EXCLUSIVE DEALING
IN GENERAL BUSINESS PRACTICE

Timothy J. Brennan
Graduate School of Arts and Sciences

George Washington University
Washington, DC

Exclusive dealing is where a firm or individual deals with a worker, supplier, pur-
chaser, or retailer on the condition that the latter works only for the firm or individual
in question. Examples illustrate the breadth of this practice. Most companies expect
their managerial and professional workers not to work for other firms, certainly not
for other firms in the same business or in the same capacity for another employer.
One would be very surprised to find a firm permitting its, say, vice president for sales
to do the same work for another firm, even for one not a competitor. Even blue collar
or line employees are usually hired with the implicit if not explicit expectation that
they will work solely for the employer. The decision to hire a worker to do a job or to
have the job done by an independent contractor could be viewed as little more than
a decision as to whether the firm wants its workers to "exclusively deal" their labor.

These arrangements are hardly limited to labor settings. A partnership frequently
will establish contractual expectations that the partners not engage in related business
outside the partnership. Firms may often expect their suppliers not to supply similar
products to other firms. A pen manufacturer, for example, might buy from an ink
manufacturer, under the condition that this ink manufacturer not sell similar ink to
another pen company. The very idea of "vertical integration" presupposes the idea
that the production stages within the firm work exclusively for the firm. One would
regard exceptional that, say, an automobile plant was used to produce cars for another
car company. A "firm," in fact, could usefully be defined as that set of production
facilities and workers committed to work exclusively with each other.

An important special case in which exclusive dealing may be applied is in the
manufacturer/retailer relationship. In one direction, a manufacturer may grant a re-
tailer the exclusive right to sell a product in a particular geographic area. A case in
point is a franchise arrangement, where a firm like McDonald's grants a franchise to
a firm along with an agreement not to permit another McDonald's not to deal with
another food outlet within the marketing area. In the other direction, a manufacturer
may employ a retailer on the condition that it sell only the manufacturer's products.
Looking at the McDonald's example in this direction, McDonald's \\~ll t,ypically ex-
pect its franchisee not to sell Burger King products, pizzas, or other non-McDonald's
food items.

Journal of Business Strategies, Volume 5, Number 2 (Fall 1988)

53



54 Journal of Business Strategies

Literature Review

Vol. 5, No.2

One would think that the study of "exclusive dealing" would have been motivated
by this ubiquity, and that it would be understood by economists and students of
industrial organization in that light. Unfortunately, this has not been the case. Since
exclusive dealing predated sophisticated economic analysis of contractual practices,
it was assumed that exclusive dealing must have been an indicator or manifestation
of some kind of antitrust-like anticompetitive activity. It seemed that a fum only
sacrifices profits by restricting the abilit.y of its employees, retailers, or input suppliers
to engage in other business opportunities, since these parties need to be compensated
for agreeing to face the restriction. Therefore, it seemed that a firm would impose
exclusivc dealing requirements on another only if it could do so without added com-
pensation, i.e., by "foreclosing" its competitors from access to the individual or firm
now "t.ied up" under the exclusive dealing requirement.

Because of its association with antitrust law, the emphasis of the exclusive dealing
literature ([3], [7], [13], [14], [16], [21]) has been on whether exclusive dealing can
enhance or protect a firm's market power. Fortunately, however, exclusive dealing is
among a number of non-price "vertical restraints" that have become the subject of
considerable scrutiny and ret.hinking, both in the courts and in the academic literature
([1]' [8], [10], [17]). Antitrust courts and legal commentators over the past ten years
([1], [4], [15], [17], [18], [20]) have come to view non-price vertical restraints more
benignly than in the past. As we have seen, exclusive dealing is far more widespread
than can credibly be attributed to antitrust considerations.

