contract provisions, or whether efficiency considerations (either investments in relationship-specific assets or free-rider problems) serve better to explain the use and design of the agreements adopted. We begin by discussing in some detail the case that, in our opinion, conformed most closely to the assumptions of the strategic model, Barry Wright Corp. v. ITT Grinnell Corp. We then examine the two cases offered by Aghion and Bolton as illustrations of their arguments, United States v. United Shoe Machinery Corp. and Automatic Radio Manufacturing Co. v. Hazeltine Research Inc., and relate these to relevant aspects of some related cases.

17 Barry Wright Corp. v. ITT Grinnell Corp.37 Consistent with the strategic model, this dispute involved just three parties: Pacific Scientific Corp. ("Pacific"), an incumbent supplier of "mechanical snubbers" for nuclear power plants; ITT Grinnell Corp. ("Grinnell"), who makes and installs nuclear plant pipe systems and was Pacific's major customer; and Barry Wright Corp. ("Barry") who sought to enter the business of producing mechanical snubbers. Until 1975 most snubbers, which act as shock absorbers for pipe systems, were hydraulic. At that time, architects and engineers for nuclear plant manufacturers began to specify mechanical snubbers due to leakage problems with hydraulic units. Only Pacific's mechanical snubber received Nuclear Regulatory Commission approval, making Pacific the effective monopolist in the late 1970s.38 At about the time that Barry entered the picture, Pacific offered Grinnell price discounts if Grinnell would agree to long-term contracts containing implicit cancellation penalties. Specifically, in the Fall of 1976, Pacific offered Grinnell additional 5 and 10% discounts9 on its product if Grinnell would sign contracts specifying large dollar orders. Grinnell was not prevented from purchasing additional units from other suppliers, but the record shows that the dollar amounts approached Grinnell's expected needs. In addition, the contract contained a clause, which was at the center of Barry's claims, requiring Grinnell to purchase from Pacific 100l of the dollar amounts stipulated in the contract. In January of 1977, Grinnell and Pacific agreed to a one year contract for $4.3 million, and in May of that year signed two additional one year agreements stipulating purchases of $6.9 million in 1978 and $5 million in 1979. The 1977 discount prices applied for the first two years with an

18 inflation adjustment for the final year. Barry, the would-be entrant, brought suit against Pacific and Grinnell, arguing that the price cuts offered by Pacific were predatory and that the cancellation clause was exclusionary. In particular, Barry argued that the cancellation provisions compelled contract performance and, except to the extent that Grinnell's needs exceeded the dollar amounts specified in its contract with Pacific, effectively excluded Barry. Although on the surface these facts fit the Aghion-Bolton scenario, the record reveals important details that bear on the the nature and purpose of the contracts. First, the history of the relations among the parties and their behavior provides a rich example of real world bargaining. In particular, Grinnell's actions prior to signing the contracts with Pacific show clearly that Grinnell was not a passive buyer whose agreements with Pacific were intended to exclude Barry as a second source. On the contrary, Grinnell was an active participant in Barry's efforts to produce mechanical snubbers. As noted earlier, Grinnell became a major customer of Pacific when the market turned from hydraulic to mechanical snubbers. During this period, Grinnell attempted to develop its own snubber production capability,40 but having failed at these attempts, sought to have Barry, which had previously produced a mechanical snubber prototype for aerospace applications, manufacture snubbers for Grinnell's use. Indeed, the terms of the agreement between Grinnell and Barry resembled a joint venture.41 Grinnell agreed to pay up to $294,000 of Barry's development costs and to buy snubbers exclusively from Barry, committing itself to between $9 and $15 million worth of purchases in the period between 1977 and 1979. According to the

19 agreement, Barry would sell only to Grinnell for this period and left Grinnell the option to buy Barry's production facilities within the three year period. Only when it became evident that Barry would not be able to meet its contractual obligations did Grinnell open negotiations with Pacific to meet its snubber needs. Furthermore, even though it was clear early on that Barry could not qualify its products by January 1977, Grinnell rejected Pacific's initial offer of price discounts tied to placing a $5.7 million order to cover its 1977 requirements. Instead, Grinnell placed a $1 million order at the usual, undiscounted price. Barry continued to have production problems and in January 1977 signalled to Grinnell its inability to deliver small units until August 1977 and larger units until February 1978. Grinnell informed Barry that it had breached their earlier agreement and subsequently entered into the three contracts with Pacific that assured Grinnell of the discount prices through 1979. Contrary to the strategic model, the facts in this case reveal that the buyer (Grinnell) had substantial bargaining power in its dealings with both the incumbent (Pacific) and the entrant (Barry). Indeed, the record indicates that the negotiations took place in an ongoing fashion with no party relying on non-discriminatory final offers. Moreover, attempts to enter the industry came either directly from Grinnell or with Grinnell's direct participation. In paying Barry's development cost and stipulating per unit prices up front, Grinnell assured itself prices at or near Barry's marginal costs. Under such circumstances, it' is unlikely that Grinnell would have acquiesced to contracus desied to tsextract the surplus from that arrangement, which mainly accrued to itself.

