Person:

Elhauge, Einer

We consider loyalty discounts whereby the seller promises to give buyers who commit to buy from it a lower price than the seller gives to uncommitted buyers. We show that an incumbent seller can use loyalty discounts to soften price competition between itself and a rival, which raises market prices to all buyers. Each individual buyer’s agreement to a loyalty discount externalizes most of the harm of that individual agreement onto all the other buyers. The resulting externality among buyers makes it possible for an incumbent to induce buyers to sign these contracts even if they reduce buyer and total welfare. Thus, if the entrant cost advantage is not too large, we prove that with a sufficient number of buyers, there does not exist any equilibrium in which at least some buyers do not sign loyalty discount contracts, and there exists an equilibrium in which all buyers sign and the rival is foreclosed from entry. As a result, with a sufficient number of buyers, an incumbent can use loyalty discounts to increase its profit and decrease both buyer and total welfare. Further, the necessary number of buyers can be as few as three. These effects occur even in the absence of economies of scale in production and even if the buyers are not intermediaries who compete with each other in a downstream market.

We show that loyalty discounts without buyer commitment create an externality among buyers because each buyer who signs a loyalty discount contract softens competition and raises prices for all buyers. This externality can enable an incumbent to use loyalty discounts to effectively divide the market with its rival and raise prices. We prove that, provided the entrant's cost advantage is not too large, with enough buyers, this externality implies that in any equilibrium some buyers sign loyalty discount contracts, segmenting the market and reducing consumer welfare and total welfare. These propositions are true even if the buyers coordinate, the entrant is more efficient, the loyalty discounts cover less than half the market, and all the loyalty discounts are above cost. We also prove that these propositions hold even if we assume no economies of scale, no downstream competition, no buyer switching costs, no financial constraints, no limits on rival expandability, and no intra-product bundle of contestable and incontestable demand.

We show that loyalty discounts with buyer commitments create anticompetitive effects beyond those possible with pure exclusive dealing. The loyalty discount adds a seller commitment to maintain a distinction between the loyal and disloyal price. This seller commitment reduces the seller's incentives to compete for free buyers because the loyalty discount means that lowering prices to free buyers requires lowering prices to committed buyers. This softened seller competition reduces the rival's incentive to lower its own prices to free buyers. The result is inflated prices to free buyers, which in turn inflates prices to committed buyers because they are priced at a loyalty discount from those free buyer prices. Because each buyer who signs a loyalty discount contract thus softens competition and raises prices for all buyers, the result is to create an externality among buyers even without economies of scale or downstream competition. If enough buyers exist and the entrant's cost advantage is not too large, we prove that this externality means that: (1) in any equilibrium, enough buyers sign loyalty discount contracts to anti-competitively increase prices; and (2) there always exists a possible equilibrium in which all buyers sign, completely foreclosing a more efficient rival. As a result, the incumbent can use loyalty discounts to increase its profit and decrease both buyer and total welfare.