Even if the courts now view exclusive dealing in a more generous light, a firm
still may wonder whether to institute exclusive dealing. Not only may the costs and
benefits of doing so be subtle, but the decision may be controversial among the affected
parties. In the conventional "exclusive dealing" case, retailers may not want a major
supplier to cut them off if they continue to sell another manufacturer's product, and
will likely demand to be compensated for their lost business opportunities.

Our purpose here is to illuminate the tradeoffs inherent in the general exclusive
dealing situation, where antitrust -related concerns are not relevant. We note that
an obvious cost to the firm who wants an employee, retailer, or supplier to deal
exclusively OIl its behalf is that this firm will have t.o compensate these "agents" for
the lost business opportunities sacrificed in the exclusivity. The gains, on the other
hand, follow when we consider the relationship between a fum and these "agents"
in terms of "conflict of interest." "Conflict of interest" is a t.erm more familiar in
politics, philosophy, or law rather than economics. As we discuss below, however,
exclusive dealing or limitations on outside activities to mitigate conflicts of interest
can enhance the operating efficiency of a vertical relationship.

"Principal!Agent" Analysis

A useful way to identify and understand the costs and benefits involved in exclu-
sive dealing is to look at what is called a "principal/ agent" setting. The "principal" is



Fall 1988 Brennan: Exclusive Dealing 55

the party employing an "agent" to perform a service or supply a product. Our ques-
tion is when is it in a principal's (manufacturer's, wholesaler's, manager's) interest to
have its agents (suppliers, retailers, workers) work exclusively on its behalf, assuming
it must keep each agent as well off as it would be if it retained the freedom to engage
in unrelated "outside" activities. The following table lists some "principal/agent"
relationships in which exclusive dealing may become significant, along with an expla-
nation as to why there may be need for additional compensation for the agent and
why the principal might be willing to pay the price.

Table 1

Exclusive Dealing Settings

Motive for
Exclusivity
Keep trade
secrets from
competitors

Nature of Need for
Exclusion Compensation

-----c:cc------;--"-
Supply output Lost business
only to from sales
manufacturer to other firms

Principal/ Agent
Manufacturer /Supplier

Wholesaler /Retailer Sell only the
wholesaler's
product

Deprived of
other sales
opportunities

Devote sales effort
solely toward
wholesaler's
product

Manager/Worker Work exclusively
for the employer

Lost outside
mcome

Eliminate
distractions,
shirking
opportunities

These examples have a number of properties in common. First is the conflict of
interest between the agent and the principal. The principal wants the agent to do
something the agent finds unprofitable or undesirable. The supplier wants to sell to
other manufacturers; the manufacturer doesn't want the supplier who learns about the
downstream production process to use the knowledge to benefit the manufacturer's
competitors. The retail dealer wants to sell other products; the wholesaler wants the
dealer to promote and service his products exclusively. The employee wants to make
money moonlighting; the manager wants the worker to reserve her energies for the
company's exclusive use.

Second, it is difficult for the principal to monitor the agent's behavior to see that
these conflicts are not important. A manager often has no way of knowing how good a
job the worker is doing; poor results could reflect either outside circumstances beyond
the worker's control or lack of effort due to the pursuit of other employment. The
wholesaler cannot easily attribute lost market share to improvements in the image of
a competitor's product or laxity in the sales efforts of its dealers. The manufacturer
has no way of knowing whether a competitor discovered a trade secret on its own or
learned it from a common supplier.



56 Journal of Business Strategies Vol. 5, No.2

Both the conflict and the inability to monitor are critically important in rational-
izing exclusive dealing. Obviously, if the agent's desires coincided with the principal's,
the principal would have no reason to impose restrictions on the agent's actions. But
even where there is a conflict of interest, a principal could in theory monitor the
agent's effort and compensate him or her on the basis of the observed behavior. The
ability to base rewards on monitored behavior can give the agent incentives to act as
the principal prefers. If the worker knew, for example, that her payment would be
based upon how quickly she responded to the company's needs, there would be no
inherent problem in letting her moonlight. One could simply base her reward on her
performance.