20 Second, it appears that the contract generated cost savings for Pacific. The production of snubbers involved lags of about six months between orders and delivery. The court record establishes that Pacific realized substantial economies from being able to rely on a high level of production: "The price discount, by securing the firm order, allowed Pacific to operate this capacity more efficiently, saved Pacific money, and thereby produced more profit than a higher price (without the firm order) could have done, without *,42 regard to any impact on Barry.42 Nor did the duration of the contracts seem excessive in light of these lags and the small numbers negotiating setting in 43 which they were written. Grinnell's exhibited reluctance to enter the contracts with Pacific was eroded only as it became increasingly evident that Barry would not become a viable second source. In fact, Grinnell agreed to large-volume, long-term agreements with Pacific only after it had become unmistakably clear that Barry would be unable to produce a competitive substitute over any reasonable horizon. An additional consideration was the nature and effect of the cancellation clause in the contract between Grinnell and Pacific, which was a matter of dispute among the litigants. While Barry claimed the clauses required Grinnell to pay for 100% of its obligations to Pacific upon cancellation of the contract, the District Court concluded, "[i]t is clear that blanket purchase orders of the type executed by Pacific and Grinnell in January and July, 1977, were agreements governing price only. No firm obligations of the seller to deliver and the buyer to pay for the goods arose until specific purchase orders were submitted. If the agreed upon minimums were not ordered, the agreed upon discounts would be withdrawn, and the purchaser

21 would be obligated to pay at standard rates for products actually ordered an delivered."44 If this interpretation of the cancellation provisions of the contract is correct, the effective penalty for reducing orders, and thus, the contract's potential for exclusion, is substantially lessened. For the incentive provisions of the contract to exclude a more efficient rival, the effective contract price would have to be below the marginal costs of the incumbent. Whereas a 100% minimum bill requirement would have satisfied that condition, the volume-based quantity discounts left price substantially above marginal costs over all but a 5 to 10% range of the contract minimum.45 Although the cancellation provisions in this case were held to be nonexclusionary, the Appeals Court underscored the general point that even if Pacific did try to use the cancellation clause to compel performance, the provision would represent a penalty and would not be enforceable. The court acknowledged the concern that the provision's "presence does still threaten the buyer with the lawsuit that would be needed to prove that it is unenforceable. And it is this threat, and the consequent additional deterrence to the 'breach and pay damages' course of action that constitutes the 'unreasonable anticompetitive' aspect of the clause."46 But the court found this argument to be inapplicable in this case: "Given the size and competence of its legal staff, [Grinnell] is unlikely to have been deterred by Pacific's assertion of unusually high damages resting upon a legally invalid provision in the contract."47 When examined in detail, Barry v. Grinnell serves, in our opinion, to demonstrate a number of the obstacles to using contracts strategically and the hazards of entertaining claims of exclusion based on contract damages. A

22 buyer facing a sole supplier has considerable incentive to promote development of alternative sources, through either outside suppliers or integrated production, and, as long as those prospects remain viable, would be understandably reluctant to commit itself to dealing with an incumbent supplier for an extended period. The analysis also reinforces the tenuous legal status of the terms needed to support exclusion. Parties have an incentive to challenge, and courts frequently invalidate, cancellation provisions perceived to penalize the breacher. Finally, the case between Barry and Grinnell illustrates amply the potential for abuse of the antitrust laws by opportunistic agents. The prospect of treble damages was enough to induce a clearly inefficient rival like Barry to file against its former partner. 49 United States v. United Shoe Machinery Corp.4 Cited by Aghion and Bolton as an illustration of their argument, United Shoe is the most famous antitrust case involving the use of contract 50 provisions to deter customers from switching suppliers.5 United, the 51 dominant manufacturer of shoe machinery in the 1940's and 1950's,5 leased its machines under long-term contracts that included three potentially suspect provisions: (i) minimum monthly fees,52 (ii) a "full capacity clause" requiring lessees to "use the leased machine to its full capacity upon all boots, shoes, or other footwear or portions thereof... of which such machine is capable of being used,"53 and (iii) substantial fees for returning 54 machines during the term of the lease, which usually ran ten years.54 Although the government succeeded in convincing the court that these provisions combined to deter switching to United's competitors, three factors

