Why Use Requirement Contracts? the Tradeoff Between Hold Up and Breach
Abstract: A requirements contract is a form of exclusive dealing in which the buyer promises to buy only from one seller if he buys at all. This paper models a most common-sense motivation for such contracts: that the buyer wants to ensure a reliable supply at a pre-arranged price without any need for renegotiation or efficient breach. This requires that the buyer be unsure of his future demand, that a seller invest in capacity specific to the buyer, and that the transaction costs of revising or enforcing contracts be high. Transaction costs are key, because without them a better outcome can be obtained with a fixed-quantity contract. The fixed-quantity contract, however, requires breach and damages. If transaction costs make this too costly, an option contract does better. A requirements contract has the further advantage that it evens out the profits of the seller across states of the world and thus allows for an average price closer to marginal cost.