Exclusive Dealing Settings

In an earlier paper [2], I constructed models of this principal! agent relationship
to investigate further these benefits of exclusive dealing. Unlike prior analyses of
exclusive dealing ([6], 191, [101, [11], [12], [19]) we will not analyze effects beyond the
principal and agent, e.g., whether exclusive dealing is inefficient because it promotes
monopoly or excessive product differentiation. However, the discussion here may shed
some light on antitrust issues by helping to understand when and why exclusive deal-
ing would be instituted.

Simple Conflict Settings
Consider first a setting in which outside activities would discourage the agent

form acting in the interests of the principal. This is a characteristic common to all
the scenarios set out in Table 1. One would expect that it would always be in the
interest of the principal to have the agent deal exclusively on its behalf. Principals,
though, confront a tradeoff common to all these situations. The very fact of a conflict
of interest means that the agent would rather be doing something other than what the
principal wants it to do. It follows that the principal is going to have to compensate
an agent for the opportunities it gives up when it makes an exclusive commitment on
the principal's behalf.

This introduces two complications into the question of when exclusive dealing
benefits the principal. The first is that the principal V\~11 have to decide whether the
improved performance of the agent is worth the increase in compensation necessary
to get the agent to act on its behalf. To take an example, suppose a high technology
firm can hire engineers for $10,000 less in annual salary if it permits them to take
on outside consulting jobs or conduct independent research. It then has to decide
whether it will get improvements in firm-specific effort worth the extra $10,000 per
engineer to get exclusive performance. It may not if, for example, the opportunity to
do outside work complements the engineers' efforts on behalf of the firm, rather than
diverting attention from them.

This might lead one to conclude that exclusive dealing is profitable only where the
outside activity conflicts with the principal's desired activity. Conversely, one might
also conclude that where the outside activity complements the principal's interests,



Fall 1988 Brennan: Exclusive Dealing 57

exclusive dealing would never be instituted. Unfortunately, this need not be the case.
Situations can be identified in which it may be in the principal's interest to either
(1) institute exclusive dealing even where the outside activities complement those in
which the principal is most interested, and (2) permit conflicting activities even when
they discourage performance of desired activities.

The reason these unintuitive findings may hold is subtle, having to do with the
relationship between an agent's income and its incentive to work on the principal's
behalf. Consider the engineer again. Suppose the more income an engineer has, the
more the professor is willing to undertake new research opportunities that benefit the
high technology firm. Note that this is not the same thing as paying the engineer
more to work harder. Rather, the engineer's own willingness to undertake this effort
is correlated with income, in that an engineer who is wealthy will put more time into
research of his own volition, reducing the need for the high technology firm to monitor
his behavior or limit his opportunities. If this positive "income effect" is strong, it
may be in the high technology firm's interest to permit some outside activity to
increase the engineer's income, even if the outside activity itself has a negative effect
on firm-specific effort. The benefits to the high technology firm in getting more highly
motivated engineers, by allowing them to earn outside income, would exceed the costs
of the "distraction."

A similar line of argument shows that exclusive dealing may be imposed even
where the outside activity is itself complementary if the "wealth effect" is strong
but negative, i.e., more income makes acting in the principal's interest less attractive.
These arguments can be generalized to all of the exclusive dealing situations displayed
in Table 1 or discussed above.

Provision of Support Services

A more complex situation is one in which the principal can "invest" in the agent,
e.g., when a manufacturer trains a dealer in the repair of his products. Exclusive
dealing here can serve as a way in which the principal can capture the "return" Oil this
investment; otherwise, it may not be provided. Consider a bicycle maker, for example,
who would find its bicycles in greater demand if trained repairpersons were easily
available. However, repair expertise need not be specialized to the manufacturer's
own brand. Trained bicycle repairpersons could make it easier to get bicycles of any
brand repaired, not just those of the manufacturer who provided the training.

