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THE EFFECT OF BARGAINING POWER ON CONTRACT DESIGN
Author(s): Albert Choi and George Triantis
Source: Virginia Law Review, Vol. 98, No. 8 (December 2012), pp. 1665-1743
Published by: Virginia Law Review
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VIRGINIA
Volume 98
LAW
REVIEW
December 2012
Number 8
ARTICLES
THE EFFECT OF BARGAINING POWER ON CONTRACT
Albert Choi and George
DESIGN
Triantis*
Over the past forty years, an irrelevance proposition
has been preva
lent in law-and-economics
scholarship:
bargaining power should affect
and
not
terms
a
contract.
In contrast, practition
only price
nonprice
of
ers and commentators
in industry regularly invoke bargaining power to
static and dynamic variance in nonprice contract terms. This Ar
explain
ticle unpacks
and analyzes
the assumptions
weak—
of the strong—and
this
irrelevance
to
of
bargaining power
proposition
bridge the
gap between theory and the real world. In the first half of the Article, we
identify and discuss a variety of explanations for the effect of bargaining
versions
on contract
design. These include the effects of shifts in market
supply and demand and the effect of negotiating price first and nonprice
terms later. In the second half of the Article, we present an in-depth ex
power
amination
the impact of bargain
of one set of explanations,
concerning
and information asymmetry on nonprice terms, when the val
ing power
ue and cost of nonprice
*
Albert
tricia
Kowal
C. BeVier
Professor
Belfer
terms vary across
contracting
parties.
In the
Research
Professor of Law, University
of Virginia,
and James and Pa
of Law, Stanford University,
The authors thank Isaac
respectively.
and Neal Sangal (Stanford Law 2014)
for their valuable
research
2011)
Law
(Harvard
assistance.
They are also grateiul for helpful
Andrew
Ronald
Richard
Gilson,
Daughety,
comments
from Ian Ayres, Richard
Craswell,
Michael
Hynes,
Kessler,
Avery Katz, Daniel
Mitchell
Alan Schwartz,
Robert Scott,
Klausner,
Bentley McLeod,
Jay Mitchell,
Polinsky,
and Kathy Spier as well as participants
at law school
at Berkeley,
Columbia,
workshops
and Virginia,
and at the 2012 meetings
of the American
Harvard,
Stanford, Texas,
USC,
Law and Economics
Association
and the Theoretical
Law and Economics
Conference
at
Washington
Law,
in St. Louis. Triantis thanks
University Law School
and Business
at Harvard for financial support.
the John M. Olin
Economics,
1665
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Center
for
1666
Virginia Law Review
[Vol. 98:1665
extreme cases
gaining
surplus
in which one or the other party enjoys overwhelming
bar
the
that
to
a
share
power,
efforts of
party
capture
larger
of the
the efficiency of the
by screening or signaling may compromise
nonprice terms.
when bargaining
We show
that this incentive disappears
or is mitigated
is
more
shared
between
the
power
evenly
parties: for
when the
example, when a monopolist faces the threat of competition,
can renegotiate,
or when they engage
in bilateral
parties
bargaining
with more even bargaining
a
power. As a whole, the Article provides
theoretical
basis for interpreting the intuition among market partici
that the impact of bargaining
power extends beyond price terms.
we
Before concluding,
briefly suggest implications for legal policy, par
ticularly the contract law doctrine of unconscionability.
pants
Introduction
I. What
II. How
A.
B.
C.
D.
1666
Is Bargaining
Bargaining
Power?
Power
1674
Affects
Contract
Design
The Bargaining
Power Irrelevance
Propositions
Power
Can Alter the Optimal Nonprice
Bargaining
Power Can Lead to Inefficient Nonprice
Bargaining
Bargaining
Power
in Two-Staged
1677
1678
Terms
Terms....
(Price-First)
Under
Monopoly
and
Perfect
Competition
1696
of Uneven
Bargaining
Power
Under
Asymmetric
Information
1701
A.
The Irrelevance
B.
Private
V. Effect
1686
1690
Negotiations
iii. Product
Quality
IV. Effect
1680
Under Complete
Proposition
on
Buyer Type
Information
1. Dominant
Seller
2. Dominant
Buyer
Bargaining
of More
Even
Information
1704
1705
1706
1709
Power
1712
A.
Threat of Competition
1713
B.
Renegotiation
Bilateral Negotiation
1719
C.
VI. Bargaining
Power,
Discrimination,
1723
and
Legal
Policy
1732
Conclusion
Appendix:
1728
A General
Model
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1734
The Effectof Bargaining Power
2012]
1667
Introduction
WHEN power
two parties enter into a contract, their relative bargaining
of bar
affects the terms of their deal. While the allocation
gaining power clearly determines price, it is an open question whether
and how it also affects nonprice terms (what we are alternatively refer
It is common for practitioners and industry
ring to as "contract design").
one-sided
seemingly
nonprice terms to unequal
bargaining power and to explain changes in nonprice terms over time as
a result of shifts in such power. Consider the following examples of such
observations:
observers
to attribute
in a sales
of warranties and limitations on damages
(1) Disclaimers
contract are due to the power of the monopolist.
(2) Broad termination rights are included in a merger or acquisition
agreement when the acquirer has the power to dictate the terms of the
agreement to the target company.
(3) The purchase order forms of a large corporation, facing many po
tential suppliers, insist that all litigation will be held in the courts of
the purchaser's
The objective
state.
of this Article
is to begin a systematic analysis of how
the agreement
to such apparently
determine
bargaining
power might
one-sided terms. An important normative
question is whether the efforts
of the stronger party to appropriate a larger share of the surplus through
the size of the surplus. Would a more equal
these terms compromise
sharing of bargaining power be more likely to lead to efficient (surplus
contract provisions?
maximizing)
In legal scholarship, the issues
of one-sided
contract terms bear on the
antitrust regulation
under the doctrine
tained
of monopolies,
as well as the policing of contracts
of unconscionability.
main
Early legal scholarship
that monopolists
often used contracts of adhesion that contained
one-sided
terms.1 Law-and-economics
bargaining
1
power
scholars argued in response that
affects price, but not other terms.2 The basic argument
Contracts
of Adhesion—Some
About Freedom
of Contract,
Kessler,
Thoughts
L. Rev. 629, 632 (1943).
This concern
was reflected in the common
law. See,
v. Bloomfield
Motors, 161 A.2d 69, 78-79
(N.J. I960).
e.g., Henningsen
~
terms can be confusing
The distinction
between
because
price and nonprice
nonprice
43
Friedrich
Colum.
terms allocate
buyer's
surplus
surplus as well. Conditional
and increase
the seller's
on price, a limited
In addition,
profit.
warranty
many
will both decrease
nonprice
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terms,
such
the
as
Virginia Law Review
1668
[Vol. 98:1665
can be found in an early work by now-Judge Richard Posner, who ar
would offer product quality
monopolist
gued that a profit-maximizing
that efficiently meets buyer preferences, that is, improving quality until
the incremental
cost of farther improvement
outweighs the incremental
to the buyer.3 Thus, a monopolist producer of cars should find it in
its self-interest to offer any warranty for which the buyer is willing to
value
than the cost to the producer, just as if it were a seller in a
competitive market. The difference between a monopoly and a perfectly
market, then, should be the market price, not the warranty
competitive
pay more
terms offered. The argument that a monopolist
extracts
rather
than
continues
to
be
the
conventional
quality
price
and collateral
warranty
"price"
in law-and-economics.4
scholars
the leading
its rent through
wisdom among
clauses,
that the promisor
like price terms in the sense that they stipulate a
on the occurrence
of an event (or a
to the promisee
often look
has to "pay"
condition).
3
21 Stan. L. Rev. 548, 584-85
and Its Regulation,
Richard A. Posner, Natural Monopoly
of Law § 4.9, at 116 (7th ed. 2007).
see also Richard A. Posner, Economic
Analysis
(1969);
4
of this conventional
wisdom
as irrelevance
In Section
II.A, we identify two versions
that bargaining
First, the strong-form version stands for the proposition
power
propositions.
only
affects
bargaining
inefficient
statements
tract Law
in the weak-form
terms. Second,
and has no effect on nonprice
version,
terms, but the parties are no more likely to agree to
may affect nonprice
Various
rather than equal,
terms under unequal,
bargaining
power.
nonprice
are found in Robert E. Scott & Jody S. Kraus, Con
of the conventional
wisdom
price
power
and Theory
58-60
104
G. Baird, The Boilerplate
Puzzle,
Douglas
L. Priest, A Theory of the Consumer
Product
(4th ed. 2007);
L. Rev.
933, 934, 938
90 Yale L.J. 1297,
Mich.
Warranty,
stantive Unconscionability,
(2006);
1320-21
George
Alan Schwartz,
A Reexamination
ofNonsub
(1981);
. . three [weak]
L. Rev. 1053, 1072-74
("Given.
(1977)
of whether the
the same level of product quality regardless
63 Va.
a firm will produce
assumptions,
or a perfect competitor.");
firm is a monopolist
113
Law,
Theory and the Limits of Contract
Schwartz
&
Robert
E. Scott,
Contract
541, 552-54
(2003)
("Bargaining
of the surplus, which is determined
in the division
by the price
the surplus, which the price
the contract terms so as to maximize
power instead is exercised
term. Parties jointly choose
[sic]
Alan
Yale
L.J.
& Louis L. Wilde, Product Quality and
Alan Schwartz
unequally.");
that where
258 (1985)
52 Rev. Econ.
Stud. 251, 251-52,
Information,
(arguing
are imperfectly
informed about product prices and quality levels offered by the
sellers (that is, positive search costs), and where there are low fixed costs to provid
may
then divide
Imperfect
consumers
various
ing quality,
a profit-maximizing
competitiveprice).
seller
will
offer at least
the optimal
quality,
but at a supra
that bargaining
recognize
power might affect nonprice terms in
and
Ian Ayres & Robert Gertner, Strategic Contractual
Inefficiency
Richard Craswell,
Choice
of Legal Rules, 101 Yale L.J. 729, 733 (1992);
the Optimal
Prop
60 U. Chi. L.
and Related
Rules in Unconscionability
Doctrines,
erty Rules and Liability
and the Economic
Rev. 1, 39^0
Jason Scott Johnston, Strategic Bargaining
Theory
(1993);
A small
some
number
circumstances.
of Contract
Default
of articles
See
Rules,
100 Yale
L.J. 615,
621-22,
625 (1990);
see also
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infra note 55.
The Effectof Bargaining Power
2012]
1669
literature on the relationship between bargaining power and
terms, such as warranties, is thin but mixed.5 Recently, in a
Empirical
nonprice
Professor
study of terms in end user licensing agreements
("EULAs"),
found little evidence
to support the hypothesis
that
Marotta-Wurgler
market concentration
causes terms to be more seller-friendly than they
be in competitive
markets.6 The study suggests, therefore, that
market power alone should not be sufficient to trigger the scrutiny of a
court under the doctrine of unconscionability.7
In contrast, Professors
would
Ben-Shahar
and
White
examined
auto-manufacturer
supply contracts
in nonprice terms, such as warranty and termina
tion provisions,
that seemed correlated with bargaining
power.8 While
factor in consumer
reading and search costs may be a confounding
and found variations
standard-form
in Marotta-Wurgler's
contracts, such as the EULAs
study,
and White's
it
is
sample
pertinent to our analysis because
business-to-business
contracts where this factor is less likely to
Ben-Shahar
contains
be an issue.
Ben-Shahar
In light of the conventional
wisdom in law-and-economics,
and White remarked that "given the enormous
stakes, we
that economic
power would be used to dictate low prices, not
expected
selfish boilerplate."9
that the variation and the potential
They speculated
were
due
to
internal
inefficiency
agency conflicts within the parties, but
conceded
ance
that they did not "offer a satisfactory explanation
for the vari
across the different [original
manufacturer
equipment
of terms
5
Practice Regarding
Warranties
in the
See, e.g., George G. Bogert & Eli E. Fink, Business
of Goods, 25 111. L. Rev. 400, 413-15
(1930)
(stating that seller's bargaining
power may
lead to inadequate
for buyers);
Antonio
Cabrales
et al., Hidden
Infor
warranty protection
Sale
mation,
155-56
An Experiment,
14 Experimental
Econ. 133, 135,
results in principal-agent
that
experimental
bargaining
showing
Florencia
efficiency improves when multiple agents compete);
Marotta-Wurgler,
and the Quality
of Standard
Form Contracts:
The Case
of Software
License
Bargaining
(2011)
contracting
Competition
Power,
and Efficiency:
(describing
5 J. Empirical
Stud. 447, 448-51
Legal
(2008);
George L. Priest, A Theory of
Product Warranty, 90 Yale L.J. 1297, 1320—21 (1981)
(finding no relationship
between
and warranty coverage);
William
C. Whitford, Law and the
industry concentration
Consumer
Transaction:
A Case Study of the Automobile
Warranty, 1968 Wis. L. Rev. 1006,
Agreements,
the Consumer
1095-96.
6
Professor
does find the expected
between
Marotta-Wurgler
positive
relationship
price
and market share or industry concentration.
Marotta-Würger,
supra note 5, at 451.
7
Id. at 475.
8
Omri Ben-Shahar
& James J. White, Boilerplate
and Economic
Power in Auto Manufac
104 Mich. L. Rev. 953, 959, 971 (2006)
for example,
that orig
turing Contracts,
(observing,
inal equipment
manufacturers
exert their power to extract broad warranties,
discretion
over
little if any cor
quantity, and rights to terminate without cause, while giving their suppliers
responding
right to cancel).
Id. at 964.
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1670
Virginia Law Review
contracts,
("OEM")]
inefficient."10
or for the conjecture
The puzzle
that Ben-Shahar
that dominate
their industries
[Vol. 98:1665
that some
of these terms are
and White raise is echoed
repeatedly by
in the business and legal press, who in
practitioners and commentators
voke bargaining power to explain both static and dynamic observations
of contracting patterns. One static observation
is that business
entities
tend to adopt different contractual alloca
on whether they are buyers or sellers.
risks depending
When they are buyers or licensees,
they demand extensive warranties
and indemnification
from their counterparts;
when they are
promises
tions of similar
or licensors, they disclaim, limit remedies, and demand indemni
A dynamic observation
is that contract
from their customers.
in loan and debt agreements,
or material ad
terms such as covenants
sellers
fication
verse change ("MAC")
clauses in mergers and acquisitions
agreements,
fluctuate over time between "buyer-friendly"
and "seller-friendly"
ver
sions as market conditions
change.11
when and why bargaining or market
addressing
and wor
of nonprice terms remains unexplored
The conventional
law-and-economics
theory offers
The
set of questions
is a determinant
power
thy of investigation.
a starting point for this analysis by offering two irrelevance propositions:
(1) bargaining power affects the price but not the nonprice terms of a
of bargaining
contract (the strong-form version);
and (2) the allocation
may lead to different nonprice terms but does not change the like
that the parties will agree to efficient terms (the weak-form ver
sion).12 Each of these propositions
depends on a set of implicit assump
costs. We
and zero transactions
tions, including
perfect information
power
lihood
relax these assumptions
in this Article to bridge theory and practice, by
a
theoretical
framework
to understand when and how bargain
providing
ing power determines contract design. To focus on bargaining power, we
in their
assume that each party can read and understand all provisions
contract and set aside important effects that stem from lack of sophisti
cation or bounded rationality.13
10
11
12
Id. at 982.
See
infra note 41;
See
Schwartz
II.C.
13
&
Section
Scott,
II.B;
supra
see also
infra note 68; Section
note 4, at 554;
Section
II.A;
II.D.
see also
infra Sections
II.B
&
set of issues
with nonprice
terms in contract, a common
confounding
dealing
from the fact that weaker parties, particularly
individual
often do not read
consumers,
to
or understand
certain nonprice terms, either because
sophistication
they lack the necessary
it is not rational for them to spend the time and effort to read and under
do so or because
When
stems
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The Effectof Bargaining Power
2012]
1671
treats a price term as purely
The strong-form irrelevance proposition
distributional:
it allocates the surplus and has no effect on size. Howev
er, variations in price terms can change the optimal nonprice terms when
there is a change in price. We give two instances of this phenomenon.
First, a different price alters one (or both) party's rate of substitution be
tween price and nonprice terms. For example, a business executive who
is richly paid may be willing to sacrifice a greater amount in salary for
an official title than one who is less well paid. Second,
price determines the severity of the adverse-selection
a higher or lower
or moral-hazard
we would
For example,
to have
problems.
expect a loan agreement
and
more
extensive
covenants
to
address
these
tighter
problems when
the market rate of interest is high than when it is low, all else equal.14
Turning to the weak-form proposition, we outline four ways in which
the shift in the bargaining power might lead to a deviation from efficient
in negotiations
contract design. First, the pursuit of advantage
exacer
bates the inclination
of negotiators to engage in value-claiming
rather
than value-creating
the
with
strategies. Second,
party
greater bargaining
power has better incentives to invest effort and resources in innovating
and developing
contractual opportunities to create value. Third, business
often
occurs in a two-stage process: the price and other im
contracting
portant terms are decided by the business principals, and the design "de
tails"
are delegated to their respective lawyers. The exercise of bargain
ing power in the second stage, after price has been determined, may
distort the agreement on nonprice terms. Fourth, in negotiations
charac
terized by information
asymmetry,
unequal
bargaining
power
might en
stand the terms. Such bounded
can be very significant
rationality and lack of sophistication
factors leading to inefficient and one-sided
terms. See, e.g., Xavier Gabaix
& David Laibson,
Shrouded
and Information
in Competitive
Mar
Attributes, Consumer
Myopia,
Suppression
kets, 121 Q.J. Econ. 505, 509 (2006);
Avery Katz, Your Terms or Mine? The Duty to Read
the Fine Print in Contracts,
21 RAND
J. Econ. 518, 519 (1990);
Russell
Bounded
Korobkin,
Standard Form Contracts,
and Unconscionability,
70 U. Chi. L. Rev. 1203, 1206
Rationality,
Alan Schwartz
& Louis
L. Wilde,
Information
in Markets
for Contract
(2003);
Imperfect
Terms:
(1983);
The
of Warranties
Examples
Yeon-Koo
Che & Albert H.
Mass-Market
Communicating
Law
and
Econ.
Research
Contract
Paper
and
Security
Interests,
Choi,
Shrink-Wraps:
Terms? 3-4 (Univ.
Series,
Paper
No.
http://ssrn.com/abstract=1384682.
4
Albert Choi & George
Triantis, Market Conditions
Debt
Covenants
and Collateral,
87 N.Y.U.
L. Rev.
69
Who
of Va.
Va.
L.
Should
Sch.
Rev.
Bear
of Law
1389
1387,
the Cost of
John M. Olin
2009),
available
at
and Contract
Design:
Variations
in
(forthcoming
2013),
available
at
2009-15,
http://ssrn.com/abstract=2048621.
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1672
Virginia Law Review
excessive
courage
signaling
or
screening
[Vol. 98:1665
in the
activity
design
of
terms.
nonprice
Each of these effects warrants more detailed
treatment and we analyze
only one of them in this Article. We examine the impact of unequal bar
valuations
gaining power when markets have buyers with heterogeneous
of alternative
contract terms and these values
are not observable
by the
on
from
the
economics
of
industrial
seller(s).15 Building
insights
organi
that one-sided
zation, we demonstrate
theoretically
bargaining
power
can lead to the inefficient use of nonprice terms to screen or signal (de
the power lies with the seller or the buyer, respec
that
or otherwise dominant seller may
a monopolist
tively).
screen by offering suboptimal
contract quality to the buyer who values
At
less.
the
other
when the buyer has all the bargaining
extreme,
quality
similar
the
of
to
case
power,
perfect competition, the buyer who values
on whether
pending
We
show
the nonprice
term less will seek to avoid
by agreeing
sellers.16
to suboptimal
nonprice
other buyer types
subsidizing
to signal her type to the
terms,
in which sellers can
To illustrate, consider a market for automobiles
in
which buyers have
to
either
limited
or
extended
warranties
and
agree
different valuations
careful
or careless
careful
or careless.
of the warranty provisions
because
they are either
drivers. The seller cannot observe which drivers are
that both groups of buyers would pay more
it would cost the seller to provide, and
than
warranty
therefore
efficient. A monopolist
would seek to
warranty is
Suppose
for the extended
the extended
maximize
and limited
its share of the surplus in each sale by offering both extended
warranties at prices that would induce the careful driver to
purchase a limited warranty. Similar inefficient separation would occur
in a perfectly competitive market. If sellers offered the extended warran
the
ty to all buyers at a single price, careful drivers would subsidize
careless
choose
15
drivers.
The
careful
the limited warranty
drivers, then, would have an incentive to
so as to signal their type to the market and
that are plausible
across a significant domain of nonprice
make several assumptions
even if the underlying
nonassignable,
including:
(1) contract rights are generally
affects not only the value of
idiosyncratic
(2) a buyer's
preference
product can be resold;
attributes
terms to the buyer, but also the cost to the seller; and (3) unlike physical
nonprice
to another and also to
of a product, contract terms are easier to vary from one consumer
We
terms,
modify, even after sale.
16
See Philippe Aghion & Benjamin
Hermalin,
Legal
Enhance
6 J.L. Econ. & Org. 381, 381-82,
Efficiency,
problem of inefficient signaling).
Restrictions
400-01
on Private
(1990)
Contracts
(describing
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Can
a similar
1673
The Effectof Bargaining Power
2012]
receive
that exceeds
a price reduction
the value
of the foregone
warran
ty.17
The problem of extreme allocations
of bargaining power in either di
in
from
the
fact
that
one party has the power to dic
rection stems,
part,
tate the terms of trade. The party with this power is willing, in many cir
to sacrifice
some of the aggregate
cumstances,
surplus in order to
of
the
a
more
"even" sharing
capture a larger share
surplus. Therefore,
in contract design. The
of the surplus may address these inefficiencies
balance
bargaining
power in this manner,
After
however,
all, competitive markets essentially al
locate all the power to the buyers without leaving any surplus for the
sellers. We suggest three ways of representing more "even" sharing of
bargaining power. In the first, some competition is introduced by allow
that would
circumstances
are not obvious.
seller (an entrant) to compete with an existing seller (an in
In
the second, the power of commitment is reduced by letting
cumbent).
the contracting parties renegotiate the original contract. In the third, the
ing another
seller's
power to dictate the terms is curtailed by allowing the buyer to
the terms with some delay. In each of these cases, we demon
strate the key result that the conditions mitigate or eliminate the ineffi
dictate
ciencies
of screening and signaling through nonprice terms.18
The Article is organized
as follows. Part I investigates various mean
for
ings
unequal
bargaining power. Part II states the weak and strong
forms of the bargaining
and then out
propositions,
power irrelevance
lines various
paths by which bargaining power might determine contract
III
reviews related literature in industrial organization
con
Part
design.
cerning how monopoly and perfect competition can distort the quality of
goods provided. Part IV provides a more detailed analysis of the effect
of unequal
17
bargaining
power
on contract
design
when parties
are asym
This
is familiar in markets for health insurance
and can be applied
more
argument
to contracting patterns in other industries. When both the healthy and sick people are
the healthy will be subsidizing
the sick, and they
insurance,
pooled
together for a common
will have an incentive to drop out of the common
less than
policy by, for instance, choosing
broadly
full insurance
Equilibrium
at a much
lower
in Competitive
90 Q.J. Econ.
See, e.g., Joseph Stiglitz & Michael
Rothschild,
premium.
Insurance
Markets:
An Essay
on the Economics
of Imperfect
see also Albert H. Choi & Kathryn E. Spier,
629, 638 (1976);
Information,
Should Consumers
be Permitted
and
Selection
to Waive
Products
Product Safety, Private Con
Liability?
at
available
25, 2011)
(unpublished
manuscript,
http://ssrn.com/abstract=l
680932)
(making similar argument with respect to product safety).
