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Article

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

Journal of Institutional Studies. 2019. Vol. 11. No. 2. P. 29-28.

The paper discusses an alternative to vertical integration – the vertical restraints (VRs)

which have been the subject of numerous studies in neo-institutional economics. It offers a

new approach to analysis of vertical restraints as voluntary self-restraints in the situations of

uncertainty. Not limited to consideration of uncertainty generated by market shocks (Rey and

Tirole, 1986; Hansen and Motta, 2016), this approach takes into account possible termination

of initial contract between firms at the ex post stage, i.e. when specific investments have been

already made. Risks of contract termination are especially significant for so-called «cooperative»

specific investments which might be defined as investments favorably affecting the outside

options of opposite side, i.e. the investor’s partner. Lotteries associated with cooperative specific

investments are characterized by higher risk than lotteries associated with selfish specific

investments (positively affecting the investor’s outside options) because cooperative specific

investments (unlike selfish specific investments) increase the risk of initial contract termination

and often worsen the investor’s outside options. Firms actively respond to risk of contract

termination by choosing an under-investment strategy. The problem of underinvestment could

be solved by an advance compensation paid by a supplier to retailers for taking risk associated

with specific investments. Unfortunately, the implementation of this scenario is complicated by

threat of double moral hazard. VRs voluntarily adopted by the supplier may be considered as

substitutes to such compensation. They can increase the attractiveness of lotteries associated

with specific investments by improving the retailer’s probability beliefs or payoffs in uncertain

outcomes:

VRs redistribute control in favor of the dealers reducing the uncertainty they face;

VRs may be interpreted as an element of the signaling activity aimed to convince the

dealer of the supplier’s willingness to continue cooperation at the ex post stage;

in case the supplier prefers to interrupt the business agreement with the dealer at the ex

post stage, the VRs, such as exclusive territories, will ensure that the dealer gets at least

partial compensation for contract termination;

and, finally, VRs limit the possible redistribution of quasi-rent between the supplier and

the dealer in the internal trade