If the services provided by the bicycle maker cannot be linked to his brand, the
benefits of those services will be diffused over the market as a whole. Other manu-
facturers need not provide training; they can just "free ride" off the training already
provided. If the training does not provide a competitive advantage to the bicycle
maker, it will have little or no incentive to provide this training. Here, exclusive
dealing can provide the restriction necessary to generate the advantage. A bicycle
retailer would receive instruction on how to fix Brand X bicycles only if he or she
refused to carry any other brand for which this training would apply. In that way,



58 Journal of Business Strategies Vol. 5, No.2

other manufacturers cannot "free ride" off the repair training provided by Brand X's
manufacturer.

Prevention of free riding has been the beneficial effect of exclusive dealing most
discussed in the economic literature ([8], [10J, [17]). According to this story, increased
outside activity by an agent discourages the provision of support services. If a bicycle
dealer can sell other makes of bicycles, a manufacturer providing the training may
"capture" less of the benefits of the training. The "income effect" discussed above
comes in here in an interesting way, though. The more outside activity, the more
income the agent can make in using that training, and the less the principal need pay
to the agent. To rcturn to our example, the bicycle maker can reduce its compensation
to its retailers if those retailers can make money by using training in the repair of
other makes of bicycles. Because of this "income effect," the principal's incentive to
provide support services to its agent may actually be enhanced if its agent is able to
profit from these services in the provision of outside activities.

Concluding Remarks

To summarize, we have found that exclusive dealing is far from being an aberration
present only in alltitrust~related contexts. Rather, it is a commop. device used to
mitigate conflicts of interest between principals and their agents who cannot otherwise
be monitored or controlled. An important special case is when an agent would have
the incentive to use special training or support services on behalf of other "principals."
When the effect of outside activity on an agent's income is recognized, though, a
number of counterintuitive possibilities could occur. Exclusive dealing may make
sense even where outside activities complement work for the principal. It may not
make sense even where there is a conflict of interest, and some outside activity may
make it more profitable to provide support services that might benefit other principals.

Before leaving the topic, we should consider the possibility that exclusive dealing
might be a device to exploit an agent. For example, once someone has decided
to work at a particular firm, personal and financial commitments may reduce his
mobility to the point where the firm may not need to maintain his welfare at the
originally "promised" level. One way would be to cut salaries, but salary is often
set over time by exclusive contract. A more feasible opportunistic strategy would be
to impose exclusive dealing rules after the worker is already committed to the firm.
Such a change may get the worker to work harder for the firm without the need to
compensate for lost earnings from foregone alternate employment opportunities.

The theory of this kind of opportunism is set out by Klein, Crawford, and Aichian
[5J. While it may be in the principal's interest to take advantage of its agents' com-
mitments, this will typically offer only short-run benefits, with potential long-run
costs. A firm or wholesaler will not be able to continue to exploit its employees or
retailers in this manner if it wants to recruit new agents or to retain those agents who
are more mobile. It will have to promise salaries and compensation ex ante contingent
upon the possibility of ex post exploitation, eliminating much of the gain and leaving
only a mutually undesirable inefficiency. If the firm expects to be growing, it will find



Fall 1988 Brennan: Exclusive Dealing 59

this kind of behavior detrimental to its long-run interests. Tightening anti-conflict
rules in midstream may be Inconsistent with plans for growth.

References

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4. Continental T. V. Inc., d. al. v. GTE Sylvania Inc., 433 U.S. 36 (1977).

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10. Mathewson, G. F. "Incentives and Exclusive Dealing." Mimeo, University of
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60 Journal of Business Strategies Vol. 5, No.2

15. Posner, R. "The Next Step in the Antitrust Treatment of Restricted Distri-
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17. Schwartz, M. and D. Eisenstadt. "Vertical Restraints." Economic Analysis
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	Exclusive Dealing in General Business Practive