The Appendix
de
presents a more general model in which a social planner (mechanism
tracts,
Adverse
signer) can choose,
and the seller.
without
18
knowing
(July
buyer
type, what types of contract
to offer to the buyer
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1674
Virginia
Law
[Vol. 98:1665
Review
metrically informed as to the value and cost of a given nonprice term.
Part V shows that more even bargaining power can attenuate inefficient
screening and signaling through nonprice terms. Despite the inefficien
cies caused
that legal
power, we suggest briefly in Part VI
to be able to mitigate these problems
with a
freedom of contract. We conclude
by unequal bargaining
institutions are unlikely
the parties'
by constraining
comment as to possible directions
I. What
for future research.
Power?
Is Bargaining
Although bargaining power is often cited as a critical determinant of
contractual terms, neither the meaning of power nor the path of its influ
ence is very clear.19 People differ in the meaning they attach to the ex
The slipperiness
of the term is due at least partly to the fact
pression.
that "bargaining
power" frequently boils down to a tautology: one party
had bargaining power when the resulting agreement is more favorable to
use of the ex
that party than its counterpart.20 In light of the ubiquitous
and then to
its
we
to
its
and
hope
meaning
vagueness,
clarify
pression
affect
contract
can
of
the
in
which
some
bargaining power
explore
ways
design.
Consider
isolate
19
See
a deal
struck between
the meaning
David
A.
Lax
of bargaining
&
James
K.
and Competitive
Gain
Cooperation
is "notoriously
Richard
slippery");
a buyer and seller of a good. We can
power by setting aside contract design
Sebenius,
249 (1986)
A. Posner,
The Manager
as Negotiator:
for
Bargaining
power
(noting that the concept of bargaining
of Law
101-04
Economic
(3d ed.
Analysis
the concept
of unequal
bargaining
power is
whether
"the general
1986)
(raising
question
Duncan
fruitful, or even meaningful");
Kennedy,
References
Contract
and Tort Law, with Special
gaining
Power,
bargaining
power
See Thomas
41
Md.
L. Rev.
as "internally
C. Schelling,
563,
623
(1982)
Distributive
and
Paternalist
Motives
in
Terms and Unequal
Bar
to Compulsory
of
(referring to the doctrine of inequality
incoherent").
The Strategy
of Conflict
22 (1960)
('"Bargaining
power,'
skill' suggest that the advantage
goes to the powerful, the
'bargaining
are defined to mean only that ne
It does, of course, if those qualities
to be
are won by those who win. But, if the terms imply that it is an advantage
gotiations
more physical
more intelligent or more skilled in debate, or to have more financial resources,
strength, more military potency, or more ability to withstand losses, then the term does a dis
strength,'
'bargaining
strong, or the skillful.
in bargaining
are by no means universal
situations;
they
advantages
qualities
of the Contract at Will, 51 U.
Richard A. Epstein, In Defense
a contrary value.");
Chi. L. Rev. 947, 974 (1984)
"[t]he ques
(stating that, with respect to a bilateral monopoly
tion of inequality
of bargaining
power can now be helpfully restated: which side will appro
service.
These
often have
between
priate most of the surplus in any negotiations
of bargaining
be said to possess
an inequality
power
than half the surplus").
them?
when
can therefore
... An employer
more
he is able to appropriate
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The Effectof Bargaining Power
2012]
1675
that the nonprice terms have been fixed. That is, all rights
the
purchased by
buyer are well defined and settled, and the only ques
is
The
tion
parties will agree to a price within a bargaining range
price.
that is defined by the parties' respective reservation prices. The negotia
and assuming
tion literature calls
these boundaries
Settlement
Negotiated
seller's BATNA
the parties' Best Alternatives
to a
At the bottom of the range is the
("BATNA").21
or reservation price: the value of the seller's next best
(for example, the seller might choose to sell it to another
use of the good
buyer or use it herself). At the top end of the range is the buyer's
BATNA
or reservation price: the value of the buyer's next best use of
her funds (for example,
the price at which she can buy the good from
another seller or the foregone benefit if she walks away from the pur
models presume that the point within this
chase). Many game-theoretic
range at which the price is agreed upon is determined by the relative pa
tience and risk aversion of the parties, as they look at the prospect of
continued bargaining and delayed agreement.22 In contrast, the negotia
tion literature
and practitioners think of bargaining power as adjusting
of the bargaining range itself, in addition to placement
the boundaries
within the range.
From this perspective,
price is a function of the seller's and buyer's
of the two reservation prices (each party's own
respective perceptions
and that of her counterpart).23 The perceived
bounds for the bargaining
range, and the price ultimately chosen within this range, are determined
or endogenous
to the nego
by a mix of factors that might be exogenous
tiations. We divide these factors into five categories:
(1) demand and
supply conditions, (2) marketconcentration,(3) private information,(4)
patience and risk aversion, and (5) negotiating skills and strategy.
The first category of exogenous
factors consists of the demand and
supply conditions in the relevant market. When there is a significant in
crease
in the demand
ket-clearing
21
See,
for the product or reduction in the supply, the mar
will
tend to increase and sellers are often said to have
price
e.g., Roger
Fisher
97-105 (2d ed. 1991).
22
et al., Getting
to Yes:
Negotiating
Agreement
Without
Giving
In
In complete,
Ru
models, such as those by Professors
symmetric information bargaining
and Stahl, the party who is more patient—that
is, who has a lower discount rate—
binstein
Ariel Ru
gets a larger share of the surplus. See Ingolf Stahl, Bargaining
Theory 121 (1972);
in a Bargaining
50 Econometrica
In the
binstein, Perfect Equilibrium
Model,
97, 108 (1982).
is partly reflected through the dis
two-period
bargaining
games that we present, the patience
count factor S.
23
Fisher et al., supra note 21, at 102 ("The better your BATNA,
the greater your power.").
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1676
Virginia
Law
[Vol. 98:1665
Review
bargaining power. An example we discuss further below is the
tightening of credit during and following the 2007 financial crisis: indus
substan
try participants noted that when the supply of credit decreased
increased
tially,
lenders
enjoyed
greater
"bargaining
power"
over
their borrow
ers.24
A second
A
factors is market concentration.
category of exogenous
market
is
often
referred
to
as
its
monopolist's
power
bargaining power.
A buyer's no-agreement
alternative is limited by the fact that there are
no other sellers in the market and his reservation price is corresponding
the same good from a competing
ly higher than if he could purchase
seller. Typically, market concentration
on the seller side increases price
and concentration
on the buyer side decreases
it.
third category of exogenous
ad
factors contains
informational
the
other
par
vantages that one party may enjoy by knowing more about
about
A
with
infor
or
information
itself.
party
private
ty
by concealing
A
can be thought of as having a type of monopoly
stemming from
this information.25 In the analysis later in this Article, we isolate the pri
vate information relating to one's own reservation price and treat it dis
mation
tinctly from bargaining power. Thus, in Parts IV and V, the buyer has
private information as to how much he values the good being sold, while
the other aspects of bargaining
power shift between the buyer and the
seller.
such as pa
We identify a fourth category containing
characteristics
tience and risk aversion that may determine where the agreed price will
fall within a given bargaining range.26 Bold parties, for example, may do
better than timid players, and the patient negotiator
typically enjoys
higher returns than her impatient opponent. Patience may be, in turn, a
function of other factors, such as the solvency and liquidity constraints
of the party, or its ability to diversify the risk of an unfavorable bargain
ing outcome.
tactics that can
In a fifth category, we put the various negotiating
reservation
of
either
the
actual
or
party, so as to
price
change
perceived
induce a favorable shift in the bargaining range.27 For example, a party
24
text.
and accompanying
of a valuable
re
et al., supra note 5, at 135 ("[T]hey
are the sole 'owners'
source—information
about their type.").
26
text.
See supra note 22 and accompanying
27
of bargaining
ex
determinants
the exogenous
Rather than analyze
power, negotiation
its counterpart's
perts focus on the means by which a party can increase its own and decrease
25
See
infra notes 41^3
See
Cabrales
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1677
The Effectof Bargaining Power
2012]
if she can improve her alternative to reaching an
to third parties that increase the cost of
will be more successful
or make commitments
agreement
in the negotiations.
Or, a party might take steps to
granting concessions
her opponent's
outside
worsen (or appear to worsen)
opportunities,
or
We
credible
threats
otherwise.28
might put in this category the
through
hold-up issue in contract theory: the tactic of inducing the
investments that can later in
other party to make relationship-specific
loss
on
that
from
flict a significant
non-agreement.29
Strategic ne
party
gotiators also exploit the cognitive biases and errors of opponents, par
well-known
ticularly the tendency of individuals
and be overconfident in their abilities.
to anchor, escalate
commitment,
In some cases, bargaining through
results. These skills are the subject of
one or more agents might improve
and we do not attempt to summarize
many books on negotiation
here.
them
In any given transaction, one or more of these factors may be in play.
Which ones are present may determine the path by which unequal bar
gaining power affects contract design. This Article is meant to set a
framework
ing power
for further investigation
terms.
of the interaction
II. How
Bargaining
Power
Affects
Contract
in bargaining
In this Part, we explore how changes
influence
terms.
We
start
by articulating
may
nonprice
weak-form versions of the bargaining power irrelevance
irrelevance
between
bargain
and nonprice
is one that flows
proposition
in the process.
advantage
of itself has often proved
logically
Design
power balance
the strong- and
An
proposition.
from a set of restric
Lax
& Sebenius,
supra note 19, at 257 ("Analyzing
to be a sterile exercise.
However,
directly focusing
of the bargaining
set and the ways that such changes
in and
'power'
on factors that
can change perceptions
influence out
comes seems more fruitful for both theory and practice.").
28
The Competi
K. Dixit & Barry J. Nalebuff,
See, e.g., Avinash
Thinking
Strategically:
tive Edge in Business,
Life 291 (1991)
matters is his outside
Politics, and Everyday
("[W]hat
to that of his rival. He will do better in the bargaining
even if he makes a
both parties'
so long as that of the
outside opportunities,
rival is damaged
more severely.");
G. Richard Shell, Bargaining
for Advantage:
Negotiation
for Reasonable
103 (2d ed. 2006)
Strategies
People
(noting that threatening your opponent
opportunity
commitment
relative
or a threat that lowers
with losses
"as astute negotiators
have
resulting from the failure to agree works because,
for centuries and psychologists
have repeatedly
losses loom larger
proven, potential
in the human mind than do equivalent
gains").
29
Structure 26-27
Oliver E.
See, e.g., Oliver Hart, Firms, Contracts, and Financial
(1995);
known
Williamson,
The
Economic
ing 52-54, 61-62 (1985).
Institutions
of Capitalism:
Firms,
Markets,
Relational
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Contract
Virginia Law Review
1678
[Vol. 98:1665
tive assumptions
that are suspected
to be both unrealistic and binding.
in law-and-economics
Two famous irrelevance
are Modi
propositions
and
the
Miller's
of
gliani
("MM")
significance
proposition
concerning
debt and equity in corporate finance30 and Coase's
of legal entitlements.31 The assumptions
proposition
on which the bargaining power proposition
is based are very strong. In
the choice
between
about the allocation
par
they are similar to those of the MM and Coase propositions,
the
of
information
and
no
transaction
ticularly
assumptions
symmetric
costs. These are the assumptions
that we begin to unpack in this Article.
deed,
then divide
We
our hypotheses
of influence of bargaining power on
terms
into
two
First, contrary to the strong-form
nonprice
categories.
a
in
version,
change
bargaining power, through its effect on price, may
alter the optimal nonprice terms. Second, contrary to the weak-form ver
sion, bargaining power may lead to inefficient terms as a result of the
of the bargaining
exercise
power. We also briefly introduce the more
complicated
question of how bargaining power influences contract de
when
sign
negotiations are conducted in stages and through agents.
A. The Bargaining
Some
nopolist
theorists have
will
competitive
Power
Propositions
that the contract terms offered by a mo
as those offered by a seller in a
asserted
be essentially
market.32 Each
Irrelevance
the same
provision
of a contract
creates
value
for at
30
Finance
and the
Franco Modigliani
& Merton H. Miller, The Cost of Capital,
Corporate
The authors later presented
48 Am. Econ. Rev. 261, 262-64
(1958).
Theory of Investment,
an irrelevance
the effect of dividend
policy on firm value. Merton H.
proposition
concerning
of Shares, 34 J.
Dividend
Miller & Franco Modigliani,
Growth, and the Valuation
Policy,
Bus. 411,412-14(1961).
31
R. H. Coase,
The
In some
Econ.
1, 15-16
(1960).
of the
can be thought of as an extension
setting, parties bargain over legal rights so as to elim
proposition.
if any, that is engendered
Id. In the
inate the inefficiency,
by the initial legal entitlement.
there are no default nonprice
terms; rather, the
bargaining
power irrelevance
proposition,
sense,
Coase
the bargaining
Problem
of Social
power irrelevance
In a standard Coase
Cost,
3 J.L. &
proposition
the surplus from the transaction.
parties choose a set of nonprice terms that maximize
32
In an early article, Alan Schwartz
based his analysis
on three very weak assumptions
demand
for quality does not vary with
that now seem especially
(1) "consumer
incomplete:
the amount of physical
industry use
(2) "all firms within a competitive
product consumed,"
of the level of industrywide
technology
regardless
output," and (3) "the production
is 'similar'
to that of a competitive
of a monopolist
industry in the sense that the
factor combinations
at
and competitive
monopolist
industry face the same cost-minimizing
the same
function
supra note 4, at 1073. In a footnote,
any level of output." Schwartz,
to set aside
that the monopolist
does not price-discriminate
assumes
n.44, he also
the possibility
raised by
id. at 1075
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The Effectof Bargaining Power
2012]
1679
least one party and that party may view the provision as part of the good
being sold. For example, a warranty, a termination right, or a
selected dispute resolution venue is "sold" by one party to the other. The
or service
states that, if the cost and demand curves are the
proposition
same for both monopolist
and seller in perfect competition, each will of
fer the same nonprice terms. The proposition
would extend to bilateral
between
and
seller
in
which
the balance
of power
buyer
bargaining
irrelevance
shifts between
the two parties.
The proposition
is based on the observation
that a monopolist
that re
fuses to sell the quality desired by its customers, when their willingness
to pay exceeds his cost of providing that quality, is simply leaving mon
theorists refute the
ey on the table. On this basis, law-and-economics
concern
leads
of more
to unfair
Scott provide
traditional
contract
contract
terms.
scholars
Professors
Alan
that bargaining
Schwartz
and
power
Robert
a recent statement of this refutation:
It is widely believed that parties exercise bargaining
ing weaker contracting partners to take unfavorable
that superficially appear one-sided
are commonly
power by requir
terms....
Terms
described
as the
product of "unequal bargaining power." But when bargaining power is
determined prior to contract formation, as is common in business con
texts, these views are incorrect. Bargaining power instead is exercised
in the division
of the surplus, which is determined by the price term.
Parties jointly choose the contract terms so as to maximize the surplus,
which the parties may then divide unequally.33
Our interest in this Article
terms
nonprice
of
is the effect of bargaining
power on the
We assume
a
successfully
completed
bargain.
to understand the
throughout that both parties have the sophistication
terms of the contract. This assumption
ensures that the contracts we are
discussing clearly improve the welfare of both parties, compared to each
literature suggests that par
position. Experimental
to fail to reach a welfare-improving
if
agreement
they have significantly unequal, as opposed to roughly equal, bargaining
party's no-agreement
ties are more likely
Professors
Michael
Mussa
and
Sherwin
Theory 301, 301 (1978).
33
Schwartz
monopolist
&
looks
Rosen,
Monopoly
and Product
Quality,
18 J. Econ.
supra note 4, at 554; see also Baird, supra note 4, at 941
for efficient warranty terms. Using inefficient terms compromises
to extract rents. She is much better off providing
quality goods
Scott,
nopolist's
ability
cient terms and charging
as much
as she can from them.").
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a
("Even
the mo
and
effi
1680
Virginia Law Review
power.34 The relevant
power affects contract
question
[Vol. 98:1665
in this Article
is whether
bargaining
of the bar
design,
gaining surplus. We return to the simple sale example introduced above
and ask whether a shift in the relative bargaining
power between the
seller and buyer might alter the agreed-upon
warranty. A warranty allo
in addition
to the distribution
cates the risk of product malfunction, depending
on features such as its
In
the
sets
incentives for the sell
and
duration.
so,
warranty
scope
doing
er to raise the quality of the good and the buyer to take care in using it. It
might also be a means by which the seller can signal the quality of the
good. One could think of a surplus-maximizing
warranty that optimized
of the buyer and
given the characteristics
seller. Bargaining
power might affect the agreed-upon
warranty in two
directions. It might change the terms of the optimal warranty or it might
across
these
considerations,
lead the parties to deviate from the optimum in their agreement.
In Section
II.B that follows, we suggest that a shift in bargaining
power might change the optimal nonprice terms through its effect on
price. The change in price may have a wealth (or substitution) effect on
a party's tradeoff between price and nonprice terms. It may also alter the
of one or
or moral hazard problems
severity of the adverse selection
of risk. Then, in
both of the parties, leading to a new optimal allocation
Section II.C, we identify several ways in which bargaining power can
affect the efficiency of the nonprice terms.
B. Bargaining
Power
Can Alter the Optimal
Terms
Nonprice
In this Section, we explore how bargaining power can alter optimal
nonprice terms.35 In the first instance, a shift in bargaining power puts
34
See
the dignity
et al., supra note 21, at 105 (noting the importance
of preserving
Lax & Sebenius,
supra note 19, at 129 ("A number of studies suggest
to his own weakness
and the counterpart's
a bargainer
attributes his concession
Fisher
of the weaker
that when
party);
strength, a blowup
is likely.");
Jeffrey Z. Rubin
& Bert R. Brown,
The
Social
Psychology
of
Bargaining and Negotiation 217 (1975) ("Pairs with equal [bargaining]power attainedhigh
er joint payoffs than those with unequal
Environmental
Complex
Negotiations:
ory 247,
252,
"In
269
addition
(1997)
(noting
to removing
in
Nina Burkardt et al., Power Distribution
power.");
Does Balance
Matter?, 7 J. Pub. Admin. Res. & The
that power imbalance
the negative
factors
tends
to inhibit
detailed
above,
successful
negotia
symmetrical
power
to creative,
deal
between
the parties,
to encourage
feelings
open parties
good
and remove the temptation to use force and threats." Robert S. Adler
enhancing
suggestions,
in
with Power Differentials
& Elliot M. Silverstein,
When David
Meets Goliath:
Dealing
tions).
tends
Negotiations,
In many
the optimal
5 Harv.
cases,
(citations omitted).
Negot. L. Rev. 1,18 (2000)
the conditions
that lead to a shift in bargaining
power
terms by changing,
for instance,
the volatility
in the economic
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might also change
environment
of
The Effectof Bargaining Power
2012]
pressure
1681
on the price term. This effect, in turn, can change the optimal
of nonprice terms in the contract. The important insight here is
design
that any "price" term does not simply allocate
surplus. A significant
in
bears
on
the
and
for
change
price
surplus
may provide opportunities
surplus creation by the adoption of different nonprice terms. We explain
how this might happen in two types of circumstances.
First, it is helpful
to recall that a contract term is part of the "quality" of the good or ser
A party's willingness
vice being exchanged.
to purchase
quality is a
function of her wealth, just as is her willingness
to buy the underlying
or
service.
as
increases
because
of a shift in bar
Therefore,
good
price
gaining power toward a seller, the buyer's wealth declines and so does
her demand
for various nonprice terms, such as an extended warranty or
the right to sue in the buyer's own state courts.36 To a casual observer, it
may seem like the seller is exercising its bargaining power by reducing
the quality of the nonprice terms, whereas the seller is in fact responding
to the wealth
effect of a higher price
on the buyer's
demand
for such
terms.
This
effect may be at work in an employment
contract or a venture
in
investment
a
capital ("VC")
start-up enterprise. VC contracts contain
financial terms (dividing the equity payoffs between the VC fund and
the entrepreneur)
and governance
terms (for example,
the VC fund's
seats on the board).37 The financial terms can be thought of as "price"
and the governance
terms as "nonprice"
terms. The governance
terms
are valuable
tend to place
in addressing problems of moral hazard, but entrepreneurs
offsetting value on maintaining control of the fate of their
the parties. For example,
an increase in the volatility of economic
conditions
can lead to both
a shrinking in the availability
of credit and the value of covenants
that constrain the borrow
er's incentive to take risks. See infra note 41 and accompanying
text. We set this possibility
aside
36
in this Article
There
may
because
be other
it does
not follow
substitution
effects
from the shift in bargaining
from price changes.
arising
power.
Professor
Dennis
Carlton
customers
tomorrow
for today, so that con
suggests
may trade off consumption
At least to the extent that the impetus to change prices shows a
sumption shifts to tomorrow.
some empirical
studies have documented
conditions,
change in supply and demand
price ri
can be market-clearing
devices
in lieu
gidity in some industries. Delivery
lags, for example,
of or in addition to price. Dennis W. Carlton, Equilibrium
Fluctuations
When Price and De
in
Lag Clear the Market, 14 Bell J. Econ.
562, 562 (1983)
(finding that fluctuations
as important to the equilibration
of demand
and supply as
delivery lags are approximately
are fluctuations
in price);
Dennis
W. Carlton,
The Rigidity of Prices, 76 Am. Econ.
Rev.
livery
637,638(1986).
37
See
World:
82 (2003)
Steven
N. Kaplan
An Empirical
(describing
&
Analysis
financial
Per Stromberg,
Financial
Contracting
Theory
of Venture Capital
70 Rev. Econ.
Contracts,
and governance
characteristics
of VC
Meets
Stud.
financings).
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the Real
281,
281—
Virginia Law Review
1682
[Vol. 98:1665
If the VC has more bargaining power than the entrepre
own company.
to sell a larger portion of the value
the
neur,
entrepreneur is compelled
the
as
well
as
to
surrender control of, for instance, a
of
company,
agree
given number of seats on the board of directors. As power shifts to the
in available
of expansion
capital, she can offer a
entrepreneur because
smaller share of equity to the VC fund for every dollar of capital invest
wealth increases
and the
Her expected
ed (a lower price for capital).
marginal tradeoff between money and control changes as a result: in
stead of reducing the share of equity she gives the VC, she would offer
instead fewer outside seats on the board.
This phenomenon
may occur even in contracts between firms because
benefits at
their individual
agents trade off monetary and nonmonetary
another
wealth. Consider
on their individual
different rates, depending
contract in the stream of VC
of the VC
the limited partnership agreement
fees and
provides for the management
funding:
fund. This
agreement
interest that are paid to the venture capitalist. The venture capi
the fund, including
talist also enjoys private benefits from managing
is costly to the in
of
these
benefits
and
His
pursuit
perquisites.
prestige
carried
vestors
(limited
partners)
to the fund. To
includes
address
these
restrictions
incentives, the
on the decisions
typically
partnership agreement
and activities of the venture capitalist. The tightness of these restrictions
reflects, no doubt, the cost of the private benefits to the investors, but al
so the tradeoff in the eyes of the venture capitalist between monetary
and the value of such private benefits. In their study of
compensation
venture capital partnerships in the 1990s, Professors Paul Gompers and
Josh Lerner observed that cyclical changes in the demand for and supply
of venture capitalists may explain shifting contracting patterns.38 While
of experienced
the supply of capital varies, rigidity in the availability
in
market. When
this
imbalances
causes
venture capitalists
periodic
monetary returns are
capital inflows are greater, the venture capitalists'
higher. Gompers
leads to dilution
also
of restrictions
they do not explain
38
noted, however, that the increase also
but
on activities of venture capitalists;
the mechanism
by which this effect takes place.39
and Lerner
& Josh Lerner, The Venture Capital Cycle 31-32,45^17
(1999).
