Contracting versus Bypassing

One existing distributor controls the existing access to end users. There are one incumbent producer and one potential entrant, both with a potential for bypassing the distributor. We find that the distributor always signs a contract with the producer that leads to the highets industry profits, a choice that can be detrimental to welfare. The contracting producer earns more than the profit it would have earned if it bypassed. We show how the contracting producer's profit is influenced by (1) its market share if it had bypassed, (2) the rivalry it would have triggered if bypassing, and (3) the rival producer's costs of bypassing.