Competition and Contracting in Service Industries

Abstract

Two very different contractual structures are commonly observed in service industries with congestion effects: service level guarantees (SLGs) and best effort (BE) service. We analyze the impact of these contractual agreements on market outcomes in oligopolistic industries. First, we consider a model where firms compete by setting prices and SLGs simultaneously. The SLG is a contractual obligation on the part of the service provider: regardless of how many customers subscribe, the firm is responsible for investing so that the congestion experienced by all subscribers is equal to the SLG. We then consider the BE contractual model where firms compete by setting prices and investment levels simultaneously. With BE contractual agreements, firms provide the best possible service given their infrastructure, but without an explicit guarantee. 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 show that the SLG game can be reduced to a standard pricing game, greatly simplifying the analysis of this otherwise complex competitive scenario. We then compare the SLG game with the BE game; equilibria for the BE is characterized in a previous paper. Using these results we show that in the case of constant returns to investment, while the NE price for the SLG game is perfectly competitive, firms obtain positive markups in the unique NE for the BE game. We also study the firms' choice of the strategy space, i.e., whether to offer SLG or BE contracts to the consumer, and find that competition is intensified if even one firm chooses to offer SLG contracts. Our results contribute to the basic understanding of competition and contracting in service industries and yield insight into business and policy considerations.

Keywords: competition, game theory, contracting, services, congestion, pricing

JEL Classification: L13, L21, L80