Gompers
in the World of Ven
Contract Design
Id. at 25; see also George G. Triantis, Financial
the irrelevance
68 U. Chi. L. Rev. 305, 319-21
ture Capital,
why
question:
(2001)
(asking
not use their bargaining
would
venture capitalists
power to capture a larger share of the
39
Paul
monetary
surplus
from efficient
contracting?).
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The Effect of Bargaining
2012]
1683
Power
explanation
may lie in the shifting rates of substitution
wealth effects we describe here.
The
caused
by
The effect of bargaining power through price on nonprice terms may
also run through a second causal chain. Changes in price have an impact
on the nature of adverse selection and moral hazard problems in some
as lending or in
plagued by these problems—such
demand
or excess sup
not
excess
clear, leaving
markets—may
with
insurers
faced
excess demand,
may be reluctant
ply. For example,
to raise premiums for fear of driving out the lower-risk customers and
transactions.
Markets
surance
being left with a riskier pool. Nonprice contractual terms are commonly
designed to mitigate these information problems by, for instance, screen
A change in price can increase or de
ing out the high-risk customers.
the severity of these problems, and some nonprice terms become
more or less valuable.
Thus, changes in price can alter
correspondingly
the optimal use of these terms. In the warranty example, when a seller
crease
bargaining power and can charge more for a warranty, it is more
likely to lose low-risk customers and attract a riskier pool of customers.
Therefore, the rise in price may itself lead to a narrowing of the scope of
the optimal warranty.
gains
A loan
lems
contract
of adverse
is a more powerful example because
selection and moral hazard are widely
the dual
known.
prob
These
and events of default. The
typically include a set of covenants
of the covenants may give the lender the right to accelerate the
of the loan and if the borrower fails to pay the accelerated
contracts
violation
maturity
as
amount, the lender may then enforce its claim against the borrower's
restrict
actions
or
such
as
the
bor
sets. Covenants
some
decisions,
may
rower's incurring new liabilities, selling assets, or making distributions
Or, covenants may set tripwires that trigger default, in
financial-ratio tests such as maximum debt-to-equity or interest
to stockholders.
cluding
to-earnings ratios. Contracts vary in terms of the types of behavior that
are restricted or the types of tripwires, as well as how close the tripwires
are set to the borrower's
current condition. Both the breadth and tight
ness of covenants
are matters of contract design.40
are sometimes
regarded as "boilerplate"
provi
across contracts between
packages
vary considerably
covenants
Although
covenant
sions,
40
Since
Contracting:
scholarship
instruments.
work on debt covenants,
Clifford Smith & Jerold Warner, On Financial
An Analysis
of Bond Covenants,
7 J. Fin. Econ.
117 (1979),
a large body of
the determinants
in loan agreements
and bond
has investigated
of debt covenants
the classic
See,
e.g., Choi
& Triantis,
supra note 14 (manuscript
at 2).
This content downloaded from 149.142.112.3 on Wed, 12 Feb 2014 14:25:38 PM
All use subject to JSTOR Terms and Conditions
1684
Virginia
different lenders
Law
[Vol. 98:1665
Review
A growing body of theoretical and em
identifies firm-specific and market determi
and borrowers.
pirical finance scholarship
The industry press also
nants of the intensity and tightness of covenants.
a
connection
between
the
and
demand conditions
suggests
strong
supply
and covenant
deals grew at a staggering pace
patterns. Covenant-lite
the
first
half
of
the
decade
until the onset of the financial
throughout
past
crisis in 2007, and market observers attributed this growth to the excess
loans collapsed
in the
supply of credit.41 The market for covenant-lite
second half of that year and was followed by a period of more extensive
that cove
and tighter covenants
during 2007-2009.
Reports suggested
of the excess supply of in
nant-lite deals then emerged again because
vestment funds, at least for higher-grade borrowers.42 The following re
cent explanation
by a partner at the law
Wharton & Garrison is typical:
firm of Paul,
Weiss,
Rifkind,
(cov-lite) loans became widespread at the top of the last
credit cycle before the 2007 credit crunch. During the credit crunch,
Covenant-lite
41
Ana
tures
Lai
&
Steven
Diminish
M.
Bavaria,
The
Leveraging
2 (2007),
of America:
available
Covenant-Lite
Loan
Struc
at
http://s3.amazonaws.com/
In this report by
zanran_storage/www2.standardandpoors.com/ContentPages/561145523.pdf.
that:
Standard & Poor's on the eve of the financial crisis, the ratings agency observed
LBOs
pace of private equity sponsored
Strong loan market liquidity and the continued
Recovery
Prospects
loans in 2007.
Such favorable
are driving a record volume
of leveraged
with growing investor demand
from structured finance
tors, combined
"covenant-lite"
bank facilities with weakened
hedge funds, have allowed
market
vehicles
loan
fac
and
struc
tures to emerge as the instruments of choice for many issuers. As the volume of lever
facilities has in
of covenant-lite
an all-time high, the proportion
aged loans reaches
loans will revert to
It remains to be seen whether leveraged
creased tremendously....
There has already been
structures when the credit cycle turns....
so far this year as market conditions
begin to soften, with certain
pushback
without a robust covenant package.
transactions
unable to get through syndication
more
traditional
some
Id.
42
Wall St. J., Feb. 7, 2011, at
Aneiro, Aleris Debt Sale: 'Covenant-lite,'
See, e.g., Michael
... and has allowed
has pushed the average junk-bond
("[D]emand
yield down to 7.01%
that govern
new offerings.");
or covenants,
issuers
to water down investor
protections,
Michelle
Sierra Laffitte, IFR-Covenant-Lite
Buyout Loans Return to U.S. Loan Market, Int'l
C3
Fin.
Jan.
Rev.,
31,
2011,
http://www.reuters.com/article/2011/01/31/loans-covenant-lite
are expected
to try to
("As the market gets hotter, companies
Kate
in deals
that were completed
and slash covenants
reduce
recently....");
spreads
of the Past,
Covenant-Lite
Loans Are Back but Investors Hope to Limit Mistakes
Laughlin,
idINLDE70U0T520110131
Fin.
Times,
where
investors
the covenant-lite
covenant
ldf-8d91
24,
2010,
http://www.ft.eom/intl/cms/s/2/a242e5d0-f812-l
loan market is for the most part a seller's
environment,
("[T]oday's
investors buying
are flush with cash they need to put to work ....
[S]ome
deals are not solely loan investors, so in their hunt for high-yielding
paper,
Nov.
00144feab49a.html
concerns
are a low priority . . . .").
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The Effect of Bargaining
2012]
1685
Power
from the market be
however, new cov-lite loans largely disappeared
cause lenders had greater market power to reject these types of bor
rower-friendly deals....
[Smarting in 2010, cov-lite loans began reap
pearing in the syndicated loan market. Borrowers can obtain cov-lite
loans because of market dynamics. At the top of the last credit cycle,
there was an oversupply of capital, and lenders competed for deals
there was a
from private equity sponsors and borrowers. Because
greater supply of capital than there was demand to borrow capital,
borrowers had more leverage to negotiate looser and more favorable
terms, including cov-lite structures.43
on supply and demand, and the
place great emphasis
This
of
market
is puzzling
for the conven
consequent
power.
tional law-and-economics
position, which posits that bargaining power
affects only price rather than nonprice terms such as covenants. If a cov
These
accounts
balance
and moral hazard
selection
by mitigating adverse
problems, borrowers with bargaining power should be at least as eager
to agree to them as when they lacked bargaining power. In fact, the very
enant
creates
value
ability to extract most of the surplus from a deal would give powerful
borrowers a greater share of the surplus created by these terms. A more
between
elaborate story is needed, therefore, to explain the connection
shifts in bargaining power and changes in contract design.
costs internal to lending institutions might provide part of the
Investment managers face pressures to meet targets for re
explanation.
turns. Where there is competition for relatively few debt securities, they
Agency
may be willing to sacrifice covenant protection for a higher yield. The
risk may or may
returns are immediately
apparent while the consequent
not reveal itself later. The financial crisis, however, drew dramatic atten
tion to these risks, so the re-emergence
of covenant-lite
loans is not as
In an alternative explanation,
we suggest that the im
explained.
pact of bargaining power is mediated through an effect on price.
that lenders acquire more bargaining power because
exoge
Suppose
nous forces tighten the supply of credit. The first-order effect is to place
upward pressure on interest rates. As noted above, the lower-risk bor
easily
rowers may exit, leaving a riskier pool. These borrowers also face incen
tives to take greater risks in order to make borrowing at a higher rate
and moral
worthwhile.
The prospect of exacerbated
adverse selection
43
Eric Goodison,
Covenant-Lite
37 (emphasis added).
Loans:
Traits
and Trends,
Prac.
Law
J., Sept.
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2011,
at 36,
Virginia Law Review
1686
hazard
would
cause
face of excess
[Vol. 98:1665
to refrain from raising interest rates in the
supply. The second order effect,
of strict covenants and collateral, to discour
lenders
demand
and to ration
however, is that the value
age and deter high-risk borrowers, would be greater. The optimal con
tract design would have both tighter covenants
and, probably, broader
collateral as a result of the change in market conditions.44 This explana
with empirical work that has found a positive correla
rates of interest and covenant
and
tightness
tion is consistent
tion
between
market
breadth.45
In sum, in relationships
affected by asymmetric information (such as
or
lending
insurance), price is an imperfect tool for adjusting for supply
or demand changes, or shifts in bargaining power. As we have noted,
the information problems of adverse se
changes in price can exacerbate
lection and moral hazard. Therefore, the parties can improve the effi
ciency of their contract by using nonprice terms instead to shift value
to the "stronger" party.46 As a result, the balance of
from the "weaker"
bargaining power might in fact affect contract design.
C. Bargaining
Power
Can Lead
to Inefficient Nonprice
Terms
In designing
their contract, the parties might not be aware of the
nonprice terms that maximize their surplus. Two factors are important in
this regard. First, one or both of the parties must invest in the task of de
information, considering
alternatives, tailoring them
signing: processing
44
We explore this effect in a companion
paper that presents a model of this phenomenon
and, in this light, examines
existing data concerning
cyclical changes in patterns of covenant
and collateral.
See Choi & Triantis, supra note 14.
45
of Leverage,
Debt Ma
Choice
See, e.g., Matthew T. Billett et al., Growth Opportunities,
Control
62 J. Fin. 697, 706-08
(2007);
Greg Nini et al., Creditor
turity, and Covenants,
rela
and Firm Investment
(finding positive
Policy, 92 J. Fin. Econ. 400, 400 (2009)
R. Rob
Michael
interest rates and covenant
breadth);
Bradley & Michael
tionship between
Debt Covenants
13, 2004)
2-3, 28 (May
(un
erts, The Structure and Pricing of Corporate
available
at http://ssrn.com/abstract=466240);
Zhipeng
Zhang,
published
manuscript,
Rights
Recovery
2009)
46
Rates
and
Macroeconomic
Conditions:
The
Role
of Loan
Covenants
available
at http://mpra.ub.uni-muenchen.de/17521/).
(unpublished
manuscript,
A similar argument may be made in the context of corporate
acquisition
(Sept.
2,
agreements.
return to the seller,
an exogenously
induced
reduction
in price reduces
the expected
the value of cove
the risk of moral hazard by the seller is greater and so is, correspondingly,
clauses.
We discuss
material
adverse
nants and conditions
for closing,
including
change
When
these
clauses
further below.
See
infra text accompanying
notes 60-70.
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The Effectof Bargaining Power
2012]
1687
to the parties' circumstances
and innovating new solutions.47 While de
the
is
to
who
invests in it, the incremental value of the
party
sign
costly
of this exter
is shared by both parties.48 The consequence
in
the
can
be
another
is
unless
deal, the
that,
nality
design
redeployed
and
their
be
less
efficient.49
will
underinvest
parties
agreement
may
it en
if a party has bargaining power because,
for example,
However,
investment
or the capacity for patience, it might have a better in
joys a monopoly
centive to expend the resources
to develop
value-increasing
necessary
it can capture most of the value.50 The adhesion
nonprice terms because
contracts
of monopolists
were the béte noire of the early academic
such
as
Professor
Friedrich Kessler, who thought that the
commentators,
nonprice terms in these contracts would be significantly less favorable to
the law-and-economics
scholars who
Conversely,
that they would be efficient and no different than
in competitive markets.52 Contrary to both sets of schol
the counterparties.51
followed
suggested
those produced
ars, this Article
or superior bargain
suggests that those with monopoly
are
to
the
from
innovative
able
ing power
capture
payoffs
design. There
their
be
in
fact
both
different and
fore, the terms of
agreements
may
more efficient.
Second,
vantages
ten need
agreements
in endowments
create
value
ad
by exploiting
comparative
and differences in preferences, and parties of
to make such
information
during negotiations
a
of
Yet,
bargaining power in nego
party's pursuit
agreements possible.
tiations can be antithetical to the creation of value.53 In the language
of
47
See
tion).
48
George
22,
(Mar.
to exchange
2011)
Triantis,
Standardization,
(unpublished
manuscript,
and Innovation
in Contract
Modularity,
on file with the Virginia
Law Review
Design
Associa
2
There
are countervailing
For
strategic reasons for writing the first draft of an agreement.
it can lead the opponent
to anchor on the proposed
division
of surplus and, more
of the bargaining
generally, on a perception
range. Id. at 15.
49
The general point is well documented
in contract theory. The hold-up
exists
problem
example,
when
the parties cannot contract ex ante to share the value of the specific investment,
for ex
it cannot be verified in court. Where the investing party also has the bargain
because
ing power and can capture most or all of the surplus, it has the incentive to make the value
investment.
Oliver Hart & John Moore,
See, e.g., Hart, supra note 29, at 32-33;
increasing
ample,
Property
See
51
See
52
See
53
The
of the Firm, 98 J. Pol.
note 47, at 12.
Kessler,
supra note 1, at 632-33.
supra note 4.
Rights
Triantis,
and the Nature
Econ.
1119,1132
(1990).
supra
literature speaks of a fundamental
tension between
and creat
negotiation
claiming
245^6
the "Nego
ing value. See, e.g., Lax & Sebenius,
supra note 19, at 38^10,
(discussing
tiator's Dilemma,"
where it is individually
rational for each party to claim value, but that this
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Virginia Law Review
1688
[Vol. 98:1665
negotiation experts, shared information enables value creation while pri
vate information promotes value claiming. To increase its share of the
surplus, each party strives to conceal its own information and extract the
private information of its counterpart. For example, a buyer might agree
to a limited warranty in order to hide the fact that the good or service be
is of great value to her. Faced with incomplete
infor
ing purchased
mation, the seller may screen for the relevant information by offering a
choice between a contract with a complete disclaimer and one with a full
warranty. Low-valuing
buyers, in contrast, may be eager to communi
cate their relatively low valuations but have difficulty doing so credibly.
dis
by agreeing to a complete
They may signal their low valuations
claimer. Where the parties use nonprice terms to screen or to signal, as
the case may be, these terms are likely to be inefficient.
The danger of inefficient terms resulting from screening or signaling
is well known.54 What is significant for our analysis is the more compli
of bargaining power changes strat
cated question whether the allocation
egies and thereby the degree of inefficiency.55 In Part IV, we demon
are most severe when
strate with a numerical example that inefficiencies
In
there is significantly unequal
bargaining
power in either direction.
the parties' ability to create value);
Malhotra
& Max H. Bazerman,
Nego
Deepak
Brilliant Results at the Bargaining
How to Overcome
Obstacles
and Achieve
Robert H. Mnookin
et al., Beyond
and Beyond
6-7, 82 (2008);
Winning:
Negotiating
constrains
tiation
Table
Genius:
9 (2000).
For example,
the making of binding com
Value
in Deals
and Disputes
to third parties or threats to the opposing
value,
party may be helpful in claiming
to create value. Lax & Sebenius,
but constrains
the flexibility and good will necessary
supra
note 19, at 245—46.
54
See supra note 53 and infra Part III and note 84.
55
for
Professor
Jason Johnston examines
the effect of bargaining
power on contracting
to Create
mitments
the decision
for breach: specifically,
to accept or opt out of the rule in Had
caps on damages
Johnston demonstrates
that where the seller is a
156 Eng. Rep. 145 (1854).
ley v. Baxendale,
this would
its high-value
buyer would hesitate to ask for higher caps because
monopolist,
its market power. For its
inform the seller that there is more value to extract by exploiting
in the
the seller has the incentive
to screen by price/quality
discriminating,
part, however,
see
in Subsection
IV.B.l
below.
manner described
Johnston, supra note 4, at 616, 636-37;
Professors
Ian Ayres and Robert Gertner
also Ayres & Gertner, supra note 4, at 735-36.
damages
provision
(given buyer type) would be agreed
suggest that the efficient liquidated
to if the market were competitive
instead. Ayres & Gertner, supra note 4, at 742. In their
on buyer type. Hence,
once the
of breach does not depend
model, the seller's
probability
the seller's
liability is
damages,
expected
buyer and the seller fix the size of the liquidated
of the buyer's loss from breach. This is not
for all types of buyer, that is, regardless
in Part IV. For instance, even when the size of
for the nonprice
terms we examine
on the
the warranty is fixed, the cost of serving a buyer under the warranty term depends
on the characteristics
of
of claiming
that warranty depends
buyer type since the probability
the same
the case
the buyer.
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The Effectof Bargaining Power
2012]
1689
terms of market concentration, they are most severe either when there is
a monopoly
(excessive
among sellers
screening) or perfect competition
for buyers (excessive
signaling or cream skimming). The party motivat
the
inefficient
ing
nonprice term in this way is the one with the bargain
ing power. The intuition is that the dominant party is willing to accept
the consequent
incremental loss of surplus in order to improve its share.
lit
The results are consistent with those from the industrial organization
erature.
In Part V, we show that when
"evenly," each party has less of an
ing or signaling, and the agreement
fine more even bargaining power in
some
competition
the parties share the surplus more
incentive to engage in either screen
they reach is more efficient. We de
three ways.
another seller
In the first, we introduce
(an entrant) to possibly
by allowing
In the second, the
an
compete against
existing seller (an incumbent).
the
contracting parties to
power of commitment is reduced by allowing
the original contract with some chance. In the third, the sell
to dictate the terms is curtailed by allowing
the buyer to
a
counteroffer
with
some
make
delay.
renegotiate
er's power
In each of these cases, we demonstrate the key result that the condi
tions of more even bargaining power can mitigate or even eliminate the
inefficiencies
of screening and signaling through nonprice terms. While
the three variations require different game theoretic presentations,
they
share a common
theme. When one party deliberately imposes an ineffi
cient nonprice term and leaves an unrealized
surplus on the table, it pro
vides a strong incentive to others to capture the unrealized
surplus and
In
the
the
first
that
incentive
is given
variation,
eliminating
inefficiency.
to a competitor (entrant); in the second, to the seller through renegotia
tion; and in the third, to the buyer. In the process, we argue that it is im
instance, by not introducing too
portant to strike a proper balance—for
much competition—so
erage. The Appendix
as not to give the other too much bargaining lev
presents a more general model in which a social
planner (mechanism
designer) can choose what types of contract to offer
to the buyer and the seller. The model shows that when the social plan
ner only cares about the seller's or the buyer's welfare, the social plan
ner will also
impose inefficiency on the contract, but when the social
planner cares about them more evenly, such inefficiency gets mitigated
or eliminated.
Finally, there is one more context in which bargaining
power may
have an effect on contract design:
through
two-staged
negotiations
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[Vol. 98:1665
agents. First, a term sheet, letter of intent, or similar document settles the
price and other key terms. Second, a later negotiation (typically through
lawyers) settles the remaining nonprice terms for the definitive contract.
D. Bargaining
Power
in Two-Staged
(Price-First)
Negotiations
term is unlikely to yield value to both parties.
Therefore, logrolling is an essential element for creating value in bar
in
gaining. A buyer agrees to a lower quality of product, for example,
Any
given
contract
deal
price. In commercial
to
create
value
in
this
exists
when
making,
opportunity
way
parties can trade nonprice terms for adjustments in price. For this reason,
return for an earlier
delivery
date or a lower
the broadest
it would
optimal to leave the price term open until all other terms
fail to reach the sur
settled. Negotiations
may nevertheless
in the previous
deal because
of the obstacles discussed
plus-maximizing
have
seem
been
Section. But fixing price at an earlier stage would
nities for value creation.
further limit opportu
Although price terms are usually determined after the nonprice terms
in commercial
have been set, this is not always the case. For example,
and
loans, private equity investments,
many
corporate
acquisitions,
terms are agreed upon after the price is settled.56 In the first stage of ne
often
gotiations, the parties negotiate price and key nonprice provisions,
with the signing
without their lawyers.57 This stage typically concludes
of
of a document such as a term sheet, letter of intent, or memorandum
which is not legally binding.58 The parties then turn over
understanding,
the second stage of negotiations
to their lawyers to work out the details
in a definitive contract, including representations
and warranties, closing
and termination rights. These terms are usually
conditions,
covenants,
settled without adjustment to price. The parties would probably have an
of these terms when they struck a price in the first stage
expectation
terms fall
what
is "market" at the time). If the second-stage
(perhaps
outside
reopen
to
the parties may be compelled
a range of these expectations,
is not legally
the price.59 Although
the first-stage agreement
56
such as public or private offer
One might contrast these deals with similar transactions,
ings of securities, in which these terms do appear to be priced after they are settled.
for Nego
and Techniques
of a Merger: Strategies
See, e.g., James C. Freund, Anatomy
53-55
(1975).
tiating Corporate
Acquisitions
58
Id. at 59-60.
59
.. . bear primary responsi
et al., supra note 53, at 129-35
See, e.g., Mnookin
("Lawyers
the parties' preliminary
understand
concepts
bility for translating into legally recognizable
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The Effect of Bargaining
2012]
Power
1691
binding, there would be nonlegal costs to allowing the deal to collapse
after this point. This leaves lawyers with a meaningful
space within
which to bargain on behalf of their clients over nonprice terms.
This arrangement leads to a peculiar process in the second bargaining
stage between the lawyers, during which the two sides cannot use the
for
price term in their efforts to create value by logrolling.60 Consider,
in
the
is
set
in
a
letter
of
a
which
price
example,
corporate acquisition
and war
intent before many of the terms—particularly,
representations
ranties, covenants, closing conditions, and termination rights—are nego
Although the letter of intent is usually not binding,
in these
the
for concessions
price to compensate
parties rarely adjust
terms in either party's favor. In a collective
effort to integrate the best
tiated by the lawyers.
field, the American Bar Association
appoint
practices in the acquisition
ed a task force charged with producing and updating a Model Stock Pur
it is particularly significant that
chase Agreement.61 For our purposes,
the report repeatedly emphasizes
the divergent positions of buyers and
the document as
describes
sellers. The preliminary note, for example,
follows:
Agreement has been prepared as a resource for a buyer's
first draft of a stock acquisition agreement. In a buyer's first draft, the
provisions generally favor the buyer and are not necessarily typical of
The Model
the final language in a fully negotiated agreement and consummated
transaction....
Sellers usually will not agree to all the proposed pro
visions, and their counsel can be expected to negotiate for language
more favorable to them. The commentary identifies some sections of
ing of their deal. In addition,
that the clients may not have
ancillary risks
legal drafting involves
identifying and allocating
the problem of
considered
. . . .")• They later note, in discussing
that "lawyers
can waste the client's time and money by focusing on small or
over-lawyering,
Id. at 148.
unlikely risks that do not justify contractual
planning."
60
between
terms can yield value, negotiation
also warn
Although
logrolling
specialists
about
the countervailing
feasibility or danger of having too many issues on the bargaining
To mediate between the benefits and costs of multi-issue
Professor How
negotiations,
ard Raiffa proposed
a process
under which parties first agree to a simple deal and then ask
table.
their agents to improve it by incorporating
other opportunities
for logrolling.