23 raise doubts that United's leases would have excluded an efficient entrant and lend support to an efficiency interpretation of the provisions. First, the necessary condition that entrants stood to earn above normal rates of return was probably absent. In fact, United faced competition for decades from a group of competitors properly characterized as a competitive fringe. These firms typically did not engage in research and development efforts, did not innovate, and competed by offering similar machines.55 Second, the substantial return fees charged by United are consistent with nonstrategic motives. Without any return fees, a customer would wish to return the machine whenever the lessee's valuation fell below the stream of payments required to keep the machine. United, however, would want to discourage returns unless a customer's valuation fell below United's opportunity cost. Given United's market power, the alternative value of a returned machine would have been United's marginal revenue —which would have been equated (in expected terms) to its marginal cost —rather than the rental 56 price. Thus, even absent strategic intentions, United would have set a return fee equal to the premium in excess of its marginal costs. Lastly, when a manufacturer provides information or services that are not specific to the manufacturer's product, a buyer may be able to avoid payment for the services by switching to a competitor's product, jeopardizing the provision of the services. The existence of free riding of this sort has been used elsewhere to justify exclusive dealing arrangements. In the present case, United offered an extensive network of information and services to its customers in conjunction with its machines, much of which was of a type that could be valuably employed in conjunction with non-United equipent.58 oreover, given that ost of United's iportant patents had equipment. Moreover, given that most of United's important patents had

24 59 expired,9 United was particularly vulnerable to offerings of similar machines by its competitors who did not provide similar levels of support and service. In light of this, switching fees may simply have represented a less extreme alternative to exclusive dealing for treating the problem of freeriding on manufacturer services. 60 Automatic Radio Manufacturing Co. v. Haze tine Research Inc. In addition to United Shoe, Aghion and Bolton cite one other case, Automatic Radio Manufacturing Co. v. Hazeltine Research Inc. In this case, defendant Hazeltine, a developer of radio broadcasting technology, allowed its licensees to use any or all of Hazeltine's current and future patents in return for royalties equal to a small percentage of the licensee's gross sales. At the time of the litigation, the license covered 570 patents and 200 applications used in the manufacture of radio broadcasting apparatus.61 Aghion and Bolton argue that licensees such as Automatic Radio "had to pay a fixed fee irrespective of whether it exploited the patents licensed" and that "[a]ny new licensor therefore faced an entry barrier equal to the amount of this fee."62 More precisely, a bias against using competitor's patents would arise because of differences in the marginal cost of adopting the alternative technologies. Since the fees paid to Hazeltine were a function only of the manufacturer's sales, the marginal cost of using an additional Hazeltine patent to a manufacturer who already used a Hazeltine technology was nearly zero; whereas to adopt an alternative technology, a manufacturer incurred a cost equal to the amout harged by thaed e alternative licensor. However, as each court that reviewed this case recognized, requiring that Hazeltine charge for each use of its hundreds of patents would have decreased

25 the value of Hazeltine's patents (i) by substantially increasing monitoring costs63 and (ii) by discouraging use of the patents at the margin by increasing the cost of output embodying the patented technologies relative to that of other output. Since the actual cost of extending the use of a patented technology to an additional application is negligible, the efficient use of that technology dictates a zero incremental cost to the user. Thus, the license terms appear to have given licensees the correct incentives to fully utilize Hazeltine's patents while minimizing the costs of collecting royalties.64 Other cases Two additional cases serve further to illustrate the difficulty of imputing strategic motives to contractual agreements. The first regards a recently settled dispute between Citicorp and Western Union,5 and the second relates to the role of license fees in litigation over IBM's leases for plug compatible peripheral components.66 The dispute between Citicorp Services Inc. and Western Union Telegraph Co. offers another example of the use of "exclusionary" contracts to protect against free-riding by an entrant on manufacturer-provided services. Attempting to establish itself in the "public money transfer" business, Citicorp had enlisted Western Union agents to also act as Citicorp agents, offering commission rates above Western Union's as an inducement. In response, Western Union (i) imposed exclusive dealing contracts on some of its 10,500 outlets, (ii) terminated some outlets which agreed to act as Citicorp agents, and (iii) denied other dual agents the right to handle other Western Union services.

