“Long-Term Contracts Soften Competition” by Zhiyun Frances Xu
Zhiyun Frances Xu
Service providers commonly offer both long-term and short-term contracts to consumers and consumers commonly have private information about the level of uncertainty in their future taste. We study a two period model where firms can price discriminate in the second period according to consumers' purchase history. The equilibrium involves firms offering both short and long-term contracts and leads to higher first and second period prices and higher profit compared to the case when only short-term contracts are allowed. Long-term contracts serve the purpose of locking in consumers with more stable taste and thus reducing the poaching incentives in the second period. This stands in contrast to a setting where consumer preferences are fixed, as in Fudenberg and Tirole (2000), where the availability of long-term contract hurts the prices and profit. We also show that efficiency is increased when long-term contracts are allowed because products are better matched with consumer preferences in the second period.