Howard
Raiffa,
1 Negot. J. 9, 9-10 (1985);
Post-Settlement
see also Shell, supra note 28, at 186.
Settlements,
Raiffa labels the strategy "post-settlement
settlement."
Raiffa, supra, at 9. Similarly, the two
described
above offers a hybrid alternative
stage process
the details are preset and a complex
in which
negotiation
61
1 Am. Bar Ass'n
& Acquisitions
Comm.
Mergers
Stock
Purchase
& Acquisitions
Agreement
with Commentary,
to both a simple negotiation
where
all terms are on the same table.
on Negotiated
Acquisitions,
at v (2d ed. 2010)
[hereinafter ABA,
Comm.],
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Model
Mergers
1692
Virginia
Law
[Vol. 98:1665
Review
the Model Agreement that are likely to prompt objections
but most, if not all, provisions are negotiable.62
by a seller,
The note lists three factors that may influence the scope and content of
the ultimate agreement, the second of which is "the relative negotiating
positions
of the parties":63
Where the target is highly sought-after and there are competing offers,
a seller may view some of the provisions of the Model Agreement as
too aggressive or otherwise inappropriate....
On the other hand, if the
target is financially distressed or the seller is otherwise in a weak bar
gaining position, the buyer might be even more demanding
it presents to the seller.64
in the draft
We can illustrate the perspective
of the task force through its com
ments on two types of provisions:
seller representations
and the closing
Seller repre
condition requiring no Material Adverse Change ("MAC").
sentations are among the terms negotiated between the lawyers, and the
must be true in order for the deal to close.65 The note de
representations
scribes the conflict between the parties:
The buyer typically will ask the seller to bear most of the risk associ
ated with discoveries that directly or indirectly relate to the target's
business prior to the closing—issues
that may be material to pricing
the acquisition.
The seller may counter that unknown contingencies
are inherent in operating any business and should be borne by the
owner of the business at the time they arise.66
under which
Similarly, the definition of MAC sets the contingencies
the buyer can walk away from the deal at closing. The comment states:
Buyers generally prefer a broad MAC provision such as the one used
in the Model Agreement. A broadly drafted MAC provision is thought
to provide buyers with greater protection, as it gives buyers greater
flexibility to terminate or renegotiate an acquisition agreement in the
event
62
63
of unforeseen
adverse
events
that are not described
in the
Id. at xi.
Id. at xii. The
other two factors
are the size
of the transaction
and whether
of another corporation.
Id.
subsidiary
64
Id.
65
The agreement
survive
may also provide that the representations
66
Comm.,
ABA, Mergers & Acquisitions
supra note 61, at xi.
closing.
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the target is a
The Effectof Bargaining Power
2012]
1693
agreement. . .. Sellers will want to minimize Buyers' ability to walk
In this regard, Sellers
away from or renegotiate the agreement....
will try to limit the definition of MAC to restrict the events or occur
rences that could trigger the MAC condition....
One way Sellers may
further narrow MAC provisions is by requesting exceptions ("carve
outs") to the MAC
The breadth
bargaining
conditions
definition.67
of the MAC
definition
is perceived
and business
power. Lawyers
were "seller-friendly"
to be determined
observed
analysts
more
and contained
by
that MAC
carve-outs
when
private equity firms were flush with funds before the financial crisis. Af
ter the crisis, credit tightened and buyers gained bargaining power, lead
ing to more "buyer-friendly" provisions with fewer carve-outs.68
Under what we have labeled
the irrelevance proposition of bargaining
this
is
Like many other terms, representations
power,
analysis
puzzling.
and warranties allocate risks and might be thought of as insurance prod
ucts within acquisition
For a variety of possible
reasons,
agreements.
one party can bear the risk at lower cost, and the contract can create val
ue by providing that this party will insure the other party against the risk,
for a price.69 Both parties can be better off and therefore should agree to
67
68
Id. at 31-33.
A report out of the Wharton Business
office of the law
partner in the Houston
the competition
for private
. . . ." Knowledge@Wharton,
Win
the
Compete,
Intangibles
prices,
sellers
School
in 2007 quoted William
Parish, Jr., then a
firm of King & Spalding:
"In addition
to record
equity deals is altering the terms for deals in favor of
Private Equity Bidding Wars: When Capital-Rich
Funds
Deal
wharton.upenn.edu/article.cfm?articleid=1721.
industry risk from the scope of material
2-3
available
at
(2007),
Parish cited, in particular,
adverse change and the shortening
http://knowledge.
the carve-out
of
of periods during
agree to indemnify buyers (from three years to a year or less). Id. In 2008, the
law firm of Nixon Peabody
a report of its review of acquisition
dated
published
agreements
from June 1, 2007 to May 31, 2008. Nixon Peabody
Seventh Annual MAC
LLP,
Survey 2
available
at
(2008),
http://www.nixonpeabody.com/linked_media/publications/MAC_
which
sellers
The report stated: "[WJhile
the MAC
definitional
elements
were slightly
survey2008.pdf.
narrower than in the prior year, we noted a decrease
in the number of MAC
...
exceptions
the advancement
of buyers'
Id. at 4. The
indicating
bargaining
power during this period."
shift to more buyer-friendly
terms is "likely due at least in part to a lack of credit available
and sellers' understanding
that they must decrease
their expectations
transactions,
finance
get a deal
69
MAC
done."
to
to
Id.
clauses
are understood
to promote the following
two objectives:
first, the buyer's
contingent option to terminate gives the seller the incentive to maintain the value of its assets
between the time of the contract and closing (the moral hazard problem).
the seller's
Second,
to grant such an option signals its information
as to the financial and economic
willingness
condition
subject
of the target (the adverse
selection
At the same time, most MACs
problem).
to carve-outs—defined
material changes
that do not trigger such a termination
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are
op
1694
Virginia Law Review
[Vol. 98:1665
that risk allocation,
regardless of relative bargaining power. Yet, like the
authors of the model agreement, practitioners frequently view these ne
gotiations as zero-sum. While terms can be traded within this stage, the
to trade off risk allocation
inability
value
a price adjustment removes
In this respect, bargaining
terms because the outcome of the
against
from the table.
significant potential
power is a determinant of the nonprice
second stage is constrained and predominantly distributional.
Yet, even in this setup, the impact of bargaining power is complicat
ed. Suppose
that the parties agree to the price in the first stage and leave
to the second
stage the scope
the deal under a MAC clause.
er, then it might secure
first stage. In the second
of the buyer's option to walk away from
If the seller has superior bargaining pow
a higher price than it otherwise would during the
stage, the parties' lawyers negotiate the carve
outs from the buyer's MAC condition, among other terms. Suppose
the
seller derives bargaining power from its greater patience (the buyer faces
more time pressure to have the deal signed). The seller's attorney can
then present the buyer with a take-it-or-leave-it
offer and get a more ex
tensive carve-out from the MAC.
The buyer may or may not be able to
a
on
another nonprice term at this stage. A
concession
get
countervailing
buyer anticipating this in the first stage lowers its reservation price ac
cordingly. Since the seller gets the greater portion of the bargaining sur
plus, the buyer's anticipated exercise of the seller's power in the second
stage in fact harms the seller (more than the buyer) in the first stage.
Thus, the seller has the incentive to precommit to limit the scope of its
bargaining power in the second stage, in order to secure a higher price.
In the two-stage bargaining process, this may be difficult to do; the buy
er will presume an unfavorable
outcome in the second stage (of course,
as noted above, within some range of expectations).
As a result, the
in the second stage may vary from "seller
nonprice terms negotiated
to
on which party has bargaining
friendly"
"buyer-friendly,"
depending
power. Nonprice terms may be inefficient as a result.
The buyer's inability to observe private information held by the seller
MACs.
and "buyer-friendly"
First, as
may also explain "seller-friendly"
tion.
These
downturn
in
such as the general
exogenous
contingencies,
industry, that are typically outside the control and private knowledge
in Contract
See Albert Choi & George
Triantis, Strategic Vagueness
Design:
We also discuss
a
of Corporate
119 Yale L.J. 848, 865-70
(2010).
Acquisitions,
the economy
of the seller.
The
Case
carve-outs
describe
or seller's
third objective:
facilitating
Id. at 869-70.
closing.
renegotiation
in case
the deal
turns out to be unattractive
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before
The Effectof Bargaining Power
2012]
1695
we described
in the context of loan covenants, changes in the supply or
for acquisitions
can also exacerbate
or mitigate the underlying
moral-hazard
and adverse-selection
Given the target seller's
problems.
information
as
to
its
terms
value, price
private
may function imperfectly
as a means of adjusting for supply-demand
imbalance
or changing the
demand
of surplus. In particular, a price change may make moral hazard
selection more severe. The parties may improve the efficien
cy of their deal by using nonprice terms instead of shifting value from
one party to the other.70
division
or adverse
Second, the asymmetric information about the target's value may en
courage either the seller or the buyer to screen or signal, respectively.
We demonstrate at greater length in Part IV that these actions can give
rise to inefficient contract design, particularly at the extreme ends of the
bargaining
range at which either the seller or the buyer is the residual
claimant of the surplus.
the breadth of the MAC
The party with such bargaining power may use
clause to reduce the counterparty's
information
rather than to enhance the surplus by addressing the moral
al advantage,
hazard and adverse-selection
obstacles.
the seller could
When
the seller enjoys (com
use different MACs to screen
plete) bargaining leverage,
different types of buyers. The buyer whose reservation value is less sen
sitive to an external shock would be more willing to sign a narrow MAC
than the buyer whose reservation value is more
(or broader carve-outs)
volatile.
of different MACs with correspond
By offering a combination
the
seller
can
better
extract
the surplus from the transaction.
ing prices,
A buyer with bargaining power might similarly use different MAC and
to signal a more volatile reservation value, so as to
price combinations
pay a lower
respectively,
compromise
demonstrate
price for the target. These screening and signaling efforts,
do not increase the size of the surplus. In fact, they may
the MAC goals of controlling the seller's moral hazard. We
in Section
the efficient breadth
V.C
that the parties are more likely to agree to
if their bargaining power is more even.
of a MAC
This
is a rough hypothesis at this point, but it is at least an attempt to
gain
insight into the role of bargaining
power in the design of
these terms.
some
In sum, the bargaining
rests on the
power irrelevance
proposition
that
the
are
risk neutral and that there are no infor
premises
parties
mation
70
Choi
imperfections
& Triantis,
or other transaction
supra note 14 (manuscript
costs.
We
have
at 4).
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suggested
a
Virginia Law Review
1696
[Vol. 98:1665
variety of ways in which
are relaxed.
assumptions
introduction
bargaining power may be relevant when these
Each way can be elaborated
beyond our brief
in this Part and we leave this to future work. In Parts III,
IV, and V, we examine
in cases of asymmetric
information
in greater detail the impact
information, particularly
as to its reservation price and either tries to conceal
private
it or cannot readily reveal
III. Product
of bargaining power
where one party has
Quality
it.
Under
Monopoly
and
Perfect
Competition
In the industrial
literature in economics,
a body of schol
organization
all
else
the
equal,
product quality offered by a
arship analyzes whether,
in
is
or
different from that of a social
monopolist
perfect competition
social welfare. This is relevant to our in
planner seeking to maximize
of the quality of the
that sells a single good
underlying product. Consider first the monopolist
we
at a single price in a given market. Under the standard assumptions,
will sell a lower quantity than optimal, thus
know that the monopolist
quiry because
the terms of a contract
are elements
loss. The reason is straightforward. The monopo
creating a dead-weight
in price brings additional
list knows that an incremental
decrease
cus
will
of
revenue
consumers
who
were
but
at
a
loss
from
all
other
tomers,
even at the higher price. While the second
ing to make the purchase
finds it cost
effect would yield no loss in social welfare, the monopolist
minimize
To
the
effect
of
this
revenue
loss, the mo
infra-marginal
ly.
nopolist charges a price higher than the marginal cost of production and
serves fewer customers than its competition.
When choosing the level of quality to be offered to its consumers, the
chooses the quality according to the preferences of the mar
monopolist
ginal buyer—the
buyer who is just indifferent between buying and not
price. If the marginal buyer values an incre
buying at the monopolist's
mental increase in quality at least as much as the incremental cost to the
then the monopolist
improves the quality for everyone, but
monopolist,
not otherwise. If all buyers share homogeneous
preferences for quality,
then the monopolist
the
provides
optimal quality of contract terms (albe
if the marginal buyer has a
it at a supra-competitive
price). However,
to pay for quality than the infra-marginal buyers, the
the additional
to purchase
buyers will be compelled
higher willingness
infra-marginal
if
quality even though they would be unwilling to pay for it. Conversely,
the infra-marginal
customers would pay for an increase in quality, but
the marginal
buyer assigns
an incremental
valuation
lower
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than the in
1697
The Effectof Bargaining Power
2012]
offers the higher quality to no one. Thus,
cost, the monopolist
if buyer preferences are heterogeneous,
the quality offered by a monopo
the
list may be higher or lower than
optimal.71 The social planner, on the
of the average
other hand, would base the quality on the preferences
cremental
as long as the preferences of the average buyer and the
marginal buyer are not identical, the quality chosen by the monopolist
social welfare.
differs from that which would maximize
buyer.
Hence,
The analysis so far assumes that the market can provide product with
confer dif
only one level of quality. Many types of contract provisions
at the beginning of
ferent values to different buyers. The three examples
this Article illustrate this claim. A warranty is more valuable to a buyer
who uses the good more frequently and intensively.
concerned about sudden termination if it has made
the franchise
or if its location
is more vulnerable
A franchisee
is more
a large investment
to short-term shocks.
in
A
if it anticipates
seller benefits from litigating
jurisdiction
more rather than fewer disputes over its performance, particularly those
below,
involving large monetary claims. In addition, as we emphasize
in its home
the cost to a contracting promisor is also likely to vary with the type of
the effect of market or bargain
buyer for similar reasons. In evaluating
on
contract
terms
rather
than
the
ing power
physical quality of products,
not only should we assume heterogeneity
but also that the market may offer more
of preferences among buyers
tailored products that cater to
differing preferences.
over quality and the
When buyers have heterogeneous
preferences
the monopo
can offer different price-quality
combinations,
monopolist
list can increase its profits by discriminating
its
among
buyers, on the
knew each
of price, quality, and contract terms. If the monopolist
it
would offer to each customer the quality and con
buyer's preferences,
basis
maximize
the surplus and charge a price that
the monopolist
to capture the entire surplus. If the monopo
list had this information and discriminated,
market power would not dis
tort quality, and the irrelevance
would be borne out. The
proposition
tract terms that would
would
allow
buyer who places a higher value on warranty is offered an extended war
ranty clause at a higher price, while a buyer who values it less purchases
a limited warranty at a lower price. Better yet, even if two buyers place
71
See,
Spence,
e.g., Jean Tiróle,
Monopoly,
Quality,
The Theory of Industrial
and Regulation,
6 Bell
100-04
Organization
J. Econ. 417,417-22
(1988);
(1975).
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A. Michael
1698
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[Vol. 98:1665
the highest value on extended warranty, the monopolist
will offer the
same extended warranty to both buyers, but at different prices.
Price and quality discrimination
on the basis of contract might be
effective
because
the
can effectively prevent arbitrage
quite
monopolist
where
customers would sell their rights to high-value
low-valuing
buy
ers. Warranties
are often expressly nonassignable,
for example,
as are
the franchises and purchase orders introduced earlier. The bigger prob
lem facing the monopolist,
rather, is that, in most cases, it lacks infor
mation
about
its customers'
individual
It may nevertheless
valuations.
to
more
of
the
consumer
attempt
capture
surplus through price discrimi
and
this
lead
to
the
of
inefficient quality.
nation,
may
supply
If the monopolist
cannot observe its customers'
individual valuations,
it might try to use variables related to their willingness
to pay. For ex
if
tend
to
fewer
ample,
lower-valuing
buyers
buy
products (for example,
because
of less wealth), the monopolist
may charge a higher unit price
for larger quantities, assuming it can prevent resale. Another method is
to offer a range of products, or products of different quality, in order to
smoke out the higher-valuing
buyers.72 A monopolist
seeking to maxim
ize its profit may provide lower-than-competitive
quality to all custom
ers other than those who value
quality the highest. By offering a menu of
the monopolist
to
separates customers according
price-quality
options,
their preference for quality.73
Whether
the discrimination
the lower-valuing
72
Professor
high-valuation
customers
is by product quality
may receive suboptimal
or contract
quality.74
terms,
In fact,
Tiróle
offers the example
of auto manufacturers
extracting the surplus from
who value luxury and prestige. He notes that the profit margins on
cars and optional equipment
are generally higher than those on basic cars and
consumers
top-of-the-line
the existence
of quality premia. He also suggests
that this may lead
equipment,
suggesting
the monopolist
to offer too many products. Tiróle, supra note 71, at 158.
73Michael
Mussa
& Sherwin Rosen, Monopoly
and Product Quality,
18 J. Econ. Theory
The authors assume that the monopolist
seller knows the general distribu
301, 301 (1978).
tion of tastes
and demands
in the market, but cannot distinguish
among buyers prior to sale
a
constant costs of producing
prevent resale in other markets. They also assume
costs of higher quality items. For a discussion
of
given quality and increasing
marginal
and its consequences,
see David Besanko
et al., Monopoly
and Quali
quality discrimination
Effects and Remedies,
102 Q.J. Econ. 743, 743^4-4 (1987).
For a discussion
of
ty Distortion:
and cannot
in healthcare,
see Martin Gaynor, What Do We Know About Compe
quality discrimination
tition and Quality in Health Care Markets?
4-8 (Nat'l
Bureau
of Econ. Research,
Working
Paper No. 12301,2006).
4
See Besanko
et al., supra note 73, at 749; Sherwin
Rosen
& Andrew
M. Rosenfield,
Ticket Pricing, 40 J.L. & Econ. 351, 352 (using example
of intertemporal
price discrimina
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under
1699
The Effectof Bargaining Power
2012]
some
the monopolist
its profits by
conditions,
may maximize
in
the
customers
order
to extract the
foregoing
lower-valuing
altogether,
surplus from the high-demand
buyers. For example, a monopolist
might
its
with
limited
and
discriminate
product
warranty
giving
by offering
buyer an option to purchase additional warranty. By doing so, the
can extract more surplus from those that place a higher value
monopolist
each
on extended warranty. Yet, buyers who value warranties less than others
end up with an inefficiently limited warranty or inefficiently broad dis
claimer, in order to prevent the high-valuing
buyers from pooling with
them.75
When the market is perfectly competitive and the buyers' heterogene
ous preferences are unknown to sellers, a different kind of inefficiency
can arise. An often-cited example is that of an insurance market.76 Sup
pose
the insurance
high chance
buyers can be divided
of suffering from an accident
into two groups, one with a
and the other whose accident
probability is low. Apart from the differing chances of an accident, eve
rything else is the same across the two groups, including the degree of
risk aversion. Given that both groups are risk averse and assuming that
the insurance
sellers (companies)
are risk neutral, the social-welfare
solution is to provide both groups of buyers with full insur
maximizing
ance (without, for instance, deductibles
or co-pay).
When the insurance market is perfectly competitive but the insurance
do not observe each buyer's risk propensity (risk characteris
companies
solution cannot be sustained, how
tic), the social-welfare-maximizing
ever. Suppose we start from the full insurance condition. A consequence
of not being able
that the insurance
to observe
each
risk propensity implies
tailored:
both the
individually
consumer's
cannot
premium
and low-risk consumers
be
will be paying an average premium.
that
the
market
is
each company of
given
perfectly competitive,
insurance
will
break
even.
The
fering
just
average premium charged by
the insurance companies
will be just enough to cover the average ex
high-risk
Also,
tion of tickets
the revenues
75
Another
to show that "catering to any subset of customer tastes
that can be extracted from other groups in other classes").
example
may be found in the industry that is
airlines.
The airlines restrict the
price discrimination—the
low-fare tickets in order to extract more of the surplus from
would
seem that an airline could provide
this flexibility at
many
nate.
76
leisure
Stiglitz
travelers,
it might refrain from doing
& Rothschild,
in one class
constrains
most notorious
for its
perhaps
or cancel
flexibility to change
business
travelers. Although
it
a lower
so to protect
cost
its ability
supra note 17, at 629.
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than
its value
to price
discrimi
to
1700
Virginia Law Review
will be equal to the expected
or
and
low-risk
there
is,
average
payouts
(both high-risk
buyers),
from the buyers' perspective,
an indirect subsidy from the low-risk con
sumers to the high-risk consumers.
That is, the low-risk consumers
are
pected
payouts.
Because
[Vol. 98:1665
the premium
to all
being charged a premium that is too high relative to their risk propensity
while the high-risk consumers
are being charged a premium that is too
while
each
will
make
low;
company
money from low-risk consumers
losing money to high-risk consumers.
When the companies
and the low-risk consumers
realize this cross
one
of
two
will
Either
some
will start
subsidy,
happen.
companies
things
less
than
full
deductible
and/or
insurance
offering
(with positive
co-pay)
with a lower premium
consumers themselves,
consumers, or the low-risk
if they have the power to control the terms of the
contract, will offer to share some of the risk in return for a lower premi
um. And given that the companies
were initially making profit on selling
to attract the low-risk
full insurance to low-risk consumers, they can design such a contract so
as to keep the high-risk consumers away while making both the compa
nies and the low-risk consumers better off. The first phenomenon
is of
in which companies
skim the profitable
"cream-skimming,"
of
the
while
the
second
is
called
"inefficient
market,
signaling,"
segment
in which the consumers
signal their value to the market by taking costly
ten called
action (in this case, less-than-full insurance).
Of course, once the low-risk consumers have been
skimmed away by
insurance to high
the
that
are
full
companies,
companies
offering
risk consumers
will no longer break even, and the initial full insurance
will
fall apart. If there is an equilibrium
at all, it will be one
equilibrium
some
in which
the low-risk
high-risk
insurance
consumers
insurance while the
buy less-than-full
full insurance, and the companies
selling
consumers
purchase
to either type will just break
even by charging an actuarially
fair premium.77
are
For this type of "unraveling"
to occur, at least three conditions
pref
important. First, the buyers in the market must have heterogeneous
erences and those preferences must be private information for the buy
ers. In the insurance
market context, buyers had different risk propensi
ties and that information
was private.
a buyer's
Second,
differing
for
must
not
to
affect
the
only
buyer's willingness
pay
quali
preferences
77
See
Choi
& Spier, supra note 17, at 2-3, for a more
under which equilibrium
fails to exist.
in-depth
analysis
of products
ity and conditions
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liabil
The Effectof Bargaining Power
2012]
1701
ty but also the seller's cost of providing that quality to the specific buy
er. In the insurance market, each buyer's risk propensity determines not
to pay a certain premium, but also the sell
only the buyer's willingness
er's cost of providing insurance to the buyer. Even with the same payout
amount, the high-risk buyer will be more costly to the insurance compa
relevant for various
ny than the low-risk buyer. This is particularly
nonprice terms in contracts. Buyers may attach different values to dif
ferent physical attributes of a product, but the seller's cost of producing
a certain physical attribute is usually invariant to the type of buyer con
suming the product. In contrast, nonprice contract terms, such as warran
will not only command
clauses,
ty, termination, or dispute resolution
different willingness
to pay from a buyer but will also impose different
the
on the type of buyer that purchases
costs on the seller depending
product.
or the inefficient signaling result also de
Third, the cream-skimming
in the market (vigorous
pends on either the presence of many companies
or
the
to
dictate
control
or
the terms of the
competition)
buyer's ability
In other words, the market is heavily skewed in favor
buyers and they have all the bargaining power against the sellers.
some reason, there isn't as much competition
among the sellers
terms
of
trade
are
to
control
the
restricted, one
buyers' ability
contract.
of the
If, for
or the
would
suspect that the inefficiency result may be mitigated or even disappear.