26 Although Citicorp alleged that these actions excluded it from entering the money transfer market, the actions can be interpreted as being consistent with the manufacturer services rationale for exclusive dealing and switching penalties. In establishing an effective network, Western Union needed to identify suitable agents and locations over an extensive geographic region as well as advertise the existence and qualities of its service. Quite clearly, Western Union was vulnerable to free riding on its efforts to attract customers and agents if the latter were also allowed to offer Citicorp services. By relying on Western Union's advertising and locations, Citicorp could lure away both customers and agents with more favorable terms without incurring comparable costs. The IBM litigation focused on IBM's announcement in May of 1971 of its Fixed Term leasing plan for plug compatible peripherals. Several rivals objected to IBM's reductions in rental rates and to their new one and two year leases. The leases offered discounts of up to 10% on monthly rates and imposed return fees that in the two year leases, for instance, equaled five times the monthly rental if the lease was terminated in the first twelve 67 months and two and one-half times that amount in the second year7. Again, the facts of the case make it difficult to impute strategic motives to IBM. First, the leases were introduced after several competitors had already established themselves in the peripheral market and in response to significantly lower prices by the entrants. IBM's lease terms themselves mimicked the terms offered by its competitors and, according to the Appeals Court, were commonplace commercial agreements. Moreover, the court found that by using longer leases, IBM, like its competitors, avoided costly "churning" of machines and succeeded in reducing their costs.69

27 Perhaps more importantly, the IBM case illustrates the potential misuse of the private antitrust remedy if theories of exclusion based on the use of contract provisions were generally accepted. Such theories would allow competitor plaintiffs who were "excluded" merely because of competition to bring Sherman Act Section 2 claims. Even if the courts eventually reject meritless claims of exclusion, the costs of applying rule of reason analyses to the questions of strategic use of contracts could restrict incumbents' responses to entry, and perversely, could sustain entry by less efficient suppliers. Thus, establishing antitrust liability based on the strategic model would involve a tradeoff between exclusion of more efficient entrants and restrictions on more efficient incumbents. V. Conclusions The conditions under which contracts can be used strategically are fairly restrictive. First, a new supplier must expect to earn excess rents upon winning the customer's business. Where the market for substitute performance is populated with homogeneous firms, competition among them to serve the buyer keeps price near marginal costs, eliminating the strategic motive of the original contractors. For there to be expected rents from entry, some firm must be substantially better situated to enter than others. Even then, the possibility of integrating the low-cost supplier reduces the threat of strategic deterrence. Finally, there is both theoretical support and casual evidence for the contrary conclusion that buyers, if anything, are likely to maintain even inefficient producers as second sources to gain leverage in bargaining with incumbents.7

28 When the economic conditions for the strategic use of contracts are present, the law presents a number of obstacles to deterring entry through contracts. First, the common law treatment of excessive damages undermines directly the ability of parties to use contracts strategically. In addition, rules regarding delegation of performance and mutual modification mitigate if not eliminate the commitment required to prevent the parties from striking deals, either unilaterally or in concert, with a more efficient supplier. In these respects, at least, the law of contract supports efficient outcomes. Indeed, the results of the Aghion-Bolton model provide an additional reason not previously identified in the literature for why court invalidation of contract penalties is a sensible legal precept. Our review of antitrust cases relating to the issue of contract exclusion further supports a cautious approach to exclusionary claims. Despite a presumptive bias toward a finding of strategic effect, the small set of cases that deal with exclusion through use of stipulated damages or their equivalent fails to substantiate the purported dangers of exclusionary contracts. Often, behavior or conditions necessary for successful exclusion are absent. The record of dealings in Barry Wright, for instance, illustrate the process of complicated negotiations and rivalry that often characterizes small number supplier-customer relations —and contradicts the "take-it-orleave-it" contract commitment essential to the theory. In every case, moreover, the contract provisions in question have sound efficiency rationales. What stance should the antitrust laws take toward stipulated damage and related contractual provisions in light of these findings? A central question is whether the courts can devise market tests or screens to identify

29 when contract provisions are likely to be used strategically and when they enhance efficiency by properly aligning incentives. Even if such tests can be developed, whether courts should subject such provisions to a rule of reason analysis as a general policy depends on the costs of applying the rule, both in terms of enforcement and the impairment of efficiency. The inclination of firms to use the antitruse nt treble damage remedy to impose costs on rivals suggests a substantial threshold should be established before provisions, widely recognized to enhance efficiency in many circumstances, are exposed to critical legal review because of conceivable strategic uses.

