Why Use Requirement Contracts? The Tradeoff between Price Premium and Breach
A requirements contract is a form of exclusive dealing in which the buyer promises to buy a particular product only from one seller. This paper models a common-sense motivation for such contracts: that the buyer wants to ensure a reliable supply at a pre-arranged price without the need for renegotiation. The model requires that the buyer be unsure of his future demand, that a seller make an investment 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, can result in breach. If transaction costs make efficient breach too costly, option and requirements contracts have the advantage of not inducing inefficient performance. A requirements contract has the further advantage that it balances the profits of the seller across states of the world and thus allows for an average price closer to marginal cost