In fact, the distortions caused by a monopolist
in perfect competition
seem to rely heavily on the condition that the market is very one-sided.
Yet, we do not yet have a very good idea of what may happen when the
In Part V, we attempt to demonstrate how
when the market conditions
disappear
provide a
market is more even handed.
such distortions
could
more even playing field to contracting parties and, in the process,
the gap between the irrelevance proposition and the practitioners'
standing
of the importance
IV. Effect
of Uneven
of bargaining
Bargaining
bridge
under
power.
Power
Under
Asymmetric
Information
one seller and one buyer contract over the sale of a product.
Suppose
How much the buyer values the product (her reservation value or will
ingness to pay) and how much the product costs the seller to produce
depend on two factors: buyer type and product quality. Starting with
quality, the higher the quality, the more costly it is for the seller to pro
to pay. For instance, if qual
duce, but the higher the buyer's willingness
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1702
Virginia Law Review
[Vol. 98:1665
ity is represented by the warranty that comes with the product, a more
extensive warranty will impose a higher cost on the seller but will also
increase the maximum the buyer would be willing to pay for the prod
uct. Similarly,
in the seller's
if the contract obligates the buyer to resolve dispute only
state (or grants the franchisor a broad termination right),
such a restrictive forum selection (or a broad termination) clause will re
duce both the seller's (the franchisor's)
cost and the buyer's (the fran
to pay. A forum selection clause that restricts liti
willingness
state (or a broad termination right) can also be
gation to the seller's
of
as
thought
providing low quality to the buyer (the franchisee).78
chisee's)
How
the buyer values quality and how much it costs the seller
a certain level of quality will also depend on various buyer
much
to produce
specific factors.
in
A more extensive user will value an improvement
A
user
will
also
more
than
a
less
user.
more
frequent
warranty
frequent
impose a higher warranty repair cost on the seller. Similarly, a litigious
buyer may place a higher value on the right to bring a lawsuit in her
home jurisdiction,
and for the same reason this right is more expensive
for the seller to provide. Finally, a franchisee with whom the franchisor
is more likely to terminate the relationship will value restrictions on the
right more than the franchisee who is likely to
in a longer relationship with the franchisor. We aggregate these
under the rubric of "buyer type."79 We assume
also that each
franchisor's
engage
factors
termination
buyer type's valuation of the incremental value of the contractual provi
sion is correlated with its respective valuations of the basic product.80
To succinctly represent these ideas, assume that the product can be
levels of quality: high or low. High
a
higher cost on the seller but also increases the
quality product imposes
to pay. In addition, the buyer can be of two different
buyer's willingness
types: type 1 or type 2,81 where the probability that the buyer is of type 1
manufactured
78
at two
different
cost of other types of terms may be much less affected by buyer type, such as a
739 (showing
that stipulates damages.
See Ayres & Gertner, supra note 4, at 736-37,
dam
that a competitive
market leads to more efficient contracting
around default liquidated
The
clause
ages provisions).
19
of a used car, known
This is qualitatively
similar to the story of how the true condition
value but also how much the buyer
only to the seller, affects not only the seller's reservation
is willing to pay for the car. See George A. Akerlof, The Market for "Lemons":
Qualitative
and the Market Mechanism,
84 Q.J. Econ. 488,489-92
(1970).
Uncertainty
80
more frequent and intense use of
As mentioned
earlier, it may be that a type-1 buyer's
the basic product leads her to value more both the product and the contractual
warranty.
81
while the seller type is
Here we assume
that there are two potential types of consumer
fixed. This is done to simplify the analysis.
The main implication
of assuming
no private in
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The Effectof Bargaining Power
2012]
1703
is 9 G (0,1)
and of type 2 is 1 — 6. For most of the analysis, we will as
sume that Q = 1/2: each buyer type is equally likely. Both types of buy
er value high quality more than low quality, but depending
on quality
level, the type-1 buyer is willing to pay more for the product, and it is
also more costly for the seller to provide the quality for that buyer type.
We can think of the type-1 buyer as the more frequent user of the prod
uct and the type-2 buyer as the less frequent, casual consumer. Since the
type-1 buyer is more likely to make a warranty claim, warranty is valued
of any given
more by the type-1 buyer. At the same time, provisions
level of warranty to the type-1 buyer are also more costly for the seller.
The following table summarizes
the monetized values and costs that de
pend on both buyer type and product
1: Production
Table
Costs
Type-1
Product
and Reservation
Buyer
Values
Type-2
Buyer
Low
$190
High
$250
$170
High
$200
$70
$120
$100
$150
$50
$120
$70
$130
Low
Quality
Reservation
quality.
Value
Production
Cost
Surplus
Note that when the quality of the product is low (for example, warran
ty is limited, forum is restricted to the seller's state, or broader termina
tion right to the franchisor) the type-1 buyer is willing to pay up to $190
while the type-2 buyer is willing to pay up to $170 for the product. For
the seller, it costs $70 to offer low quality to the type-1 buyer and $50
to the type-2 buyer. The values and costs for the high-quality
product
extensive warranty, no restriction on forum, or narrower
(for example,
termination
right) are analogous.82
If we define social welfare as the buyer's willingness
to pay minus the
seller's cost, by assumption,
the numbers in Table 1 imply that to max
formation
profit will
on the seller's
be reduced
power.
82
By assumption,
crease in reservation
posed
to $30
($250
versus
side is that when
to zero.
This
will
the buyer has all the bargaining
power, the seller's
not be true when the seller has all the bargaining
the type-1 buyer not only has a higher marginal
value of $60 when switched
from low quality
for the type-2
and $190
but also
to pay (in
willingness
to high quality, as op
to pay for quality
willingness
higher absolute
this assumption
in
Although
may be reasonable
many settings, if it does not hold, it may be the case that the party with all the bargaining
power might offer nonprice terms that are inefficiently high rather than inefficiently low.
$200
buyer)
versus
$170).
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1704
Virginia Law Review
[Vol. 98:1665
imize
social welfare, the seller should provide high quality to both types
of buyer.83 By doing so, the surplus of $150 is realized from the type-1
buyer and $130 from the type-2. In expectation, the maximum expected
social welfare is 9 x $150 + (1 — 0) x $130. When 9 = 1/2, this is
to $140.
we assume
that the buyer and seller realize zero
if there is no sale. These are the parties'
utility and profit, respectively,
outside
reservation
values.
respective
equal
Finally,
A. The Irrelevance
Proposition
Under Complete
Information
When
both the buyer and the seller are fully informed of each other's
and costs, regardless of the distribution of bargaining power, they
will negotiate
to achieve
the surplus-maximizing
result. They will
choose the quality level to maximize
the total surplus from the transac
values
tion while
working out the bargaining issue through price. For example,
the
seller has all the bargaining power. The seller, knowing to
suppose
which type of buyer she is selling the product, will sell high-quality
product to both types of buyer but charge two different prices: $250 to
the type-1 and $200 to the type-2.84 By engaging in perfect price dis
its expected profit by capturing all of
crimination, the seller maximizes
the surplus: $150
er for an expected
from the type-1 buyer and $130 from the type-2 buy
—
if
profit of 9 x $150 + (1
9) x $130. Conversely,
the buyer has all the bargaining
power, the type-1 buyer will offer to
purchase high quality at $100, and the type-2 buyer will offer $70 for
high quality. The expected buyer surplus will be equal to the maximum
social welfare of 9 x $150 + (1 — 9) x $130.
The only difference be
tween these two polar cases will be the price at which the parties reach
an agreement.
More generally,
if we let A G [0,1] denote the fraction of the surplus
that the seller captures in equilibrium
(or the seller's relative bargaining
power vis-á-vis the buyer), while both types of buyer will purchase high
quality
product,
the equilibrium
price
for the type-1
buyer
is $100
+
83
The assumption
that a single level of quality (high quality in the example)
maximizes
the surplus from both buyer types is not important but is used to simplify the analysis.
In the
we provide a model in which optimal qualities
differ based on buyer type.
Appendix,
8
To make sure that the buyer will make the purchase,
the prices have to be slightly less
than the buyer's
reservation
for example,
and $199.99.
This type of tie
$249.99
value,
will be common
the numerical
breaking
throughout
examples,
assume that when the buyer (or the seller) is indifferent between
ing or not selling), the buyer will purchase
(the seller will sell).
and,
for simplicity,
we will
and not buying (sell
buying
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The Effectof Bargaining Power
2012]
1705
Note that as A ris
and, for the type-2 buyer, $70 + A($130).
A($150),
=
es, so do the equilibrium
1, denoting full bargaining
prices. When A
for
the
seller
all
the
power
(or giving
surplus to the seller), prices equal
the buyer type's respective
to pay. Similarly, when A = 0
willingness
(when the buyer has all the bargaining power), the prices equal the sell
er's respective
costs.
Table 2: Equilibrium Under Symmetric Information
A e [0,11
Type-1 Buyer
Type-2
Product
Equilibrium
Quality
Equilibrium Price
Consumer
Producer
Total
Surplus
Surplus
Surplus
High
$100 + A($150)
(1 — A)($150)
A($150)
$150
$70 + A($130)
(1 — A)($130)
A($130)
$130
This result yields the bargaining
of complete
strong assumption
tive of their relative
Buyer
High
bargaining
power irrelevance proposition
and symmetrical
information:
power,
contracting
under the
irrespec
parties will always
terms and work out
choose the efficient, surplus-maximizing
nonprice
the bargaining power issue only through price. As we will see in the next
of bargaining
infor
section, the combination
power and asymmetric
mation leads to inefficient nonprice terms.
B. Private
Information
on Buyer
Type
that the buyer knows how much she is willing to pay for
quality (which type she is), but the seller does not: when the seller meets
the buyer, the seller only knows that the buyer is type-1 with probability
6 or type-2 with probability 1 — 0.85 Under this assumption,
the alloca
tion of bargaining power determines whether the parties will agree to an
Suppose
efficient quality
of nonprice
term. As in the complete,
symmetric
infor
85
We assume
that it is the seller, not the buyer, who lacks the relevant knowledge
about
the buyer's preferences.
This assumption
seems realistic since, presumably,
the buyer knows
more about her preferences
than the seller. We can flip the assumption
and let the seller be
aware of the buyer type while the buyer is ignorant of her preferences,
but this will not
results. In reality, private information will run on both sides: while the
change the qualitative
she wouldn't
know much about
buyer would know more about her preferences
necessarily
the seller's cost structure. We stay away from such complication
to keep the analysis tracta
ble.
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1706
Virginia Law Review
[Vol. 98:1665
mation case, we first start with two polar cases: when either the seller or
the buyer has all the bargaining power. In the next Section, we turn to
the more complicated
of "even"
distribution of bargaining
examples
power.86
1. Dominant
Seller
the seller has all the bargaining power. In this Subsection,
Suppose
we represent the bargaining power as the ability to make a take-it-or
leave-it offer to the buyer, without competition, which cannot be subse
If the seller were to provide high quality to both
quently renegotiated.
buyer types, the seller would not be able to charge two different prices
for high quality since she would not know which type of buyer she was
dealing with. Unless the price is so high to keep the type-2 buyer from
purchasing at all (p > $200), both types of buyer will simply choose the
offer with the lower price. With that constraint,87 the profit-maximizing
price the seller can offer for high quality and still be able to sell to both
If the seller were to charge a higher price, the
types of buyer is $200.
would
not
buy, and lowering the price would only increase
type-2 buyer
the buyer's surplus and reduce the seller's profit. With $200, and when
both buyer types accept the offer, the seller's expected profit is $200 —
86
in this Section
is known as bargaining
games with pri
is re
as soon as the informed party's private information
models,
of
vealed to the uninformed
agreement or complete
convergence
party, there is an immediate
with Private Information,
& Robert Wilson,
Bargaining
posterior beliefs. See John Kennan
31 J. Econ. Literature 45, 45-50
for a survey of this class of bargaining
games. With
(1993),
vate
The
class
of models
information.
we present
In these
that analyzes
in the game theory literature, there is a different strand of models
bargaining
of the informed party's in
with "non-convergent"
priors, in which even after the revelation
about the state of the world, or no immediate
formation, there is no immediate
agreement
Without a
of players'
Yildiz,
Bargaining
convergence
posterior beliefs. See, e.g., Muhamet
71 Econometrica
Prior—An
Immediate
Common
793, 808-09
Theorem,
(2003).
Agreement
cases, whether the parties will agree immediately
(whether there will be an ineffi
will depend a lot on how fast each player will be able to update her
cient delay in agreement)
For the sake
one remains after a communication).
beliefs (e.g., how optimistic or pessimistic
of tractability, we do not deal with this latter, important strand of literature.
87
the seller might
If the proportion
of high-value
buyers is sufficiently high (0 > 13/18),
In those
a single contract that is attractive only
be able to increase her profit somewhat
by providing
is using
to a type-1 consumer:
high quality at a price of $250. In our model, the monopolist
Alan Schwartz
that
terms to screen buyers. Professor
both the price and nonprice
suggests
when trade is uncertain ex post and the buyer is privately informed of the surplus, the mo
to screen buyer
(down-payment)
may use the initial price and liquidated
damages
are
similar
to
as being the
We
can
think
of
which
warranty,
damages,
types.
liquidated
with Contract
Price Discrimination
term in our model.
See Alan
Schwartz,
"nonprice"
nopolist
Terms:
The Lost-Volume
Problem,
12 Am.
L. Econ.
Rev.
394, 413-16
(2010).
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The Effectof Bargaining Power
2012]
1707
—
for certain, and
{0 x $100 + (1
0) x $70}. The seller will get $200
will incur an expected
cost of 0 x $100 + (1 — 0) x $70.
When
0 = 1/2, the expected cost is $85, and the expected profit is $115.
When the seller cannot identify the buyer type, the seller's ability to
limited. The problem
capture surplus from the type-1 buyer becomes
with offering high quality to both buyer types is that, although it is so
from the seller's
cially optimal, it is not profit-maximizing
point of
view. At $200
for high quality, the type-1 buyer realizes a surplus of
and this represents a foregone opportunity (an opportunity cost) to
the seller been able to identify the buyer type, she would
have been able to engage in perfect price discrimination
and earned an
$50
the seller. Had
additional
$50 from the type-1 buyer. Due to the buyer's private infor
even
mation,
though the seller has all the bargaining power, the seller is
letting the type-1 buyer enjoy a significant amount of surplus.
When
faced
with such information obstacles,
a menu of offers with different levels
by making
stead of offering high quality
at $200,
the seller can do better
of quality. Suppose,
in
the seller makes the following
menu of offers: (jpvq{) = ($230, h) and (p2, q2) = ($170,/). That is,
the buyer is given a choice between purchasing high-quality product at
or low-quality
Each type of buyer, presented
$230
product at $170.
with such a choice, will choose whichever maximizes
her surplus. For
the type-2 buyer, since she is willing to pay only up to $200
for high
the
first
offer
is
quality,
clearly unattractive. With respect to the second
for low quality, she would be
to pay $170
offer, given her willingness
willing to choose that option, although she will earn no surplus. When
p2 is slightly below $170, the type-2 buyer will choose the second op
tion. What about for the type-1 buyer? If she were to accept the second
offer, since she is willing to pay up to $190 for low quality, she would
realize a surplus of $20. Similarly, if she were to accept the first offer,
her surplus would be also $20. Again, when p1 is slightly below $230,
the type-1 buyer will choose the first option.
When the buyer type is thus separated, the seller will enjoy a larger
expected profit. Recall that when the seller was offering high quality to
both buyer types at $200, the seller's expected profit was 9 x $100 +
—
The seller's
(1
0) x $130.
expected
profit, when the buyer type is
—
—
separated with the menu, is 9 x ($230
$100) -I-(1
9) x
—
—
=
x
x
9
$130 + (1
$120. Compared to the previ
($170
$50)
0)
ous case,
the seller is grabbing a higher fraction of the surplus from the
versus $100)
while sacrificing some profit with re
type-1 buyer ($130
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1708
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Law
[Vol. 98:1665
Review
versus $130).
So long as the chances of
spect to the type-2 buyer ($120
not
too
the
are
small, making such a tradeoff will
facing
type-1 buyer
=
make sense for the seller. When 0
1/2, for instance, the seller's ex
The following
table
will
increase
from
to $125.
$115
pected profit
compares
Table
the two outcomes.
3: Equilibrium
ing Power
Comparison
When
Seller
(p,q) = ($200, h)
e = 1/2
Has
All the Bargain
(Pv Ri) = ($230, h)
Cp?,q?) = ($170,0
$20
Type-l's
Surplus
$50
Type-2's
Surplus
$0
$0
Seller's
(Expected)
$115
$125
(Expected)
$140
$135
Profit
Total
Surplus
An important
point about
the example
is that, even
though
offering
high quality to both buyer types is socially optimal, the seller is deliber
suboptimal
quality for the type-2 buyer. Such reduction
ately choosing
in quality stems from the seller's desire to exercise its bargaining power
and maximize
profit. When the seller can dictate the terms of the trade,
claimant of the transaction.
the seller becomes
the de facto residual
the seller knew which buyer type she was facing, she was able to
capture all the contractual surplus by selling the same high-quality prod
uct at two different prices. When the seller cannot engage in such perfect
due to lack of information on buyer type, she is in
price discrimination
When
inefficiency in the transaction to extract more of the
buyer's surplus. In the current example, by offering low-quality product
with a price that is sufficiently unattractive to the type-1 buyer (but at
tractive to the type-2 buyer), the seller can induce the buyer to "reveal"
clined
to introduce
the type-1
her type and is better able to reduce, albeit not completely,
contractual
however,
surplus for the
buyer's
surplus. In the process,
type-2 buyer is inefficiently reduced.
suppose we equate
Using the product warranty as an example,
low
with "limited"
and
with
"extensive"
quality
warranty
quality
high
war
ranty and let the type-1 buyer serve as the frequent user of the product
and the type-2 buyer as the infrequent user. When the seller was offering
$200 for the product with extensive warranty, the extensive user was en
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The Effectof Bargaining Power
2012]
1709
a surplus of $50, but both types of user were able to enjoy the so
her
cially optimal level of warranty. When the seller wants to maximize
profit, instead of offering the product with extensive warranty at $200,
joying
the buyer a choice:
the seller gives
the buyer can purchase
the product
with limited warrantyat $170, but by paying an additional $60, she can
get an extensive warranty. With these choices, the casual user will not
find it worthwhile to pay $60 to obtain the extensive warranty while the
extensive user will. The seller will increase her expected
profit from
$115 to $125 and reduce the type-1 buyer's surplus from $50 to $20,
but the type-2 buyer will be stuck with an inefficiently limited warranty.
The fact that the seller's bargaining
power is playing an important
role can also be demonstrated
using the following thought experiment.
due perhaps to regulation, that the seller cannot charge more
Suppose,
of this cap, if the seller
than $210 for the high-quality product. Because
she would have to leave a larger sur
were to price-quality
discriminate,
the seller's power
plus for the type-1 buyer. At the same time, because
of extracting surplus from the buyer is more limited, her incentive to in
troduce inefficiency to the type-2 buyer is also reduced. To see this, if
the seller were to offer two different contracts to separate buyer types,
she would now offer(pv q{) = ($210, h) and (p2< R2) = ($170,1). Be
cause
bargaining power, her expected profit is
is no higher than the profit the seller could gen
of the limit on the seller's
reduced
to $115,
which
erate by offeringboth types high quality at $200. If the price ceiling is
between
and $210, the seller no longer has any incentive to en
discrimination.
This example demonstrates that the
$200
gage in price-quality
incentive to produce
quality distortion depends crucially on the party's
ability to extract surplus from the other—in other words, its relative bar
gaining
power.
2. Dominant
Buyer
The quality distortion in the previous example resulted from the sell
er's desire to minimize the buyer's rent. It is natural to ask whether shift
power to the buyer would correct the distortion. Unfortu
the buyer introduces a different kind
however,
fully empowering
nately,
of distortion to the transaction. We turn to the case in which the buyer
ing bargaining
has all the bargaining power and the buyer is allowed to make a take-it
or-leave-it offer (without competition from other buyers or an opportuni
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[Vol. 98:1665
Virginia Law Review
1710
to the seller.88 Given the parameters in our example,
ty to renegotiate)
to having
offer is equivalent
make
a take-it-or-leave-it
the
buyer
letting
number
of sellers
in the market, in which a large
perfect competition
the most attractive
offers and the fully-informed buyers choose
them.89
among
When the buyer has all the bargaining power, the seller's equilibrium
make
This result is in contrast
profit will be reduced to zero (in expectation).
to the previous case where the seller, with full bargaining power, was
eliminate the type-1 buyer's surplus. The reason
unable to completely
for the difference
information
stems
about
that while the buyer has
from the assumption
her preferences, the seller does not. There is
private
no seller "type" that is kept hidden from the buyer in our analysis. When
the buyer has all the bargaining power, the buyer will be able to, in equi
librium, capture the entire surplus from the transaction. If social welfare
were to be maximized,
both types of buyer should offer to purchase high
= 9 x
cost of production:
p
quality at a price equal to the average
$100 + (1 — 0) x $70, which is equal to $85 when 6 = 1/2.
The problem with this solution, however, is that the type-1 buyer is
receiving a great benefit by paying a price that lies below the production
while the type-2 buyer is paying a price
cost for that type (p < $100)
higher than the production cost (p > $70). The type-2 buyer indirectly
subsidizes
the type-1 buyer, and the type-1 buyer captures more than the
—
while the type-2 buyer
from
the transaction ($250
p > $150)
surplus
—
when the
the
<
less
warranty example,
($200
p
$130).
Using
gets
seller offers the product with an extensive
warranty at a single price
may equal the average cost of servicing both types), the infre
the more frequent users of the product.
users
will be subsidizing
quent
health insurance contracts. When an in
be
that
of
Another example may
(which
company charges an identical premium (with imperfect screen
to
both
the healthy and the less healthy consumers, the healthy con
ing)
the less healthy.
sumers will be subsidizing
surance
break this indirect subsidy and enjoy
Can the type-2 buyer somehow
a larger surplus? The fact that the seller cannot identify buyer type and
88
in that case, is often
of inefficient quality to some segment of consumers,
problem
rather than "inefficient
as "cream-skimming,"
See, e.g., Choi & Spier, su
signaling."
pra note 17, at 27.
89
offer is
of allowing
the buyer to make a take-it-or-leave-it
Indeed, the theoretic approach
not significant.
Even if the buyer still gets to make a take-it-or-leave-it
offer, so long as there
The
noted
are multiple
sellers
and no entry barrier, the equilibrium
presented
below
will hold.
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The Effectof Bargaining Power
2012]
that the type-2 buyer is subsidizing
type-2 buyer will have an incentive
would
1711
the type-1 buyer implies that the
to make a differentiating offer that
make
better off both her and the seller. Consider this deviation:
of offering high quality at price equal to 9 x $100 + (1 — 0) x
$70, suppose the type-2 buyer offers to purchase low-quality product at
price $51. If the seller were to accept this offer, knowing that this is
coming from the type-2 buyer, the seller would realize a profit of $1, as
instead
opposed to just breaking even. For the type-2 buyer, making this (unilat
a surplus of
is better, since by doing so, she realizes
eral) deviation
$119, as opposed to $115 (assuming 9 = 1/2).