APPENDIX In this appendix, we derive the optimal stipulated damage provision between a risk neutral buyer and seller. The privately optimal choice of contract terms is that which maximizes the expected joint profits of the transactors subject to the buyer's ex post decision of whether or not to perform the contract. Using the notation in the text, the buyer breaches whenever v - p - S > v - p. The seller, in turn, receives p - c if the contract is performed and S if the buyer breaches. Since the buyer will switch only if pe < p - 6, and the entrant will find it in his interest to enter only if p > s(O), the probability of breach is Pr[s(e) < p - 6]. Suppose that the price received by the entrant is ultimately a matter of negotiation and falls somewhere between p - S and s(e). Then letting a characterize the outcome of those negotiations, the entrant's price can be written as pe = ac(p-c) + (1-cx)s(e), where c e [0,1] and may be thought of as e a parameter reflecting the bargaining strength of the entrant relative to the buyer. If a = 1, the entrant has all the bargaining power and pe = p - 6; if o =0, the buyer has all of the bargaining power and pe = s(e). Letting P represent the probability of breach, the incumbent seller's expected profits would be TS = (1-P)(p-c) + POS and the buyer's p-S TB = (l-P)(v-p) + f(v-pe-s)P'ds(e) 0

Maximizing the sum of these two expressions with respect to S yields the following first-order condition: a(TB +)S) = P' (S - p + c) - c-P = 0 aS Rewriting this expression yields aPt 8 = p - c + -p, In other words, when c = 1 and the entrant is able to extract all of the rents from entry (the Aghion-Bolton assumption), the optimal stipulated damage between the parties exceeds the lost-profit level. When c = 0 and the entrant is unable to charge a price above his opportunity cost (as in the efficient breach model), the optimal penalty reduces to S = p - c, the ex post efficient level.

Footnotes i.For an overview of this literature, see Oliver Hart and Bengt Holmstrom, "The Theory of Contracts," in Advances in Economic Theory, Fifth World Congress, edited by Truman Bewley, Cambridge University Press, 1987, 71-155. 2.See Thomas Krattenmaker and Steven C. Salop, "Anitcompetitive Exclusion: Rasing Rivals' Costs to Achieve Power over Price," Yale Law Journal, 96, December 1986, 209-293. For a comparison of the strategic and efficiency views, see O.E. Williamson, The Economic Institutions of Capitalism, Free Press, 1985, at 23-29. 3.See, in particular, P. Aghion and P. Bolton, "Contracts as a Barrier to Entry," American Economic Review, 77, June 1987, 388-401. 4.See U.S.v. Joint Traffic Association, 171 U.S. 505 (1898); Chicago Board of Trade v. U.S., 246 U.S. 231 (1918); Continental T.V. Inc. v. GTE Sylvania Inc., 433 U.S. 36 (1977); and Broadcast Music, Inc. v. Colombia Broadcasting, 441 U.S. 1 (1979). 5.See, e.g., V.P. Goldberg and J.R. Erickson, "Quantity and Price Adjustment in Long-Term Contracts: A Case Study of Petroleum Coke," Journal of Law and Economics, 30, October 1987, 369-398. 6.See, Shavell, "Damage Measures for Breach of Contract," Bell Journal of Economics, Autumn 1980, 11, 466-90, at 470, note. 7.S.E. Masten, "Minimum Bill Contracts: Theory and Policy," Journal of Industrial Economics, September 1988; and S.E. Masten and K.J. Crocker, "Efficient Adaptation in Long-Term Contracts," American Economic Review, 75, December 1985, 1083-1093. More sophisticated contractual arrangements have

been devised in the economic literature on contracting (see, for instance, M. Harris and R.M. Townsend, "Resource Allocation Under Asymmetric Information," Econometrica, January 1981, 49, 33-64). We are restricting our attention here to relatively simple pricing arrangements both to simplify the analysis and because they, unlike the former, are commonly observed in practice. 8.See, for example, B. Klein, A. Alchian, and V. Crawford, "Vertical Integration, Appropriable Quasi-rents and the Competitive Contracting Process," Journal of Law and Economics, October 1978, 21, 297-236; O.E. Williamson, "Transaction-Cost Economics: The Governance of Contractual Relations," Journal of Law and Economics, October 1979, 22, 233-262; and S. Shavell, 1980, supra note 6. 9.See, for example, H.P. Marvel, "Exclusive Dealing," Journal of Law and Economics, 25, April 1982, pp. 1-25. 10O.A now substantial literature in law and economics has developed on contract damages and efficient breach. See, for example, J.H. Barton, "The Economic Basis of Damages for Breach of Contract," Journal of Legal Studies, 1, June 1972, 277-304; S. Shavell, 1980, supra note 6, and "The Design of Contracts and Remedies for Breach," Quarterly Journal of Economics, February 1984, 121-148; and W.P. Rogerson, "Efficient Reliance and Damage Measures for Breach of Contract" Rand Journal of Economics, 15, Spring 1984, 39-53. The model described below most closely follows Shavell, 1980. 11.See Shavell, 1980, supra note 6, at 474. 12.This result is demonstrated in the appendix. Also see Shavell, 1980, supra note 6.

