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amount. If a rival steals one of your customers, you’ll need less input from your supplier. Suppose that, instead of the 1,000 tons you’re currently using, you now need only 900 tons of input. Because you’re still paying for the next 100 tons of input, even if you’re no longer using it, you’ll surely look around for some new business to replace the business you’ve just lost. Your variable costs are now a mere $10 a ton—the difference between the $50 “take” price and the $40-a-ton “pay” price. At this cost level, you can hardly afford not to replace the business you’ve lost, and your rival’s customer base is the obvious place to look.

With a take-or-pay contract, you’re paying part of your input costs up front. You’ve turned some of your variable costs into fixed costs. If a rival takes one of your customers, the economics virtually force you to take one of his in return. Thus, take-or-pay contracts have a deterrence effect. Smart rivals will recognize the greater likelihood of retaliation and refrain from going after your customers in the first place.

Take-or-pay contracts can help stabilize market share in your industry. That’s more good news for your supplier. If you don’t have to fight to keep every customer, you’ll make more money. And if you’re making more money, you’re less likely to fight with your supplier over cost.

There is a caveat. It’s always possible that someone will act rashly and go after your market share, even though you have a take-or-pay contract. You’re forced to retaliate, and that in turn could trigger a sequence of tit-for-tat responses that escalate into a full-scale price war. The war may be particularly brutal, since a part of your costs are already sunk. The deterrence effect of a take-or-pay agreement is not unlike nuclear deterrence: you hope it works, because the cost if it doesn’t is extremely high.

Take-or-Pay Contract

PROS

1. Reduces risk to your supplier, in return for which you can ask to pay less.

2. Reduces a rival’s incentive to come after your customers by making retaliation a near certainty.

CON

1. Increases severity of price war if deterrence fails.

3. Mass-Market Rules

So far we’ve been looking at rules in business-to-business settings. When businesses deal with each other, buyers and sellers negotiate not just over price but over the rules of the game as well. For example, you may want to have a meet-the-competition clause, but the customer may balk. Since you don’t have the power to impose rules unilaterally, what the rules will be is itself subject to negotiation.

Mass consumer markets are very different. Sellers don’t negotiate. And since sellers don’t negotiate, buyers can’t negotiate. As a seller, you have the power to unilaterally lay down some rules of the game. One rule is that you get to name the price of the item you’re selling. If the customer wants your product, he has to pay your price. That’s the way it is in supermarkets, gas stations, restaurants, department stores—in fact, in almost every part of the retail sector.

This state of affairs is something people take for granted. Still, it’s interesting to ask why it’s the case. Once again, the Card Game proves illuminating.

Just for a moment, imagine that Adam has one hundred decks of cards and is playing the Card Game simultaneously with 2,600 students.12 Paralleling the analysis of the very first version of the Card Game, you’d say that Adam and the students will split the $100 prizes equally. Nothing has really changed.

Or has it? The fact that it’s a large-numbers game makes a big difference. Adam can very plausibly refuse to negotiate with each student individually. There just isn’t the time. Instead, he can announce a price and require students to take it or leave it.

The large numbers effectively turn the situation into the ultimatum version of the Card Game. As we saw in the Game Theory chapter, that puts Adam in a much stronger position. He gets to pick the price. He can offer $10 for a red card and expect the students to accept his offer. They’ll do so because they