When
the type-2 buyer thus realizes
that she is paying too high a
for
the
to
indirect subsidy to the type-1
price
high-quality product (due
she
has
an
incentive
to
herself
to get a better deal. Of
buyer),
separate
course, when the type-2 buyer thus deviates, the seller will no longer
break even by serving only the type-1 buyer at the average cost price
—
(p = 9 x $100 + (1
0) x$70).
fall apart and the only possible
The initial (pooling) equilibrium will
equilibrium
is for the type-1 buyer to of
fer (pv q{) = ($100, h) and the type-2 buyer to offer
The
seller will break
—
even
when serving both types at the re
prices. The type-1 buyer would not want to mimic the type-2
buyer. If she were to do so, her surplus would only decrease from $150
to $140. Likewise,
the type-2 buyer would not want to mimic the type-1
($50,/).
spective
buyer since that would reduce her surplus from $120
the equilibrium results.
lowing table summarizes
Table
4:
gaining
Equilibrium
Power
9 = 1/2
Surplus
Type-2's
Seller's
(Expected)
Surplus
Profit
Surplus
When
(p,q) = ($85, fi)
Type-l's
Total
Comparison
(Expected)
$165
$115
Buyer
to $100.
Has
All
The fol
the Bar
(PvRi) = ($100, ft)
(P?,qt) = ($50,0
$150
$120
$0
$0
$140
$135
When
the buyer has all the bargaining power, the buyer will deliber
offer
ately
suboptimal contract terms so as to increase her gain. The rea
son stems from the bargaining power and the temptation to signal her
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Virginia Law Review
1712
[Vol. 98:1665
type to capture a bigger surplus. When the seller cannot distinguish be
tween buyer types, the socially optimal equilibrium
might force certain
buyer types to subsidize
by paying a higher price than justified by the
=
cost.
When
the
0),
production
buyer has all the bargaining power (A
because
she is the de facto residual claimant, such a cross-type subsidy
for her, creating an incentive for her to engage in costly, but
As the buyer's bargaining
signaling.
strength decreases
(A
an
incentive
to separate herself through inef
gets higher), she has less of
ficient signaling because
she will not be able to capture the full benefit
is a burden
inefficient,
from doing so.
V. Effect
In the previous
of More
two polar
Even
Bargaining
Power
the party with all the bargaining
examples,
inefficient terms to capture more of the con
power deliberately imposes
tractual surplus. In this Part, we
explore whether these terms would
change if the bargaining power were more evenly distributed. But, what
of bargaining power? We sug
would constitute a more even allocation
seller might face a threat of
First, a monopolist
gest three possibilities.
future competition if its contract terms are inefficient, but not otherwise.
the monopolist
Second,
may be tempted to renegotiate after the initial
sale, to profit from the surplus created by removing the inefficiency. We
examine these cases in Sections Y.A and V.B, below. Third, in Section
in
in a bilateral monopoly,
V.C, we present an analysis of bargaining
which
the parties may trade offers and counteroffers. In this game, bar
gaining power can be adjusted by varying the rate at which the payoffs
from future agreements are discounted to the present.90 In the Appendix,
we present a more general model that does not rely on any specific bar
gaining protocol but does allow the mechanism
designer (social planner)
over buyer's and
to implement the solution based on her preferences
seller's
welfare.
90
In the complete,
share of bargain
case, reflecting a more "even"
symmetric information
A 6 [0,1]. In
the parameter
and was done by adjusting
ing power was fairly straightforward
the presence
of private information, this is not as straightforward,
the equilib
partly because
as to who
rium tends to be sensitive to the structure of the bargaining
Assumptions
process.
gets to make an offer first, whether the offeree can make a counteroffer, and how much delay
the equilibrium
of the game. This, in turn,
there is between
offers can matter in determining
makes it more difficult to make a strong generalization
about the effect of bargaining
power
on nonprice terms. The
ideas of how deviations
duce
or eliminate
three variations,
therefore, are meant to illustrate the main
following
offer bargaining
models
can re
from the simple take-it-or-leave-it
the inefficiency.
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The Effectof Bargaining Power
2012]
1713
A. Threat of Competition
between
In this first variation, after the initial period of negotiation
the buyer and the seller, the seller (now called the incumbent) will face a
competitor (called the entrant) in the market with some delay. The intro
duction of competition has two important implications.
First, it will keep
in
incumbent
will be
the incumbent's
check
so
that
the
pricing power
more im
unable to extract as much surplus from the buyer. Second,
will also diminish or eliminate the incumbent's
portantly, competition
to impose inefficient nonprice terms on the buyer. This is be
an inefficient term offers a profit opportunity for the entrant.
incentive
cause
When an entrant sees an inefficient term, the entrant will recognize that
not all the potential surplus is being realized. The entrant will compete
with an efficient term and induce the buyer to breach the contract with
and
the incumbent. The possibility of breach will make discrimination
imposing inefficient nonprice terms more difficult for the incumbent.
To represent these ideas more formally, we take the previous seller
offer game and turn it into a two-period
take-it-or-leave-it
competi
=
the buy
nature
determines
with
(t
0),
tion/entry game
delay. Initially
er type and only the buyer observes the type. In the first period (t = 1),
the seller) makes an offer to the buyer with
the incumbent (previously,
out knowing the buyer's type. As in the seller take-it-or-leave-it
game,
the incumbent can either make a single/pooling
offer ((p, q)) or a menu
of offers ((pi,/i),
(p2, 0)- The buyer either accepts or rejects. After the
=
2) with some
buyer's action, the game moves to the second period (t
G
To
we
use
a
discount
rate
of
8
delay.
represent delay,
[0,1]. If any of
the contractual
surplus is realized in the second period, rather than in the
first, all payoffs that come from the second period surplus are multiplied
("discounted")
by 8. A higher 8 implies that the second period payoff is
less discounted
vis-á-vis the first period payoff and this provides less of
an incentive
for the players to reach
when 8 is low, the players
an agreement in the first period.
will have a stronger incentive to
Similarly,
reach an agreement in the first period.
When <5 = 1, as an extreme case, the parties are indifferent between
realizing a payoff in the first or in the second period. There is no cost in
and the buyer would be happy to simply wait until an entrant ap
in
the market, making the game identical to the one in which the
pears
offer to the seller. That is,
buyer was able to make a take-it-or-leave-it
with a higher 8, there is more robust competition between the incumbent
and the entrant. If 8 = 0, on the other extreme, having the option of be
delay
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1714
Virginia Law Review
[Vol. 98:1665
ing able to wait for the second period becomes useless. The players must
reach an agreement in the first period if they are to realize any surplus,
making the game identical to the one in which the seller was able to
make a take-it-or-leave-it
the second
offer. With a lower
S, potential competition in
to the buyer and the incumbent has a
the entrant. The discount factor 5, hence,
means
less
period
stronger upper hand vis-á-vis
also determines the degree of competition between the two entities.
In the second period (t = 2), a competitor (the entrant) appears in the
market. If the buyer rejected the incumbent's
offer in the first period, the
incumbent
and the entrant will make competing offers to the buyer in the
offer in the first
period. The buyer's rejection of the incumbent's
second
period implies that the buyer's type remains unknown to both the in
cumbent and the entrant.91 When two sellers thus compete for a single
is for both
buyer whose type is unknown, the unique Nash equilibrium
sellers to make an identical menu of offers: ((px, h), (p2< 0) =
(($100, h.),($50, /)). The equilibrium will be the same as the one in
which the buyer was making a take-it-or-leave-it
offer to the seller. With
between
two sellers is strong
only two types of buyers, competition
to
create
a
(but
inefficient)
enough
perfectly competitive
equilibrium.
If the buyer accepted the incumbent's
offer in the first period, how the
entrant's appearance
in the market will affect the equilibrium
depends
on the efficiency of the incumbent's
nonprice term. When the incum
bent's
realized
nonprice term is efficient, since all the potential surplus is being
by the incumbent and the buyer, the entrant cannot offer any set
of terms to successfully
lure the buyer away from the incumbent. Hence,
the initial contract between
the incumbent
and the buyer will stand.
When the incumbent's
term
is
inefficient, on the other hand,
nonprice
the entrant can successfully
ficient nonprice term. Even
induce the buyer's breach by offering an ef
if the buyer has to pay the incumbent expec
tation damages,92 the presence of a residual surplus implies that the en
trant can still make both the buyer and itself better off through breach.
91
It is also
that only one type of buyer accepts the offer while the other does not.
possible
will reveal the buyer's type to the incumbent
and the entrant. This type of separation
is
dealt with through refinements,
are not dealt with in detail.
which, due to their complexity,
This
The equilibria
are constructed
to survive the refinements.
presented in all three variations
92
The optimal response
when faced with entry, is to set liquidated
dam
by the incumbent,
This
will
allow
the
incumbent
to
ages at an amount higher than the expectation
damages.
extract
more
rent from the buyer-entrant
duo. See Philippe
to Entry, 77 Am. Econ. Rev. 388, 396-97
tracts as a Barrier
sume
that the court would
honor
such a penalty
clause
when
& Patrick Bolton,
Even if we were
(1987).
all three parties are aware
Aghion
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Con
to as
of the
The Effectof Bargaining Power
2012]
1715
For instance, suppose
the incumbent makes a menu of offers to the
in
in
the
first
buyer
period, ((p1( h), (p2, Q), and the buyer self-selects
accordance
with her type. In the second period, the entrant, after observ
that
the
ing
type-2 buyer has chosen the low-quality contract, will selec
contract to the type-2 buyer. Since there is
tively offer a high-quality
$10 of residual surplus from switching the type-2 buyer from low quali
even when the type-2
ty to high quality (surplus of $130 versus $120),
~ $50 to the
has
to
of
incumbent,
buyer
pay expectation
p2
damages
there still is enough to make both the entrant and the type-2 buyer better
off. When the entrant thus attempts to induce the type-2 buyer to breach
contract, the incumbent will respond by also offering high
quality to the type-2 buyer.93 The result will be that the type-2 buyer will
the initial
be able
to obtain
the residual
p2
— $50.
high-quality
surplus of $10
product at a price of $70 and capture
while the incumbent's
profit remains
all
at
1 represents the potential outcomes
of the competition/entry
After
nature
makes
its
the
selection
game.94
(at
top of the tree), the in
cumbent (the seller) makes an offer to the buyer, which the buyer either
Figure
or rejects. The bottom numbers represent the (expected)
surplus
For simplicity,
captured by the buyer and the incumbent, respectively.
the payoffs to the entrant are not shown, and the second period actions
accepts
are folded
into the payoffs.
The dashed
curve represents
the assumption
relevant
based on type, setting ineffi
values, which is the result when the buyer separates
not prevent the type-2 buyer from obtaining
would
high liquidated
damages
high
cannot commit not to renegotiate
the liqui
quality in the second period when the incumbent
dated damages
clause.
93
When the incumbent
himself offers the high-quality
contract in the second period, this
ciently
will
lead
to modification
or renegotiation
of the initial contract. We will analyze
the renego
in more detail with the third variation.
it
So, for the sake of distinction,
possibilities
that the type-2 buyer will breach the initial contract with the in
might be easier to suppose
cumbent and purchase high quality from the entrant at $70.
94
Note that the diagram already partially reflects both pooling
and separating
of
equilibria
the game. It is not the usual extensive
tree form representation
of the game. This will be true
tiation
for all the tree diagrams
in the Article. In a true extensive tree representation
of the game, for
action by the buyer, the seller will form a belief that assigns probabilities
of <r e [0,1]
on the buyer being type-1 and I — a of being type-2. The equilibrium
concept we are using
here is known as Perfect Bayesian-Nash
See Robert Gibbons,
Game
Equilibrium
("PBE").
each
Theory
concept.
for Applied
Economists
149-52
(1992),
We also apply the Cho-Kreps
"intuitive
for an easy exposition
of this equilibrium
criterion" to rule out any unreasonable
off
David
M. Kreps,
Games
and Stable
Signaling
belief. See In-Koo
Cho &
the-equilibrium
102 Q.J. Econ.
The
179, 201-04
Equilibria,
(1987).
portant role in the third variation in Section V.C.
intuitive
criterion
will
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also
play
an im
1716
Virginia
Review
[Vol. 98:1665
is making the offer in the first period, the in
not know which node she is at, that is, she does not know
the incumbent
that when
cumbent
Law
does
the buyer type.
First, note that when
the buyer rejects the initial offer from the in
cumbent (represented
written next to them),
by branches with "Reject"
the competition between the incumbent and the entrant in the second pe
that the buyer captures all the surplus. The type-1 buyer
a surplus of $150
(multiplied
by 8 due to delay) while the
type-2 buyer will realize a surplus of $120
(multiplied
by 5). Second,
whet) the incumbent induces the type-2 buyer to accept low quality in
the first period (represented
branch that follows the
by the "Accept"
riod
ensures
will realize
of offers for the type-2 buyer), both the entrant and the incumbent
will offer high quality to the type-2 buyer in the second period and in
the initial
duce the type-2 buyer to breach (or anticipatorily
repudiate)
menu
The type-2 buyer will switch to the high-quality contract while
the
of p2 — $50. The type-2 buyer, in the
expectation
damages
paying
process, will capture the residual surplus of $10 (multiplied by S to rep
— $50.
resent delay), while the incumbent's
profit stays at p2
contract.
Figure
1: Competition/Entry
Game
with Breach
Nature
/2S0
-
p\
Ip-iooJ
/5l50\/250
-
Pi\/S150\/200
K o iU-iooJl
- p\ /S120\A70~
o /1 p —70J v 0 A
p2 + SlO\fSl20\
P.-50
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A o )
The Effectof Bargaining Power
2012]
1717
What will be the equilibrium of this competition/entry game? In short,
the threat of having to face a competitor in the second period induces the
incumbent to both lower the offer price and not impose an inefficient
= 0.5, for instance, the
nonprice term on the type-2 buyer. When <5
the
to
make
a pooling
offer of
is
for
incumbent
unique equilibrium
=
(p, q)
($140, h) and for both types of buyer to accept the offer in the
first period. The equilibrium
price is substantially lower than the type-2
to pay for high quality ($200).
The type-1 buyer
buyer's willingness
will realize a surplus of $110 and the type-2 buyer will realize a surplus
of $60. The incumbent, when 6 = 1/2, will realize an expected surplus
of $55. Compared
to the game where the incumbent was able to make a
offer to the buyer, even though the game ends in the
first period, the buyer enjoys both a larger surplus and efficient nonprice
terms. Table 5 summarizes
the outcome of the game when S = 0.5.
take-it-or-leave-it
Table
5: Equilibrium
e = 1/2
Type-l
Buyer's
Surplus
Type-2
Seller's
Buyer's
Profit
Surplus
Total (Expected)
The
of Competition/Entry
Surplus
Game
When
S = 0.5
(p,q) = ($140, h)
$110
$60
$55
$140
reason
why the incumbent offers a lower price to the buyer is
straightforward. When the buyer is aware of the potential competition in
the second period, the buyer becomes
unwilling to accept a high price
offer in the first period. The type-1 buyer, for instance, knows that if she
were to wait until the second period, she would be able to obtain high
quality at a price of $100 and realize a surplus of $150. Delay imposes
some cost, so that the surplus of $150
from the second period, when
S = 0.5, is equivalent
to an immediate, first period surplus of $75. For
the type-1 buyer to accept the high-quality offer from the incumbent in
the first period, given that the type-1 buyer is willing to pay up to $250
for high quality, the price must be $175 or lower. Since the incumbent,
when endowed with the power to make a take-it-or-leave-it
offer without
competition, was offering $230 to the type-1 buyer, the type-1 buyer is
already enjoying an additional
(potential)
surplus of $55. Similar logic
also applies to the type-2 buyer.
What is more interesting and somewhat
less intuitive is (1) why the
incumbent
is disinclined
to offer low quality
to the type-2 buyer and (2)
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1718
Virginia Law Review
[Vol. 98:1665
why the type-2 buyer is unwilling to signal its type to the market by re
jecting the incumbent's
pooling offer. To better understand the underly
for
the
still makes a
moment, that the incumbent
ing logic, assume,
menu
of alternatives for the buyer, ((Pi,/i),
designed to induce
(p2,0),
the type-1 buyer to choose high quality and the type-2 buyer to choose
low quality. When the incumbent was able to make a take-it-or-leave-it
offer to the buyer, the incumbent only had to make sure that the terms of
the low-quality
contract that the incumbent offered were sufficiently un
attractive to the type-1 buyer. This constraint was satisfied when the
—
—
p2. With the threat
prices were chosen to satisfy $250
px > $190
of competition,
the incumbent now also needs to worry about
trant's offer to the type-2 buyer in the second period.
the en
in the second period means that even if the type-2 buyer
Competition
had chosen low quality in the first period, the type-2 buyer would still be
able to obtain high quality through breach when an entrant emerged.
is that this will not only improve the welfare of the
more
importantly, will also lessen the incentive of the
type-2 buyer, but,
to
with
the high-quality
contract in the first period.
stay
type-1 buyer
the low-quality
contract
that choosing
The type-1 buyer now realizes
What is interesting
not necessarily mean she will be stuck with low quality. Rationally
and correctly expecting that the price of high quality offered to the type
2 buyer will be quite attractive in the second period (due to competi
does
tion), the type-1 buyer is less inclined to choose high quality at a rela
tively high price in the first period. If the incumbent still wants to sepa
rate the buyer types, therefore, the incumbent will have to give a larger
makes
to the type-1 buyer, and a large price concession
price concession
more competi
discrimination
less attractive. When the market becomes
tive (when
8 rises), discrimination
becomes
even less attractive from
the incumbent's
perspective.
When the market gets too competitive
(when 8 is too close to 1),
the
would
want
to offer high quality to
incumbent
however, although
both types of buyer, the buyer, particularly the type-2
longer want to choose high quality. As 8 gets larger,
high-quality,
pooling offer gets closer to the expected
both buyer types ($85 when 9 = 0.5), and the type-2
that she is indirectly subsidizing
the type-1 buyer, will
buyer, would no
the incumbent's
cost of serving
buyer, knowing
have a stronger
to signal her type to the market. With too much competition (8
breaks apart and the
close to 1), the high-quality,
pooling equilibrium
market will revert back to an equilibrium
that is similar to the one in
incentive
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The Effectof Bargaining Power
2012]
1719
which the buyer was able to make a take-it-or-leave-it
offer to the seller:
the type-1 buyer acquires high quality at a price close to the cost of serv
ing that type while the type-2 buyer receives low quality at a price cor
to its cost.95 For the pooling
equilibrium
a
moderate
level
of
therefore, maintaining
competition
range) is important.
responding
to be
sustained,
in
the
middle
(5
B. Renegotiation
In the previous
uted by allowing
take-it-or-leave-it
more evenly distrib
who are making
competition
among
offers to the buyer. Another important source of bar
example,
for some
bargaining
power
was
sellers
gaining power is the power not to renegotiate or modify the terms. When
one party is endowed with the power to make a take-it-or-leave-it
offer,
the offeror has an incentive to deliberately introduce inefficiency in the
a larger share of the surplus. The presence of such in
however,
implies that, if the bargaining parties have a chance
efficiency,
to renegotiate
the terms, they would
be willing to make a welfare
The ability to extract the maximal share of sur
improving modification.
hopes
of capturing
plus through the introduction of inefficiency is sensitive to the assump
tion that the party with bargaining power could commit not to renegoti
ate the terms that were previously agreed upon.
An important aspect of renegotiation is that such possibility is particu
larly salient and relevant to contract terms, such as warranty, termina
rather than other aspects of the transac
tion, choice-of-forum
clauses,
tion, such as the product's physical attributes. It may be fairly easy for
the parties to renegotiate over such contract terms either before or even
after the product has been sold. On the other hand, physical attributes of
a product tend to be immutable: once the seller has decided on the phys
ical attributes, for instance before introducing the product to the market,
95
What we mean by the pooling equilibrium
no longer being sustained
is that the pooling
in which both types of buyer acquire
equilibrium,
high quality at a single price, no longer
satisfies the Cho-Rreps
"intuitive criterion."
See Cho & Kreps, supra note 94. With a large
8, only the type-2 buyer will have an incentive to reject the incumbent's
offer, and the mar
ket (the incumbent
and the entrant) correctly
the incumbent's
offer. There is some welfare
believes
loss,
that it is the type-2 buyer that rejects
the type-2 buyer will have to wait
since
until the second
the transaction.
As S approaches
one, this equilibrium
period to consummate
to the Nash equilibrium
in which the buyer was making a take-it-or-leave-it
offer
converges
to the seller.
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1720
or once
change
When
Virginia
the product has been
the attributes.
Law
Review
[Vol. 98:1665
sold to the buyer, it is often impossible
to
the contracting parties cannot commit not to renegotiate
the
to the one-period
terms, this will introduce two important modifications
take-it-or-leave-it
offer models. First, since the parties will voluntarily
renegotiate
the terms when the nonprice
will mitigate the inefficiency.
terms are inefficient, such rene
In equilibrium,
the parties are
terms (either at initial formation
gotiation
more likely to adopt efficient nonprice
or through renegotiation).
Second, even when
only one party has all the
power to make offers, both in the initial formation and the renegotiation
stages, the lack of commitment implies that a bigger share of the surplus
will have to be shared with the counter party because
it makes the initial
discrimination
more difficult.
To understand
these points more clearly, let us go back to the exam
the
where
seller
had the power to make a one-time take-it-or-leave-it
ple
offer to the buyer. When the seller could commit not to renegotiate the
terms, the seller was able to separate the buyer types and extract the
maximal surplus from the buyer. Once the buyer types self-select, on the
other hand, the buyer type is revealed to the seller: the seller knows for
certain which type has accepted which offer. In the one-shot game, even
after knowing the buyer type, the full commitment implies that the par
ties will go ahead and execute the inefficient, low-quality
contract with
respect to the type-2 buyer.
If the seller cannot commit
not to renegotiate the terms, on the other
when
the
hand,
type-2 buyer accepts the offer with low quality, the sell
er will attempt to renegotiate the terms so as to capture the residual sur
plus. Although this will be better for both the seller and the type-2 buy
the
er, when the type-1 buyer expects that the seller will renegotiate
the
no
have
an
incentive
contract,
low-quality
type-1 buyer may
longer
to stay with the high-quality contract. The type-1 buyer now may want
to mimic the type-2 buyer by choosing
the low-quality
contract in the
first stage, hoping that she will be able to get the high-quality contract,
at a lower price. To achieve separation, the seller
through renegotiation,
will have to leave a larger surplus to the type-1 buyer. Contractual
sur
will
be
more
shared
with
the
even
the
seller
is
plus
evenly
buyer
though
the only one making offers.
To present these ideas more formally, suppose, as in the previous var
iation, we have a two-period bargaining game with delay but with only
the seller making offers in both periods. Like before, at t = 0, nature se
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The Effectof Bargaining Power
2012]
1721
lects the buyer type, and in the first period (t = 1), the seller makes an
offer to the buyer. If the buyer rejects, the game moves to the second pe
riod (t = 2) with delay (discount
factor 5), where the seller gets a se
cond
chance
to make
the offer in the second
an offer to the buyer. When
period, since there already
the seller is to make
is an agreement, the
sure that both parties will get more from the re
negotiated contract than what they are entitled to receive under the ini
tial contract for renegotiation
to be successful.
The following diagram
seller will have to make
represents
Figure
the possible
2: Possible
scenarios
Scenarios
of the game.
of the Renegotiation
Game
Nature
Type 1
Offers
{&)yS
((Pv^UPi'lz))/
\
/
\
Buyer/
/
Accept
Pi
j
l A ~ci(9i) J
\
2 (1 - 0)
~~^~~-\SeUer
Seller^-"""
/\
^s\Type
Reject
Seller Makes
Second Offer
with delay S
offers
7\
V(A>?.X(P2.?2>)
(/
Accept
\ Buyer
/
Seller Offers to
Renegotiate
with delay S
\
Reject
Seller Makes
Second Offer
with delay S
To construct an equilibrium
of this game, first hypothesize
that, in the
first period, the seller makes a menu of offers, ((px, h), (p2, /)), to the
in accordance
with her
buyer and the buyer self-selects
(and accepts)
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1722
Virginia Law Review
[Vol. 98:1665
type.96 In the second period, with respect to the type-1 buyer, since high
quality has been agreed upon, the seller knows that there is no gain from
With respect to the type-2 buyer, on the other hand, since
renegotiation.
the buyer has agreed to purchase low quality (i.e., has accepted
(p2, /))
in the first period, the seller knows that there is a surplus to be captured
from renegotiation.