13.E.A. Farnsworth, Contracts. Boston, Little, Brown and Co., 1982, at 896. 14.See Williamson, "Franchise Bidding for Natural Monopoly —In General and with respect to CATV," Bell Journal of Economics, 7, Spring 1976, 73-104; and Paul Joskow, "Contract Duration and Durable Transaction Specific Investments: Empirical Evidence from Coal Contracts," American Economic Review, March 1987, 168-185. 15.Aghion and Bolton, supra note 3. 16.We examine in detail only one of two models contained in their paper. The second postulates contractual forms that, to the best of our knowledge, are not observed in practice. 17.The new seller will enter only if there exists a price, pe, above his costs, s(9), and below p - 6, which will be true if s(9) < p - d. Hence, the probability of breach is Pr[s(e) < p - d]. 18.See the appendix. 19.Note that the equilibrium price in the strategic model will be lower than in the efficiency model to compensate the buyer for the higher strategic penalties. The result of the strategic model is that, given the contract price, the penalty chosen will be at a level that will induce too little breach relative to the efficient level. 20.If the entrant's costs are uniformly distributed, damages would be set so that s is the average between the incumbent's costs, c, and the lowest possible value of s(e). Those familiar with the literature on optimal auctions will recognize that the damage provision is set so that p - 6 equals the optimal reserve price in an auction with symmetric bidders with

independent private values. For an overview of this literature, see R.P. McAfee and J. McMillan, "Auctions and Bidding," Journal of Economic Literature, 25, June 1987, 699-738. Despite this correspondence, we doubt that many would advocate making the use of reserve prices in auctions or competitive bidding schemes an antitrust violation. 21.See Aghion and Bolton, supra note 3, at 396. 22.Lack of commitment raises a technical problem with the strategic model. Anticipating that the original seller and buyer have the incentive to take a stronger position once entry has taken place, no supplier would enter. But this is inconsistent with the original contract being expected profit maximizing. Hence, unless the contract constrains not only concessions but also new demands on the part of the original contractors, the model does not have an equilibrium. We thank Naveen Khanna for bringing this point to our attention. 23.Reputation for adhering to such offers might assist an incumbent seller in its strategy, but several factors including the infrequency of this type of interaction suggest that reputation would not be a reliable source of commitment. Also, the ability of the buyer to establish a reputation for integrating new supply sources would provide the buyer with a dominant strategy. 24.Uniform Commercial Code, section 2-210; also see Restatement (2nd) of Contracts, section 318. 25.The principal exceptions to this rule "relate to contracts for personal services and to contracts for the exercise of personal skill or discretion" (Restatement (2nd) of Contracts, section 318) or if delegation is prohibited

by prior agreement. Even the latter may be voided if the terms are deemed contrary to the public interest. 26.To the extent that contracts between automobile manufacturers restrict the ability of their dealers to carry competing manufacturers' products, American company dealings with low-cost foreign manufacturers is modest evidence of this practice. 27.See Uniform Commercial Code, section 2-209. 28.Restatement (2nd) of Contracts, section 356. 29.The use of the terms liquidated damages and penalties reflects legal conclusions as to whether stipulated damages are reasonable (see, Uniform Commercial Code, section 2-718). The courts frequently rely on the principle that allowable damages to the seller correspond to the lost profits from breach. In David & David, Inc. v. Myerson, 277 F. Supp. 973 (1966), the court found that the requirement that a buyer take specified minimum quantities of a new product or reimburse the patent holder for any price reductions on sales to others was enforceable. Similarly, In International Electronics Corporation v. United States, 646 F. 2d. 496, the court upheld damages reasonably related to the costs imposed on the Government from a seller's breach. Also see more generally, K.W. Clarkson, R.L. Miller and T.J. Muris, "Liquidated Damages v. Penalties: Sense or Nonsense?," Wisconsin Law Review, 1978, 1978, 351-390; S.A. Rea, "Efficiency Implications of Penalties and Liquidated Damages," Journal of Legal Studies, 13, January 1984, 147-167; and P.H. Rubin, "Unenforceable Contracts: Penalty Clauses and Specific Performance," Journal of Legal Studies, 10, June 1981, 237-247.

