Competition and Contracting in Service Industries

Two very different contractual structures are commonly observed inservice industries with congestion effects: service level guarantees(SLGs) and best effort (BE) service. We analyze the impact of thesecontractual agreements on market outcomes in oligopolistic industries.First, we consider a model where firms compete by setting prices andSLGs simultaneously. The SLG is a contractual obligation on the part ofthe service provider: regardless of how many customers subscribe, thefirm is responsible for investing so that the congestion experienced byall subscribers is equal to the SLG. We then consider the BE contractualmodel where firms compete by setting prices and investment levelssimultaneously. With BE contractual agreements, firms provide the bestpossible service given their infrastructure, but without an explicitguarantee. Using the Nash equilibria (NE) of the games played by firms,we compare these competitive models in terms of the resulting prices,service levels, firms' profits, and consumers' surplus. We first showthat the SLG game can be reduced to a standard pricing game, greatlysimplifying the analysis of this otherwise complex competitive scenario.We then compare the SLG game with the BE game; equilibria for the BE ischaracterized in a previous paper. Using these results we show that inthe case of constant returns to investment, while the NE price for theSLG game is perfectly competitive, firms obtain positive markups in theunique NE for the BE game. We also study the firms' choice of thestrategy space, i.e., whether to offer SLG or BE contracts to theconsumer, and find that competition is intensified if even one firmchooses to offer SLG contracts. Our results contribute to the basicunderstanding of competition and contracting in service industries andyield insight into business and policy considerations.