The Governance of Exclusive Territories When Dealers can Bootleg

A transaction cost approach is used to investigate a manufacturer's policy towards exclusive territory dealers who bootleg (sell across their assigned territories). We show that optimal enforcement policies will generally tolerate some level of bootlegging. This tolerance is a natural consequence of the transaction cost principle that institutional arrangements are not fully enforceable, and that self-enforcing implicit agreements will require some degree of tolerance. The actual degree of tolerance is determined by (a) the importance of reseller services, (b) the reduction in margin realized from surreptitious sales, and (c) the resellers' beliefs about the manufacturer's long-run commitment to the channel. We also show that deploying exclusive territories is beneficial to the manufacturer because it safeguards reseller services and permits resellers to capitalize on their superior local information. However, the latter effect is contingent on being able to convince resellers of the manufacturer's long run commitment to the channel.