30.In deciding whether a stipulated damage clause is enforceable, the courts consider, in addition to the relationship between stipulated damages and anticipated or actual losses, two other factors: (1) the intent of the parties, and (2) the precision with which actual losses can be estimated. The courts try to ascertain whether the parties intended payment of damages in lieu of performance or intended that the damages would compel performance. If the court finds the latter, the damage provision is a penalty and not enforceable. Regarding the estimate of actual losses, the courts will not void provision fixing liquidated damages "when the amount of actual loss is incapable or difficult of price estimation" (see Leasing Service Corp. v Justice, et al., 673 F. 2d. 70 at 73 (1982); Truck Rent-A-Center, Inc. v Puritan Farms 2nd, Inc., 361 N.E. 2d 1015, 1018 (1977)). 31.See, for instance, D. Baron and R. Myerson, "Regulating a Monopolist with Unknown Costs," Econometrica, 50, 1982, 911-30. 32.See the appendix. 33.This may be thought of as the scenario implicit in the efficient breach models. 34.See Aghion and Bolton, at 390, on their version as to why entry is limited. 35.See T.M. Palay, "Comparative Institutional Economics: the Governance of Rail Freight Contracting," Journal of Legal Studies, 13, June 1984, 265-287; V.P. Goldberg and J.R. Erickson, supra note 5; P. Joskow, "Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants," Journal of Law, Economics, and Organization, 1, Spring 1985, 33-80; and Joskow, 1987, supra at 14; S.E. Masten and K.J. Crocker,

supra note 7; J.H. Mulherin, "Complexity in Long-term Contracts: An Analysis of Natural Gas Contractual Provisions," Journal of Law, Economics, and Organization, 2, Spring 1986, 105-117; and K.J. Crocker and S.E. Masten, "Mitigating Contractual Hazards: Unilateral Options and Contract Length," Rand Journal of Economics, Autumn 1988. 36.We searched all federal cases using LEXIS to identify antitrust cases alleging exclusion due to either the use of stipulated damages, return fees, penalties, or multi-part pricing. The search revealed four disputes: United Shoe (see infra note 49); Barry Wright V. ITT Grinell (see infra note 37); the IBM litigation concerning plug compatible peripherals (see infra note 65); and BMI v. CBS (supra note 4). We discuss these four cases and two others: Automatic Radio, (infra note 59), which was cited by Aghion and Bolton, and a recently settled dispute between Citicorp and Western Union (infra note 64). Note that our search procedure was not designed to identify cases involving either requirements contracts (e.g., Standard Oil v. U.S., 337 U.S. 292 (1948)) nor tie-ins (e.g. International Salt v. U.S., 332 U.S. 392 (1947). In addition, we note that reported decisions represent a non-random sample of cases (see G.L. Priest and B. Klein, "The Selection of Disputes for Litigation," Journal of Legal Studies, 13, January 1984, 1-55), and so may not be representative of all complaints. In a similar vein, the rules against anticompetitive exclusion may suppress obvious instances of the strategic uses of contract provisions. 37.555 F. Supp. 1264 (D. Mass. 1983); 724 F.2d 227 (1st Circuit, 1983). 38.Its share of mechanical scrubber sales was 94% in 1979.

39.Pacific's standard rate was 20% off list price; it offered an extra 5 or 10% off list. 40.Grinnell had been a major producer of hydraulic snubbers. 41.Reflecting the character of the Grinnell/Barry agreement, Grinnell internal correspondence referred to it as such (555 F. Supp. 1264, at 1270). 42.724 F.2nd 227, at 236. 43.District Court Judge Skinner concluded: "It seems to me to be an extraordinary extension on [sic] antitrust theory to hold a noncancellable clause in a one-year purchase contract illegal because [fulfillment is] not economically inevitable. I have found no case so holding, and I rule that the imposition of this clause, given the history of the relations between Grinnell and Pacific, and Pacific's legitimate desire to plan its production for at least a year, is not illegal exclusionary conduct..." at 1272. 44.555 F. Supp. 1264, at 1272. 45.The court found the discounted prices "generated revenues more than sufficient to cover the total cost of producing the goods to which they applied," a finding that Barry did not dispute. 46.F. 2d 227, at 238. 47.F. 2d 227, at 239. 48.For a discussion of the problems ensuing from the availability of the private antitrust remedy to competitor plaintiffs, see E. Snyder and T. Kauper, "Misuse of the Antitrust Laws," University of Michigan, January 1988.

