Contracting with Externalities

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Project Abstract In many economic situations, bilateral contracting imposes external effects on third parties. For example: A shareholder tendering his shares to a corporate raider who is superior to the firm's incumbent management increasing the probability of takeover, thereby benefiting the firm's other shareholders. A creditor exchanging debt for equity in a distressed firm reduces the probability of bankruptcy, thereby benefiting the firm's other creditors. A buyer of a VCR increases the market for video rentals, thereby benefiting the owners of compatible VCRs. A merger of competing firms increases the market price, thereby benefiting other firms in the market. A private contributor to a public good benefits other consumers of the good. A buyer signing an exclusive dealing contract reduces the potential for future competition in the market, thereby hurting other buyers. A manufacturer selling his output to a retailer reduces the price in the downstream market, thus hurting competing retailers. In all these instances, the contracting parties' failure to take external effects into account may give rise to socially inefficient outcomes. This project develops a general model of contracting with externalities which unifies the examples listed above, and illuminates the general nature of arising inefficiencies. In particular, the dependence of the arising distortions depend on various assumptions, including the number of parties involved, the nature bargaining among them, their ability to make discriminatory offers, and the set of contracts available to them. This analysis has numerous implications for the optimal design of property rights and contracting procedures in environments with externalities. Applications include those from finance (bankruptcies and takeovers), industrial organization (vertical and horizontal contracting and mergers), and property law (the design of legal entitlements).