Contracts and Induced Institutional Change

Abstract

We study agents’ incentives to form horizontal coalitions before a principal offers vertical contracts. When a vertical contract generates negative externalities on other agents, the agents may collude in order to obtain better deals; when one contract benefits other agents, the agents may decentralize, instead. Contractually induced institutional changes always harm the principal and the negative effect can outweigh the direct effects of the contracts, making the contracts counterproductive. The model is tractable and sufficiently flexible to be relevant for applications such as regulation of pollution, payments for forest conservation, and mergers between firms in a supplier–franchisee relationship. (JEL D86, H23, H87, Q58).