49.110 F. Supp. 295 (D. Mass. 1953), affirmed; 347 U.S. 521 (1954). The analysis of this section is developed in more detail in S.E. Masten and E.A. Snyder, "United States v. United Shoe: a Belated Defense," University of Michigan, 1988. 50.Posner cited United Shoe to illustrate his claim that suppliers must compensate customers for exclusionary contract provisions: "[C]ustomers of United would be unlikely to participate in a campaign to strengthen United's monopoly position without insisting on being compensated.... " R.A. Posner, Antitrust Law: An Economic Perspective (Chicago, University of Chicago Press: 1976), at 203. However, for reasons articulated by Aghion and Bolton, the strategic argument must be evaluated on its merits. For a detailed review of United Shoe, see Carl Kaysen, United States v. United Shoe Machinery Corporation: An Economic Analysis of an Anti-trust Case (1956). 51.United's dominance dates back to industry considerations in 1899 and some twenty-five subsequent acquisitions. 52.The minimum monthly fee equaled a fixed base rental fee plus a minimum usage charge equal to 10% of the machine's estimated capacity. As a result, the lessee's marginal cost was zero up to this minimum usage. 53.District Court opinion at 316. 54.United leased most of its machines, a practice that may reflect its customer's preferences, as leasing made it "easy for a person with modest capital and of something less than superior efficiency to become a shoe manufacturer," (id. at 323). But, as is well understood, by leasing a manufacturer retains control over the secondary market and as a result may be able to better exploit its demand. In support of this view, the record cites

that United purchased used machines only to dispose of them. (From 1931 to 1942, United spent approximately $350,000 for used machinery that was not re-sold or leased (id. at 333-334).) 55.Although strategic lease provisions could account for the failure of firms within this fringe to attract substantial numbers of customers from United, the ability of United to deny an outlet for its competitors' machines is disputed by the ease of entry into shoe manufacturing evinced by the existence of some 1400 firms in that industry. 56.Cf. Ryder Truck Lines, Inc. v. Goren Equipment Co. Inc., 576 F. Supp. 1348, N.D. Georgia (1979). In this case concerning the sale of used diesel engines, the court found that a stipulated damage clause requiring the buyer to pay the full contract price in the event of breach was unenforceable since "had plaintiff repossessed the unpaid engines, it would have had the option of reselling those engines in an attempt to 'cover,' and it would be able to recover the difference between the resale price and the contract price" (at 1357). The issue of Ryder's market power was not addressed. Given that shoe machines, like diesel engines, are not specialized assets and therefore have a high alternative value, the same reasoning could be applied to United's return fees. Note, however, that placing of a used machine could require some discounting due to a "lemon's effect." 57.See, for example, H.P. Marvel, 1982, supra note 9. 58.The service included expert advice on how to improve the quality of shoe production, help in various technical shoemaking and shoe factory problems, and technical assistance to "shoe manufacturers desiring engineering surveys

on production methods, on costs, on factory layouts, and other matters." District Court at 321. 59.Ibid. at 333. For a discussion of United's patents, see Kaysen, 1956, infra note 50, at 78-90. 60.176 F.2d. 799, aff'd 77 F. Supp. 493, aff'd 339 U.S. 827. 61.339 U.S. 827, at 829. 62.Aghion and Bolton, 1987, supra note 3, at 398. 63.The cost of monitoring usage of patented or copyrighted material was also the basis for justifying ASCAP and BMI's use of blanket licenses for rights of all musical compositions in their repertories in exchange for flat annual fees. See Broadcast Music, Inc. v. Columbia Broadcasting, supra note 4. 64.In addition, licensees were not otherwise compelled to adopt the inventions covered by the patents or restricted from producing goods using other patents. 65.Citicorp Services Inc. v. Western Union Telegraph Company, complaint dated 11/9/87, filed D. New Jersey, Response and Counterclaim filed by Western Union, 1/15/88. 66.Telex Corp. v. IBM Corp., 267 F. Supp. 258 (1973), aff'd in part, reversed in part, 510 F.2d. 894 (1975); ILC Peripherals Leasing Corp. v. IBM Corp., 458 F. Supp. 423 (1978), 636 F.2d. 1188 (1980); California Computer Products v. IBM Corp., 613 F.2d. 727 (1979). 67.Telex Corp. v. IBM, 510 F.2d 894, at 903.

68.Telex, 367 F. Supp. 258 at 301. 69.Telex, 510 F. 2d 894, at 906. 70.See, for example, J.S. Demski, D.E.M. Sappington and P.T. Spiller, "Managing Supplier Switching," Rand Journal of Economics, 18, Spring 1987, 77-97. 71. F.H. Easterbrook, "The Limits of Antitrust," Texas Law Review, 63, August 1984, 1-40.