Credible Spatial Preemption through Franchising

Abstract

The analysis of strategic behaviorfrequently revolves around the problem of identifying commitment technologies that credibly expand strategic opportunities. This article revisits the question of spatial preemption to investigate the potential for organizational form to serve as a commitment in the effort to deter entry. The analysis demonstrates first that delegation of pricing authority to independent outlet operators through a franchise contract can deter entry. Moreover, this delegation can be made credible in the sense of being renegotiation-proof through appropriate contractual design. * The analysis of strategic interaction is frequently centered around the dynamic problem of commitment. Often, actions that appear to enhance strategic performance fail to coincide with contemporaneous utility or profit maximization and so cannot be considered credible. Consequently the focus of strategic analysis is often on identifying commitment technologies that credibly expand strategic opportunities. A case in point is the study of spatial preemption. Schmalensee ( 1978 ) and Eaton and Lipsey ( 1979) both suggested that a monopolist who arrived first to a differentiated product market could preempt entry by filling up the space of products. In this way, the monopolist could restrict the market area available to an entrant's differentiated product so that, with competitive pricing on the monopolist's neighboring products, the entrant's net profits would be below zero. These models overcame the commitment problem that plagues efforts to deter entry by simple limit or predatory pricing by employing the technology of spatial location. Judd ( 1985 ), however, showed that these models merely traded one commitment problem for another: since entry reduced prices at the monopolist's locations as well as the entrant's, the monopolist faced the incentive to shut down locations and raise prices in the event that entry did occur. Judd argued that in the absence of exit costs, the monopolist would in fact remove the locations in response to entry. Consequently the monopolist was left with the same set of strategic opportunities available in the absence of the technology of spatial location.