Strengthening a Weak Rival for a Fight

We provide a new model wherein firms of different productivities survive in an industry despite the threat of entry by high productivity firms. We demonstrate that an efficient incumbent has a unilateral incentive to establish a relational contract, softening price competition to strengthen its inefficient rival in a war of attrition that emerges post-entry, and raising the price of the inefficient firm in the acquisition market. We show that this equilibrium gives rise to persistent performance differences, market compression, and stability in the identity of firms in the market. Moreover, the relational contracting equilibrium is facilitated by strong anti-trust laws.