Under the initial agreement, the type-2 buyer ex
—
pects to realize a surplus of $170
p2 and the seller expects to realize a
—
of
Since
$50.
profit
p2
selling high-quality product to the type-2 buy
er generates a larger surplus, the seller will offer to renegotiate
tract by making a renegotiation
offer of (p2, q2 = h) where
—
p2 > $170
p2, that is, the buyer's surplus from renegotiation
the con
$200 —
must be
at least as large as that from the initial contract. Having the power to dic
tate the terms of renegotiation, the seller will offer p2 = $30 + p2 to the
type-2 buyer in the second period.
Moving back to the first period,
when the seller offers a menu of con
the type-1 buyer knows that if she were to
tracts, ((p1( h), (p2,0),
choose the contract with low quality, (p2, I), with the discount factor of
offer of
S, in the second period, the seller would make a renegotiation
<
where
So
as
the
of
the
$200.
(p2, K),
p2
long
price
high-quality prod
uct is higher than $200, that is, p1 > $200,
the second con
choosing
tract and waiting for the renegotiation becomes attractive. To prevent the
type-1 buyer from doing so (and pooling with the type-2 buyer), the
seller has to make a bigger concession
on p1. That is, the seller has to
—
—
ensure
that $250 — px > (1 — 5) x ($190
p2).
p2) + <5 x ($250
When 6 = 0.8, the profit-maximizing
set of prices for the seller is
= $206,
= $170, and
= $200.97 The
p1
p2
p2
following table summa
rizes the results.
96
9 > 1/4, offering a menu of contracts to the buyer is
It is easy to show that whenever
more profitable for the seller than making a pooling offer.
97
in the industrial organ
This result is similar to what is known as the "Coasean
dynamic"
izations
literature. Professor
Ronald
Coase
that if a durable-goods
conjectures
monopolist
cannot commit not to lower its price, the monopoly
rent and the deadweight
loss will disap
and Monopoly,
15 J.L. & Econ.
This is
143, 143^44
Coase,
(1972).
pear. Ronald
Durability
because
after selling to only a subset of consumers
at a mo
(with high reservation
values)
will attempt to satisfy the residual demand (the consumers
who
nopoly price, the monopolist
value the good more than the cost of production
but less than the initial monopoly
price) by
consumers
lowering its price. If the initial high-reservation-value
expect this, they will simp
ly wait for the lower price. Our story is similar but different since we are more concerned
with renegotiation
of an existing contract, rather than forming new contracts with other sets
of consumers.
and
decreases
in our game, the price of the high-quality
Nevertheless,
product starts at $206
to $200 in the second period. See also Faruk Gul et al., Foundations
of Dy
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The Effectof Bargaining Power
Table
6: Equilibrium
ate (S = 0.8)
When
Seller
Commit
Not to Renegoti
((Pi, h), (p2,/)) = (($206, h), ($170,1)
9 = 1/2
(p2,q?) = ($200,h)
Type-1
Buyer's
Surplus
$44
Type-2
Seller's
Buyer's
Profit
Surplus
$0
Total
Cannot
(Expected)
Surplus
$117
$139
to the game where the seller was able to make a one-time
Compared
take-it-or-leave-it
offer, by taking away the power of commitment not to
both
the
total surplus and the type-1 buyer's surplus have
renegotiate,
the total surplus from $135 to $139 and the type-1 buyer's
surplus from $20 to $44. We can think of S as being inversely related to
the power of commitment. With a larger 8 (a weaker commitment pow
increased:
er), we can expect a bigger surplus for the buyer and larger efficiency
while, with a smaller S (a stronger commitment power), the equilibrium
will produce a smaller surplus for the buyer and lower efficiency. In
deed, when 5 = 1, with the seller having no commitment
power, the
profit-maximizing
strategy for the seller is to offer ($200, h) in the first
and serve both types of buyer. With no commitment power, inef
when 5 = 0, we come back to the
ficiency disappears.
Conversely,
in
which the seller is able to make a one-time take-it-or-leave-it
game
period
offer to the buyer, with maximal
inefficiency.98
C. Bilateral
Negotiation
way of reducing the bargaining power gap is by giving both
a
chance
to dictate the terms of the contract (in sequence).
parties
Sup
pose, similar to the competition/entry
game, the bargaining
game con
Another
sists of two periods. But rather than having a competitor enter the mar
ket in the second period or the seller renegotiate,
we let the
suppose
and the Coase
39 J. Econ. Theory 155, 169 (1986)
Monopoly
Conjecture,
(showing
that monopolist
rent and deadweight
loss disappear
as the time interval between
offers goes
to zero).
98
S (or reducing
Note that in this renegotiation
the seller's
game, increasing
bargaining
increases
This is partly due to the fact that the seller still retains
power)
always
efficiency.
namic
the power to make a take-it-or-leave-it
offer in the renegotiation
stage. If the buyer were
S too much would create a signaling
offer, increasing
making the renegotiation
inefficiency.
The model, then, will be qualitatively
similar to the first and the third variations.
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1724
Virginia
Law
[Vol. 98:1665
Review
buyer make a counteroffer to the seller. In the first period (t = 1), the
seller makes an offer to the buyer, which the buyer can either accept or
the game ends on the seller's
reject. If the buyer accepts,
proposed
terms. If the buyer rejects, on the other hand, the game moves to the se
cond period. In the second period (t = 2), the roles are reversed and the
buyer gets to make an offer to the seller. If the seller accepts, the game
ends
on the buyer's proposed
if the seller rejects, the
terms, whereas
ends
with
no
trade
and
both
Unlike the
game
parties getting nothing."
the
and
competition/entry
renegotiation games, however,
game moves to
the second
period
firstperiod.
only when
an agreement
has not been
reached
in the
As in the previous games, we assume that delay is costly for both par
ties. Since the buyer has the last chance of dictating the terms of the
transaction, if the buyer were to make the second period offer immedi
ately after rejecting the seller's offer, the game would collapse to the one
that allows the buyer to make a take-it-or-leave-it
offer to the seller.
Similarly, if the buyer never gets to make an offer in the second period,
the game will be identical to the one in which the seller was able to
make a take-it-or-leave-it
offer to the buyer. To keep the respective par
in
check
ty's bargaining power
(and allow both parties a chance to dic
tate the terms of the transaction), we again multiply the payoffs from the
second period by a discount factor of 8 G [0,1]. As before, the higher
the Ö, the less costly the delay in reaching an agreement (or the more pa
tient the parties become)
and the more bargaining power the buyer has.
The discount factor plays the dual role of providing the parties an incen
99
We can reverse the roles and let the buyer make the initial offer and the seller the subse
results will not change. There are (at least) two
quent offer (with delay), but the substantive
other ways of representing
more "even"
One is through a "flip-a
bargaining
assumption.
in which the outcome
coin" mechanism,
of a coin flip will get to make a take-it-or-leave-it
offer to the other party. In that game, however,
no matter who comes to be the offeror, the
offeror will act as if she had all the bargaining
will contain
power. Hence, the equilibrium
the inefficiencies
that are identified in the previous
models.
The other is by allowing
both
parties to make simultaneous
that setting, when the buyer's
a double
auction mechanism.
In
offers, that is, by imposing
bid price is larger than the seller's
ask price, trade is executed
whereas
if the buyer's bid price is lower than the seller's
ask price,
price in between
takes place.
See Kalyan
& William
Under In
Samuelson,
Chatterjee
Bargaining
31 Operations
Res. 835, 838 (1983).
full bargaining
solu
Information,
complete
Although
tions have not been worked out yet, in that model it is likely that the set of inefficient equi
at some
no trade
libria cannot
be ruled out.
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1725
The Effectof Bargaining Power
2012]
an agreement
early and also distributing the bargaining
to
dictate
the
terms) between the parties.100
power (the power
The following
ways that the game could
figure represents possible
=
0), nature determines the buyer type. In the first
play out. Initially (t
=
the
seller
makes an offer. Given that the seller does not
1),
period (t
tive to reach
know the buyer's type, the seller can either make a pooling offer, (p, q),
If the seller were to choose the lat
or a menu of offers, ((pv h), (p2,1)).
ter, the buyer can either reject the entire menu or choose one of the of
If the buyer were to reject the offer, the game moves to
period. In the second period, given that this is the last chance
fers in the menu.
the second
an agreement and that the buyer has all the bar
the
offers that are iden
buyer will make type-dependent
gaining power,
tical to the ones the buyer used when the buyer could make a take-it-or
for the parties
to reach
leave-it offer: (($100, ft),($50, Z))-10' In the figure, as before, the se
cond period actions are folded into the payoffs for simplicity. The pay
offs are discounted by <5 in case the buyer rejects the seller's offer in the
first period.
100
Another
a chance
way to think about
to make a counteroffer.
S is that it represents the probability
that the seller is given
If there is a chance that the consumer
will simply walk out
of the store when the seller rejects the consumer's
offer in the first period, the seller's ability
to make a counteroffer should be reduced by that probability.
101
This results from refinement of the off-the-equilibrium
beliefs. When 8 > 5/6 « 0.83,
we can show that this will always be true. When the buyer rejects, as an off-the-equilibrium
the offer of (p, h) or ((p1( h), (p2l /)), the seller correctly assigns probability
9 to
deviation,
the possibility
that the offer is coming from a type-1 consumer.
And, therefore, knowing this,
in the second
in signaling
period, the type-2 buyer will have to engage
by offering low
belief (by the seller) will satisfy the Cho-Kreps
"intui
quality. This out-of-the-equilibrium
See Cho & Kreps, supra note 94. When 8 < 5/6, however,
this will no long
er be true. With respect to the pooling offer, (p, h), the seller will assign the probability
of 1
that the rejection
is coming
from the type-2 buyer. Similarly,
when the buyer rejects the
tive criterion."
menu
is done
of offers, ((p1; h), (p2,/))>
the seller
by a type-2 buyer when 5 < 2/3.
will
assign
the probability
of 1 that the rejection
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All use subject to JSTOR Terms and Conditions
1726
Virginia
3: Possible
Figure
Scenarios
Law
Review
of the Alternate
[Vol.
98:1665
Offer Game
Nature
Type2 (1-6)
Type 1 (0).
Seller
Seller
Offers
Offers
Offers
\((p».h).{Pi.O)
\«Px.h),(Pz, 0)
(p,h)/
Type-2
Type-1
\ Buyer
Buyer
VReject
(250-p\
lp-ioo/
\Reject
^Reject
Accept,
Accept/
fSlS0\(2S°-PA
v o J Ipi - loo;
Accept/
\Rqect
Accept/
fSl50\ f200-p\fsi20s.n70-p2\
k o Mp-70/1
0 Jvp2~5o;
(S1Z0\
I o J
How will the equilibrium
change from the one-period
game? Assume
and start
that S — 0.9. To construct an equilibrium,
we move backwards
from the second period. As we have noted, in the second period, assum
ing that the buyer has rejected the seller's offer in the first period, the
buyer will behave as if she has the power to make a take-it-or-leave-it
offer to the seller in a one-shot
game: the type-1 buyer will offer
($100, h) while the type-2 buyer will offer ($50, Z). The seller will ac
cept both offers, rendering
$120 to the type-2 buyer.
a surplus
of $150
to the type-1
buyer
and
Moving back to the first period, whether or not the seller would want
to make a pooling offer, (p, q) — (p, h), or give the buyer a menu of op
she will have to ensure that the type-1 buyer will
tions, ((px, h), (p2,0),
while the type-2 buyer will at
a surplus of S x ($150)
a surplus of ö x ($120).
Furthermore, if she were to offer a
she has to further make sure that the type-1 buyer is better off
at least realize
least realize
menu,
choosing
(p1( h)
selecting
(p2,0
102
rather than (p2,1), and the type-2 buyer is better off
rather than (p1( /i).102 Under the first option, the best
—
—
the pooling
5150,200
offer, the seller must satisfy p < min{250
5120}.
—
< 250 — 5150;
the separating
offer, the seller has to satisfy (1)
(2) p2 — 170
and (3) pi — p2 < 60. Intuitively,
5120;
having to satisfy a larger number of constraints,
ceteris paribus,
usually implies that the seller's profit will be lower.
With
With
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1727
The Effectof Bargaining Power
2012]
= 0.9, is
possible price the seller can offer for the high quality, when 5
$92. Under the second option, the optimal set of offers for the seller is
(($113, h), ($53,0).
In both cases, the buyer will accept. The first,
pooling offer, option will allow the seller to capture a surplus of $7,
while the second, a menu offer, option will allow the seller to realize a
the seller will choose to make a
profit of $3.5. Clearly, in equilibrium,
pooling offerof ($92, h) and the game will end in the firstperiod with
is better off since, had the game pro
period, the seller would have made no profit. The
better off since the buyer does not need to wait for the se
out any inefficiency.
ceeded to the second
The
seller
buyer is also
cond period, that is, there is no delay in contract formation.
Table
7: Equilibrium
When
e = 1/2
Type-l
Buyer's
Surplus
Type-2
Seller's
Buyer's
Profit
Surplus
Total
(Expected)
Parties
Alternate
in Offers
(p,q) = ($92, h)
$158
$108
(S — 0.9)
$7
Surplus
$140
An important factor that determines the characteristics
of the equilib
=
factor
Ö.
If
Ö
for
the
rium is the discount
0,
instance,
buyer's ability to
and the two
make an offer in the second period is of no consequence
to letting the seller make a
equivalent
game becomes
=
if
S
there
is no cost in delay in
offer. Similarly,
1,
an agreement (or the buyer gets to make a counteroffer for cer
period bargaining
take-it-or-leave-it
reaching
tain), and the buyer will fully exercise her right to make the last offer:
identical to the monopsony
the bargaining
bargaining
game becomes
scenario.103 As 5 gets smaller, the buyer's last-shot power becomes more
and the seller will be able to get a larger share of the surplus.
So long as <5 does not get too large or too small, the above pooling equi
librium can be sustained and the first best can be achieved.
diminished
One intuitive way of thinking about this bargaining game is by recog
that the
nizing how much pricing restriction is imposed by 8. Suppose
parties are still playing the two-stage bargaining game but with complete
and symmetric information over the buyer's type. In that scenario, as we
have seen earlier, the parties will choose the optimal nonprice terms to
103
two games (monopolist
and perfect competition,
The previous
can be thought of as special cases of this more general game.
or monopsonist,
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games)
1728
Virginia
Law
[Vol. 98:1665
Review
that
the contractual surplus. At the same time, the assumption
the buyer can make a counteroffer only with some delay introduces an
important check on the buyer's bargaining power.
To see this, with symmetric information, the buyer, in the second
maximize
product with prices of either
stage, will offer to purchase high-quality
This
allows the buyer to realize a
or
on
her
$100
$70, depending
type.
respective profit of $150 and $130 in the second period. The seller, ex
pecting this outcome from the second period, will offer, in the first peri
od, respective prices that make the buyer just indifferent. To the type-1
— $100 >
buyer, the seller will offer p1 with high quality, such that pl
while to the type-2 buyer, the seller will offer p2 such that
8 x $150,
— $70 >5x
p2
$130.
If we let p1 = $100 + 8 x $150
and p2 =
her profit, we get
+ 8 x $130, which allow the seller to maximize
— $30 + 8 x $20. Note that as 8 gets smaller, so does the dif
P2
Pi
ference between pt and p2. When 8 — 1, the buyer can fully extract all
case. However, when 8 < 1,
surplus from the seller as in the monopsony
$70
~
the buyer no longer
buyer's
has unlimited
decreases,
pricing power
power in setting prices. And as the
so does her incentive to impose ineffi
ciency.
VI. Bargaining
The motivation
Power,
Discrimination,
of this Article
is to address
and
Legal
Policy
what we identified
at the
theory of bargaining power's effect on contract
how does bargaining
is
Our
descriptive:
purpose
predominantly
design.
the
influence
terms?
way, we have commented
Along
nonprice
power
and
under
different
the
of
the
outcomes
on
power allocations
efficiency
outset as the irrelevance
this naturally leads to the question
bargaining or market inefficiencies.
in correcting
that legal institutions are
so
to mitigate these problems
of the role of the law
We believe
unlikely to have the information needed
that the cure may be worse than the disease.104
Nevertheless,
before con
of our analy
as to the implications
cluding, we offer some observations
sis on the policing of bargains under contract law.
a court may re
Under the common law doctrine of unconscionability,
contract term or the entire contract by
fuse to enforce an unconscionable
either modifying or voiding the contract. The doctrine requires not only
but
a defect in the bargaining process ("procedural
unconscionability"),
to the vulnerable
unfavorable
also a term that is harsh or unreasonably
104
See
Craswell,
supra note 4, at 33.
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The Effectof Bargaining Power
2012]
1729
While gross inequality
of
unconscionability").105
is
often
mentioned
as
a
factor
to
bargaining power
contributing
proce
dural unconscionability,
it is rarely sufficient on its own.106 Unless the
party
("substantive
imbalance
amounts
to duress, undue influence, or incapacity, courts typ
further
defects in bargaining, especially
a finding that the
ically require
weaker party also lacked the opportunity to read or understand the harsh
term. Courts do not interfere with commercial
contracts based solely on
a procedural concern with unequal bargaining power.107
When parties are rational and fully informed about the terms of their
concerns are less severe because
at least each
agreement, distributional
105
The
terms
"substantive
coined
originally
Code—The
by
Professor
unconscionability"
Arthur Leff.
and
were
"procedural
unconscionability"
A. Leff, Unconscionability
and the
L. Rev. 485, 487 (1967).
The formulation
of
Arthur
New Clause,
115 U. Pa.
Emperor's
Court of Appeals
for the District of Columbia
Circuit in Williams v. Walker-Thomas
Furniture
Cir. 1965),
is often cited: "Unconscionability
has
Co., 350 F.2d 445, 449 (D.C.
to include an absence
of meaningful
choice on the part of one of
generally been recognized
the parties together with contract terms which are unreasonably
favorable
to the other party."
the U.S.
In addition to noting the imbalance
in bargaining
the fact
power, the court also emphasized
that the terms were written on the back of the order form in fine print and in language
that
was difficult to understand.
Id. at 448-49.
106
Both the Restatement
of Contracts
and Article 2 of the Uniform Commercial
(Second)
Code adopted similar interpretations
of the doctrine. According
to the Restatement,
"[a] bar
the parties to it are unequal
in bargaining
gain is not unconscionable
merely because
posi
tion ....
But gross inequality
of bargaining
favor
power, together with terms unreasonably
able to the stronger party" may support a finding of unconscionability
in the bargaining
Restatement
of Contracts
the high-water
process.
(Second)
§ 208 cmt. d (1979).
Perhaps
mark of the concern over the imbalance
of bargaining
power on its own was the famous case
of Henningsen
v. BloomfieldMotors,
Inc., 161 A.2d 69 (N.J. 1960). The court struck down a
that was not specifically
but
warranty disclaimer
brought to the attention of the consumer,
the main
thrust of the court's
focused on the concentration
of bargaining
opinion
power in
Id. at 92, 94. Since then, the occasional
court has based a finding of
on bargaining
procedural
See, e.g., Gianni
unconscionability
power.
Sport Ltd. v. Gantos,
Ct. App. 1986) (upholding
the lower court's determi
Inc., 391 N.W.2d
760, 762-63
(Mich.
nation that a cancellation
clause benefitting a large retailer against a small independent
man
the automobile
industry.
ufacturer was unconscionable);
Shell Oil Co. v. Marinello,
307 A.2d 598, 601 (N.J. 1973).
most do not. Comment
1 to § 2-302 of the Uniform Commercial
Code
However,
suggests
that bargaining
of op
power is not by itself enough: "[t]he principle is one of the prevention
of allocation
of risks because
of supe
pression and unfair surprise . . . and not of disturbance
rior bargaining
U.C.C.
power."
§ 2-302 cmt. 1 (2011).
107
U.C.C.
v. Caterpillar,
1995
§ 4.9 (5th ed. 1996);
see, e.g., Coursey
Inc., No. 94-1348,
WL 492923,
at *3 (6th Cir. Aug. 6, 1995) ("Unconscionability
is rarely found to exist in a
commercial
& Eng'g
Inc., v. Lewis
setting.");
Cnty. Asphalt,
Welding
Corp., 323 F. Supp.
1300,
1308
commercial
(S.D.N.Y.
1970) ("[I]t is the exceptional
setting where a claim of
will be allowed
But see Campbell
....").
Soup Co. v. Wentz, 172 F.2d 80,
where the bargain was one-sided
and op
(refusing specific performance
unconscionability
83 (3d Cir. 1948)
pressive).
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1730
Virginia
Law
[Vol. 98:1665
Review
party is better off than without an agreement. While one could imagine a
policy striving to achieve more even sharing of the surplus, another con
cern is with cases in which the exercise of bargaining power undermines
that inefficiently
The analysis in Part IV demonstrates
terms can persist even between sophisticated
parties when the
in
or
the
in
seller engages
buyer engages
screening
signaling, particular
This result underscores
that the
ly when bargaining power is unequal.
value-creation.
one-sided
current judicial
and scholarly skepticism as to the earlier
adhesion and the lack of meaningful choice is exaggerated.
concern
over
it re
Indeed,
that a menu of terms may itself be evidence of a problem. When a
seller screens, it may impose harsh terms on one set of buy
monopolist
veals
ers (the low-value
warranties to
buyers) by, for example,
disclaiming
to the other group (high-value
them while offering broad warranties
If courts were to be more aggressive
in policing
buyers).
bargaining
be particularly vigilant when faced with a discrimi
Sometimes
the monopolist's
nating monopolist.
screening is obvious, in
which case the court should scrutinize the nonprice terms of the lower
power,
they should
quality
contract:
purchase
for example,
a warranty
disclaimer
with an option
to
an extended
warranty.
as Part IV also demonstrates,
the absence of bargaining
Conversely,
power on the part of the seller does not resolve the danger. Inefficient
Of course, in cases in
might occur in perfect competition.
signaling
the low
which the buyer has all the bargaining power (monopsonist),
value
to her
buyer may propose inefficient terms that are unfavorable
self, to avoid being pooled with the high-value buyer.108 If that were the
case, since it is the buyer's exercise of bargaining power that is causing
more seller-friendly terms, it will be difficult for the buyer to claim the
After all, the
sympathy of the court in a review for unconscionability.
gains from the inefficient signaling accrue to the buyers rather than the
competitor sellers. Therefore, mandatory terms might be a superior solu
tion.
On the other hand, it is difficult to know what a court should do with
If the law compelled
the monopolist
to offer only a sin
such a contract.
108
tion
This
about
result,
derived
from the numerical
the buyer's
relative reservation
not
had
a higher marginal
buyer
only
in Part IV, is sensitive to the assump
example
we have assumed
that the
values.
Throughout,
will
to pay but also higher absolute
willingness
reservation
val
ingness to pay for quality. If the type-2 buyer were to have a higher absolute
ue vis-á-vis
the type-1 buyer, when the buyer has all the bargaining
power, the buyer will
demand quality that is inefficiently high. See supra note 82.
type-1
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1731
The Effectof Bargaining Power
2012]
gle contract (rather than a menu of contracts or options) in order to pre
vent inefficient screening, we observed
earlier (and show in the more
in
model
the
that
this
Appendix)
may not improve welfare in the
general
of heterogeneous
preferences
requiring different nonprice terms.
establish
a mandatory minimum quality and
the
court
Alternatively,
may
refuse to enforce anything less—for
example,
by prohibiting warranty
disclaimers
or requiring a period of notice before termination. Of course,
face
as others have argued, any attempt to mandate quality levels for specific
classes of buyers must also deal with the informational limitations of the
lawmaker, whether regulator or court.109
Even assuming that a court can set a floor at the optimal level for the
buyer that values quality the least, however, the discriminating monopo
list or a perfectly competitive market may still offer lower-than-optimal
quality to intermediate classes with preferences between the lowest and
highest or, perhaps even worse, may decide not to serve consumers who
quality the least. As a variation to the numerical example, if there
are three types of buyer and three different levels of optimal quality, set
ting the minimum quality standard may improve the welfare for the con
value
sumer who
values
the quality the least, but it may not do anything for
who also purchases inefficiently low-quality prod
uct. If the quality minimum gets too high, the monopolist
or the compet
itive market may decide not to serve the lowest-type consumer, thereby
the middle
consumer
generating
an even greater inefficiency.110
price regulation, an instrument that courts have been reluctant
Perhaps
to invoke,111 might be more effective:
courts might impose
limits, both
109
The doctrine of unconscionability
has been criticized
on this score. See, e.g., Craswell,
Another relevant critique is that the
supra note 4, at 1066-67.
supra note 4, at 33; Schwartz,
will lead stronger parties to extract
court's refusal to enforce one-sided
nonprice provisions
their rents by raising the price, leaving weaker parties worse off than if the original contract
had been
enforced.
not feasible
extract
that this is
e.g., Kennedy,
supra note 19, at 619. We note, however,
where the monopolist
is already maximally
utilizing price terms to
Since a price term is more efficient for
rent, as in our numerical
example.
See,
in situations
consumer
extracting rent, our result seems not unreasonable.
110
See Besanko
et al., supra note 73, at 750-51,
for a demonstration
who desire a moderate
level
quality threshold (1) will leave consumers
and (2) may induce the monopolist
els of quality.
1'1
Courts seem to be reluctant
to altogether
stop serving
to strike down
the boundaries
difficulty of determining
sor Farnsworth
notes two other possible
of "fair"
reasons:
likely to be known and understood
by the weaker
struck down as being unconscionable
(i.e., being
consumers
of how
a minimum
of quality unaffected
who desire low lev
of the
terms, at least partly because
markets. Profes
prices in noncompetitive
(a) the price, being much more salient, is
party and (b) even if the contract price is
price
outside
the bounds
of "fair"
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price),
the
1732
Virginia Law Review
[Vol. 98:1665
upper and lower, on price for the product. At least in theory, this can
work because
once the monopolist's
incentive to extract consumer sur
plus (or buyers' incentive to engage in signaling) is kept in check, its de
sire to quality discriminate will disappear or at least be substantially mit
is prevented from
igated. From the numerical example, if the monopolist
above
for
she
can
no longer profit
$220
charging
high-quality product,
from inefficient
and will, instead, offer both types
price discrimination
of buyer high quality at $200. Also, if the minimum price of $70 can be
maintained
when the buyer had all the bargaining
power, the type-2
buyer can no longer benefit by deliberately choosing a low-quality prod
uct. Price regulations,
lenge of institutional
of course,
immediately
run into the familiar
chal
competence—particularly,
identifying the proper
limits in any given market.
These considerations
suggest that a general structural policy to pro
mote competition might be preferable to contract regulation. Our analy
sis, however, demonstrates that shifting bargaining power to buyers may
overshoot
the objective
if it gives buyers too much power. The policy of
in this sense may backfire. As was demonstrat
empowerment
ed through the numerical example, the buyers themselves may choose to
consumer
create
a signaling equilibrium
that leaves some of them with inefficient
when
are
aware
of
the possibility of indirect subsidy to oth
quality
they
er buyers. This is true even in markets that appear to courts as competi
tive where
power
the valuation
of customers is private. The interior range of
is golden in this context: a more even distribution of
power and sharing of rents can mitigate the inefficiency. The
to achieve this balance
is an interesting question worthy of
allocation
bargaining
mechanism
further investigation.
Conclusion
For over forty years, law-and-economics
has been work
scholarship
ing on the premise that bargaining power is irrelevant to the design of
nonprice contract terms. Practitioners have the opposite
understanding
in contrast, give much weight to the balance
of power, whether
market concentration,
imbalances,
stemming from supply-and-demand
or negotiating skill. This Article takes the first steps to bridge theory and
and,
practice
by identifying
the conditions
court will be obliged in many cases to substitute
Contracts
§ 4.28, at 306-07
(4th ed. 2004).
under
a fair price
which
in its place.
bargaining
E. Allan
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power
Farnsworth,
2012]
The Effectof Bargaining Power
1733
might affect contract design. We analyze at some length one set of ex
the effect of relative bargaining power where one party has
planations:
information
about its reservation price. We also identify a variety
private
of other possible
and leave to future research the further
explanations
unpacking
of the bargaining
power
irrelevance
proposition.
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1734
Virginia
Law
A General
Appendix:
[Vol. 98:1665
Review
Model
capturing the notion of bargaining power in the presence
of asymmetric information is difficult. In this setup, we take a more re
duced-form approach by letting A denote the fraction of the equilibrium
Accurately
the social planner
surplus the seller captures in expectation.
Suppose
function
a social-welfare
(the mechanism
designer) wants to maximize
(the objective function), which is constructed on the weighted average of
con
the buyer's
and the seller's
expected
profit, subject to various
straints.
represent the fact that although the social planner can
the terms of the trade, she is still constrained by (1) the lack of
information and (2) the inability to "force" both the seller and the buyer
The constraints
dictate
to participate.
That is, although the buyer knows his type, the social
does
not
observe buyer type and the social planner has to guar
planner
antee both the buyer and the seller at least zero profit, their respective
outside
reservation
value.
The social
planner's
problem
can be written as
follows:112
~
~
ciO?i)) + C1 0)(P2
MaxÍP,q) A (9(Pi
CzOfe)))
+ (1
0)(v2(q2)
pa) + (1
A)(0(v1(q1)
subject
-
p2))
to
Pi
-
Ci(£7i)
P2 -c2(<72)
>
0
^
0
^i(<7i) ~Pi
^ 0
v2(q2)-V2
^
0
^ vi(<fc)-P2
ViM-Pi
Pi
v2(<?2) P2 ^ v2(<h)
112
the social planner will induce the buyer to
that, in equilibrium,
program assumes
a different contract based on his type: Pi =*=p2 and q1 =/=q2. If this is not feasible,
that is, Pi = p2 or qt = q2, then we can rewrite the program by defining p = min(p1(p2)
the objective
function subject
and q = max(q1,
q2) and letting the social planner maximize
The
choose
by (p, q). In theory, this formula
only to the first four constraints, where (p¡, q{) is replaced
with 0(p — c1(q))
+ (1 —
tion presents a possibility
of replacing
the first two constraints
—
>
will
but
we
the
easier,
0,
ignore
0)(p
c2(q))
thereby making
implementation
problem
this possible
relaxation.
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The Effectof Bargaining Power
2012]
We will impose
al utility(v[(q)
the usual
assumptions
1735
of strictly diminishing
margin
> 0 but v['{q) < 0) and (weakly) increasing marginal
c" (q) > 0). Furthermore,
to make the problem
more interesting, we will assume that the type-1 buyer's marginal utility
is always higher than the type-2's marginal utility (v[(q)
> v2(q)),
that
the
is
and
that
the
cost
of
is,
satisfied,
serving
single crossing property
cost
(c[(q)
>
0 and
the type-1
buyer is strictly higher than the cost of serving the type-2
> c2(q)
Vc/. To ensure interior solutions, we'll also as
buyer: c^q)
sume that c¿(0) = 0, Vi > 0, and v¡ » 0.
function is a weighted average of the
The objective (or social-welfare)
surplus
expected
profit (weighted
by A) and the buyer's
—
1
As
A
the
will
more
em
A).
gets larger,
equilibrium
put
(weighted by
A
is smaller, the buyer's surplus
phasis on the seller's profit, and when
function can be rewritten as
becomes
more important. The objective
seller's
0((1
-
A)y1(g1)
-
Acx(qj
+ (2A - l)px) + (1 - 0)((1
-
A)v2(q2)
-
+ (2A — 1 )p2).
Three special cases are worth separate consid
=
When A
to maximizing
the
1/2, the problem is equivalent
conventional
social surplus (or consumer surplus plus producer surplus,
Note that when A = 1/2, the price terms disappear
equally weighted).
from the objective function. When A — 1, the problem is identical to that
Ac2{q2)
eration.
of a monopolist
who, with the power to make a take-it-or-leave-it
offer,
tries to extract as much surplus as possible from the buyer and maximize
her profit subject to satisfying the buyer constraints. When 1 = 0, the
offer to
buyer, for instance, by being able to make a take-it-or-leave-it
the seller, is maximizing
her surplus subject to making sure that the sell
er at least breaks even.113 When A e (0,1), the bargaining power is dis
tributed between
the two parties.
113
We can also think of this model as representing
a solution to Nash bargaining
in which
A represents the seller's relative bargaining
the parties bar
power. Under that interpretation,
solution must respect each
gain ex ante, without knowing the buyer type, but the bargaining
ex post participation
the buyer's
incentive
con
and, in particular,
party's
compatibility
straints.
attempt
That is, even after they have worked out a solution, one or both of the parties can
to renegotiate
when the solution does not give the party more than what the outside
or the other option dictates. Although
it may be tempting to suggest that the equilibri
option
um with A e (0,1)
can be replicated
to
by "flipping a coin" that gives more (or less) chances
make a take-it-or-leave-it
offer to the seller (or the consumer),
this will not be true. Such a
model will produce an equilibrium
that will be a convex combination
of two polar equilibria,
and the inefficiencies
at each pole may be simply averaged
out without getting any closer to
the optimum quality provision.
The equilibrium
under our setup will be different
produced
from such combination.
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1736
Virginia
Law
[Vol. 98:1665
Review
Turning to constraints, the first four constraints represent the seller's
and the buyer's participation
constraints, making sure that they, at least,
realize zero surplus in equilibrium.
As we will see shortly, in equilibri
um, each respective buyer type will receive different quality level prod
uct. The seller, therefore, must be able to break even for respective buy
er type and each type of buyer should be able to realize more than her
outside
to be zero. The last two constraints
option, which is assumed
the
incentive
conditions:
each type must
represent
buyer's
compatibility
(at least weakly) prefer to choose the contract that is intended for the
type. Since the social planner does not observe buyer type, the social
planner must offer a menu of contracts for the buyer to self-select.114
With these
able
in the first best, if the social planner were
buyer type, regardless of the weight (A) she assigns to
the respective marginal utility would
profit, in equilibrium,
assumptions,
to observe
the seller's
be equated with the marginal cost: v[(jqf) = c¡(q¡).
Even if X = 1, for
planner will still equate the marginal utility to the
=
but
let
and p2 = v2(ql).
marginal
px
vx(.q{)
Similarly, when
=
A
0, the social planner will choose the optimal qualities for both types
and set p1 = c1(q¡)
and p2 = c2(q2).
For simplification,
we will assume
that the marginal cost of producing
for the type-1 consumer
isn't too
instance,
the social
cost
much
larger than the marginal cost of producing for type-2, so that the
first best requires the type-1 consumer
to purchase
a higher quality
and
at
first
the
that,
best,
product, q{>
q2,
type-1 buyer's
utility is
>
than
the
higher
type-2 buyer's utility, v1 (qf)
v2(q2).
Figure 4 pre
sents an example in which q{ > q2. In addition, to make the problem in
—
that v^q?,)
>
stated, we assume
teresting, unless otherwise
c2(ql)
—
The
that
when
the
v-tiql)
c^ql).
assumption implies
respective quali
ties are offered at marginal cost, the type-1 consumer will prefer to pur
114
Note that, in our setup, there always is a positive surplus from trade: the probability
that
the buyer's valuation
is larger than the seller's
cost is equal to 1. If it is uncertain whether a
values
and costs,
surplus exists and if the parties are privately informed of their respective
the mechanism
becomes
more complicated.
In particular,
if the values
problem
we may run into the (strong) inefficiency
result of Professors
Satterthwaite:
there will be no mechanism
that realizes
all positive
surplus.
costs
design
are uncorrelated,
erson
and
and
My
See
B. Myerson
& Mark Satterthwaite,
Efficient Mechanisms
for Bilateral
Trading, 29 J.
When the values and costs are correlated,
as in our example,
Theory 265, 273 (1983).
all possible
easier since the mechanism
can use one
realizing
gains will become
designer
information.
See Jacques
Crémer
& Richard
P.
party's report to learn about the other's
Roger
Econ.
Under Uncertainty
for a Discriminating
McLean,
Optimal
Strategies
Selling
When Demands
Are Interdependent,
53 Econometrica
345, 346 (1985).
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Monopolist
The Effect of Bargaining
2012]
chase the product intended for the type-2
tion will result with marginal cost pricing.
Figure
4: An Illustrative
Power
buyer.
1737
That is, adverse
selec
Example
A. Case
1: A >
1/2
When A > 1/2, the social planner cares more about the seller's profit
—
than the buyer's surplus. From the objective function, 6>((1 — A)v1(q1)
~
tei(<h) + (2Ä
!)Pi)
1 )p2),
+ C1 - 0)((1
-
^)v2(<72)
-
2{q2) + (2A
holding everything else constant, when A > 1/2, higher prices
strictly increase the value. As an extreme case, when A > 1/2, the social
welfare functionbecomes 6{p1 —
the problem
+ (1 — 0)(p2 — ^(^2))
to a monopolist
trying to maximize
a
menu
of
contracts
to
a
profit by offering
potential customer.
becomes
identical
and
her
A>
PROPOSITION
1: Suppose
1/2. The social planner will imple
ment q1 = ql and q2 < q2- In equilibrium,
the type-2 consumer realizes
zero consumer
while
the
consumer
will realize positive
surplus
type-1
-»
As
A
1, q2 decreases.
surplus.
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1738
Law
Virginia
[Vol. 98:1665
Review
PROOF:
When A > 1/2, in equilibrium,
the participation
constraint
for the type-2 consumer (the fourth constraint) and the incentive com
for the type-1 consumer
patibility condition
(the fifth constraint) will
—
—
= 0
=
If we
and
let
bind:y2(^2)
p2
—p1
vx(q2)
p2~
=
=
and
+
and
substitute
these
P2
^2(^2)
Pi
vi(fli)
vi(Q2)
^2(^2)
into the social welfare function,we get 6(A(v1(q1) — q^))
+ (2A —
~
~
1)0*2(92)
vi(Qz))) + (1
9)A(v2(q2)
c2(<?2))- When we maxim
ize the objective
-
0(2A
From
function with respect to qt and q2, we get
l)(l?2(i?2)
the first equation,
will set the quality
planner
We can rewrite the second
v'Mt)
-
= 0
c'iOji))
+ (1
0X^2(92)
Ö(^'i(£?i)
-
-
C¿(<fe)) = 0
that qx = q{. That is, the social
for the type-1 consumer at the optimal level.
equation as
= c'2^2) ~
it is clear
y~Tq
(2A
~
iX^Ofe)
-
vi(qfz))
—
< 0, in order to satisfy the equality, we must
v2(q2)
v[(q2)
have q2 < q2. The type-2 consumer will receive suboptimal
quality in
Furthermore, as A -> 1, the right-hand side of the equality
equilibrium.
Since
gets smaller,
making
it necessary
to reduce
q2 more to satisfy the equali
ty. Q.E.D.
In equilibrium,
the type-1 consumer is able to realize a positive sur
=
=
and
+ v2(q2)),
known as
plus (since p2
^2(^2)
v^q-J
vt(q2)
the "informational
rent" in the literature. Since the social planner cares
more
about
the seller's profit than the buyer's surplus (A > 1/2), any
that
is taken away from the seller imposes an opportunity cost:
surplus
one
dollar from the buyer to the seller increases the overall
transferring
social welfare when A > 1/2. Hence, to reduce the surplus captured by
the type-1 consumer, the social planner introduces inefficiency on the
Furthermore, as the social planner cares more and
type-2 consumer.
more
about
the distortion
the seller's
profit vis-á-vis the buyer's
gets larger: the social planner imposes
surplus, the size of
even less favorable
terms on the type-2 buyer.
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The Effect of Bargaining
2012]
Power
1739
Figure 5 represents the optimal set of contracts when the social plan
ner cares only about the seller's profit (A = 1). The dashed curve repre
sents the type-1 consumer's
utility shifted down to cross at the optimal
(p2,ij,2)- Note that while the type-2
nated, the type-1 consumer realizes
consumer's
surplus
has been
elimi
some positive surplus. Had the so
cial planner chosen the first best qualities
(q{, q2), surplus captured by
the type-1 consumer would have been much larger. To reduce that sur
plus, the social planner reduces the quality offered to the type-2 con
A marginal reduction in quality for the type-2 consumer produc
es the benefit of being able to charge a higher price to the type-1
consumer
and realizing a smaller profit from the type-2 consumer.
At
sumer.
optimum,
Figure
the benefit will be set equal
5: Optimum
when
to the cost.
A = 1
B. Case
2: A <
1/2
With A <
function
1/2, the seller's profit gets smaller weight in the objective
to the buyer's surplus in the social welfare function.
compared
From the objective
function, ö((l
—
A)v1(q1)
—
Ac^qJ
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+ (2 A —
1740
Virginia Law Review
+ (1 - 0)((1
l)Pi)
~
~
X)v2{q2)
[Vol. 98:1665
- 1
Ac2(q2) + (2Ä
)p2),
holding
everything else constant, when A < 1/2, higher prices strictly lower the
value. As an extreme case, when A = 0, the objective function becomes
—
0(fi(i7i)
—
Pi) + (1
0)(y2(q2)
—
p2)
and the problem becomes
to a monopsonist
equivalent
trying to maximize
a
take-it-or-leave-it
offer
to the seller.
making
her profit, or a buyer
PROPOSITION
2: Suppose
A < 1/2. The social planner will imple
ment qx — ql and q2 < q2. In equilibrium,
the seller realizes zero profit
while the buyer captures all the surplus. As A -* 0, q2 decreases.
In equilibrium,
two constraints) will bind:
PROOF:
the seller's
zero profit conditions
(the first
—
= 0 and
= 0. In ad
(<7X)
p2
c2(q2)
dition, with the assumption of Vi(q2) - c2(q*2) > vx(q{) — cx(q{), the
consumer's
incentive
condition
compatibility
(the penultimate
—
~~
=
constraint) will also bind:
Pi
vi(fo)
P2- When we use the
three equalities to simplify the welfare function, and set up a Lagrangian
with the type-1 consumer's
condition,
binding incentive compatibility
we get
type-1
L(q,n) = (1 - A){d(v1(ql) - qCqj) + (1 - 0)(v2(q2) - c2(q2))}
~
where
~
p is the Lagrangian
to (qvq2,p),weget
(1
-
qOZi)
multiplier.
-
Vx(q2) + c2(q2))
When
we maximize
with respect
= 0
(1
A)0(1
fi)(v[(ch)
ci(<?i))
= 0
1
+
A)(
0)(v¿(q2)
c2(q2)j
ß(v[(q2)
c'2(q2))
~
=
0
ViCqJ
q(i?i)
ViOfe) + c2(q2)
To satisfythe firstequality (with p > 0), we must have q1 = q{. When
the second
equality
is rearranged,
viM =
=
because
Suppose
<72
í?2 Then,
will
be
violated.
To
restore
equality
Kfo) - cá(<?2))
=
> ^2(^2)
^(^2)
c2(q2),
the equality, we must have
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the
q2 <
The Effect of Bargaining
2012]
Power
1741
q*2.115The type-1 consumer will receive product with optimal quality but
As
the type-2 consumer will receive suboptimal
quality in equilibrium.
A -» 0, the right-hand side of the inequality gets smaller, further necessi
tating the reduction of q2. Q.E.D.
Figure 6 represents the optimal set of contracts when the social plan
the consumer surplus (A = 0). Compared
to the
ner wants to maximize
eliminated and the social
previous case, the seller's profit is completely
planner allocates
able to eliminate
formation:
producer
the seller does
therefore, cannot realize
Figure
to the buyer. The social planner is
the seller has no private in
surplus
not have any informational
and,
advantage
the entire surplus
6: Optimum
because
any "informational
when
rent."
A = 0
At the same time, the social planner does have to worry about keeping
consumer from choosing the contract intended for the type-2
—
—
> ^i(íí)
the assumption
that v^q^)
Under
c2(q2)
with zero
Ci(<7Í), had the social planner chosen the efficient qualities
the type-1
consumer.
115
Starting
from q2, as we decrease
q2, v[(q2)
—
the gap between
v2(q2)
c2(q2)
thereby decreasing
decreases
and v[(q2)
at a higher
c2(q2).
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rate than
v2(q2)
1742
Virginia Law Review
=
seller profit, (p2,q2)
(c2
the
contract
intended
choosing
[Vol. 98:1665
Q2.)> the type-1 consumer would prefer
for the type-2 buyer. And, when both
types pool on (p2,q2) = (c2 (<7l)'
not only is the equilibrium ineffi
cient (thereby reducing the surplus that could have gone to the type-1
a negative profit, since
(in expectation)
buyer), the seller also realizes
the price is lower than the average cost of serving both types of buyer.
Hence, to keep the seller in the market while preventing the type-1 buy
er from pooling with the type-2 buyer, the social planner has to reduce
the quality below the efficient level offered to the type-2 buyer.
C. Case 3: X = 1/2
When
seller's
the social
surplus,
~
1/2 (flOiOh)
planner assigns equal
the objective
(social
+ (1 - e)(v2(.q2)
CiM)
to the buyer and the
function
becomes
welfare)
weight
-
c2(q2)))-
Note that the
from the objective function since they only affect
price terms disappear
the distribution of the surplus. When the social planner cares equally
about the buyer's and the seller's welfare, even though she does not di
buyer type, we can show that the social planner will al
implement the first best, that is, she will not introduce any distor
rectly observe
ways
tions.
A = 1/2.
PROPOSITION
3: Suppose
the first best: ( qt = qI, q2 = q2)
The social
planner
implements
Let q1 = q{ and q2 = q2. We just need to find the set of
prices (p1( p2) that satisfy all the constraints. This can be done in the fol
manner.
First, if q{ — q2, this is easily achieved
by letting
lowing
=
that q{ > q2. Let px =
Second,
suppose
Pi
p2 G (cx(ql),v2(q2)).
—
of
and <5 = v^ql)
Given the simplifying assumption
v2(q2)
v2(q{).
> 0. Given the single crossing condi
that
Ö
we
know
—
v2(qD
^2(^2)'
PROOF:
tion,
v[(q)
> v2(q),
and
the condition
that q{ >
- S <
^1(92)
v2(q2). Once we let p2 6 (v^ql)
found the solution.
level, the social
-
q2,
we
must
have
8,v2(q*2)), we have
the respective qualities are set at the optimal
cannot do any better. Q.E.D.
Since
planner
the proof. The dotted curve repre
Figure 7 graphically demonstrates
sents the type-1 consumer's
utility shifted down to cross at v2(ql).
Sup
=
and sets p2 at anywhere be
v2(q2),
pose the social planner sets p1
has no
tween v2(q2)
and the dotted curve. The type-1 consumer
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The Effect of Bargaining
2012]
Power
1743
(p2, q2) since that would make her strictly worse off.
the
Similarly,
type-2 consumer has no incentive to choose (plt q{) since
that would give her zero utility while (p2< q2) gave her a strictly positive
utility. Both types of consumers realize a strictly positive surplus and are
incentive
to choose
offered
When A > 1/2 or
the optimal level of quality, respectively.
can
be
varied
the social planner
because
1/2,
quality
continuously,
will again impose some inefficiency in the market. However,
as A ap
That
1/2, the size of the inefficiency will gradually disappear.
proaches
is, q2 -» q*2 as A -* 1/2.
A <
Figure
7: Candidate
First-Best
Solution
when
A = 1/2
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