|
Article Excerpt
This article considers vertical relations between an upstream manufacturer and a downstream retailer that can independently obtain a low-quality, discount substitute. The analysis reveals that under full information, the retailer offers both varieties if and only if it is optimal to do so under vertical integration. However, when the retailer is privately informed about demand, it offers both varieties even if under vertical integration it is profitable to offer only the manufacturer's product. If the manufacturer can impose exclusive dealing, then under asymmetric information it will do so and foreclose the low-quality substitute even if under vertical integration it is profitable to offer both varieties.
1. Introduction
* Downstream retailers sometimes enhance their product variety by offering low-quality, discount substitutes for the products produced by upscale manufacturers. Thus, for example, the market share of private labels that have been introduced by supermarkets and drugstores has been growing rapidly in recent years, and stores selling electronic goods and home appliances often offer reputable brands as well as unfamiliar, low-priced substitutes. At the same time, upstream manufacturers sometimes limit the variety that their retailers can offer by imposing exclusive dealing arrangements prohibiting the retailer from selling products that compete with those of the manufacturer.
This article addresses three questions. First, what are retailers' incentives to enhance their variety by offering both qualities instead of just high quality? In particular, are these incentives different for vertically integrated and separated industries? This question is of special concern in the context of private labels, because it might be expected that, with their superior production capabilities, upstream manufacturers will be able to produce high-quality products at quality-adjusted costs that are lower than those of the private labels, thus making the introduction of private labels unprofitable.
The second question relates to the incentives that an upstream manufacturer may have to impose exclusive dealing on its retailer, which prohibits the sale of brands that are substitutes for the manufacturer's brands. On one hand, a manufacturer may impose exclusive dealing because of welfare-enhancing reasons. For example, exclusive dealing may induce a retailer to focus its promotional activities on the manufacturer's products and thereby improve customers' service. Marvel (1982) argues that exclusive dealing can secure investments made by the manufacturer (in quality assurance and advertising, for instance) by preventing other manufacturers from free-riding on them. However, exclusive dealing may also be anticompetitive when a manufacturer that benefits from a leading position in the market imposes exclusive dealing for the sole purpose of foreclosing competing brands. (1)
This second potential anticompetitive effect of exclusive dealing has been challenged by the well-known Chicago School for two related reasons. (2) First, if offering a second brand increases the retailer's gross profit, then it will also benefit the manufacturer, which can now charge the retailer higher franchise fees. In this case, the manufacturer will not profit from foreclosing the competing brand because doing so will substantially reduce the franchise fee that it can charge the retailer. Therefore, if a manufacturer finds it profitable to foreclose a competing brand, then it has to be that this brand is a poor substitute to begin with. That is, the manufacturer will profit from excluding the competing brand only if it does not provide any additional value to the retailer's gross profit. (3) Second, even if a manufacturer imposes exclusive dealing, it will still need to compensate the retailer for the forgone profits from not offering the competing brand. Thus, it is not clear why exclusive dealing is any better from the manufacturer's viewpoint than offering quantity discounts such that the retailer will independently choose not to sell the competing brand. As Gilbert (2000) points out, the arguments made by the Chicago School parallel a more tolerant approach by U.S. courts toward exclusive dealing. (4) Altogether, these arguments raise the question of whether a manufacturer will ever choose to impose exclusive dealing for the sole purpose of foreclosing a competing brand and, if so, what the effect is of exclusive dealing on the retailer, consumers, and welfare.
The third question relates to the practice of market share contracts, in which a manufacturer provides a discount to a retailer for buying a certain percentage of its units from the manufacturer. For example, in the USA, tobacco wholesalers sued Philip Morris, a leading cigarette manufacturer, for its Wholesale Leaders program, which rewarded distributors based on their sales of Philip Morris cigarettes as a percentage of their total cigarette sales. (5) Brunswick, a leading manufacturer of marine engines, was sued by competing engine manufacturers for offering quantity and market share discounts to boat builders for buying its engines. (6) At first glance, this practice may appear to be a softer version of exclusive dealing, in that the manufacturer is restricting its retailer to commit to a certain percentage of exclusion, instead of the 100% exclusion of exclusive dealing. This raises the question of why manufacturers sometimes use market share contracts instead of quantity discounts or exclusive dealing, and what the effect is of market share discounts on consumers and welfare. (7)
This article studies vertical relations between an upstream manufacturer (M) that produces a high-quality product (H) and a downstream retailer (R), when R can obtain a low-quality substitute (L) at a given cost. For example, the substitute product can be interpreted as a private label or a low-quality product available from a perfectly competitive fringe. I compare three types of contracts: first, a simple nonexclusive contract that only specifies a quantity of H and a total price; second, an exclusive dealing contract that also prohibits R from selling L; third, a market share contract that restricts R to sell a certain quantity of L, which can be higher than zero. The model reveals that the answer to the three questions raised above depends crucially on the extent to which R is privately informed about consumers' willingness to pay for the two brands. Under full information, M can implement the first-best profits by offering the nonexclusive contract. This contract induces R to sell both L and H whenever L is efficient (such that a vertically integrated monopoly chooses to offer both L and H) and only H otherwise. In the latter case, M does not need to impose exclusive dealing or to use a market share contract to obtain exclusivity. The intuition for this result is that M can use the nonexclusive contract to capture R's entire added value from selling H and therefore wishes to maximize R's gross profit. This result implies that under full information, the decision whether to offer low-quality substitutes in the form of private labels, for example, is not affected by the vertical structure. It also supports the argument that exclusive dealing does not offer any advantage in foreclosing a competing brand and shows that this argument applies also to the market share contract.
Then I turn to consider the case where R is privately informed about a parameter, [theta], that measures consumers' willingness to pay for H and L. To induce R to reveal the true [theta], M offers R a menu of contracts in which the total payment and the quantity of H are contingent on the [theta] reported by R. R has the incentive to understate the true [theta] because this lowers the profits that M can extract from R. To minimize this incentive, M distorts the quantity of H downward. If M can only use the nonexclusive contract, then the ability to sell additional units of L provides R with a degree of freedom because the supply of L is independent of R's report on [theta] to M. Consequently, R can understate [theta] and compensate itself for the low quantity of H by selling additional units of L, which M cannot limit. Moreover, R can report a [theta] that misleads M into believing that R intends to sell H alone, while in practice R intends to sell both brands and earn additional profit from selling L. Thus, in the nonexclusive contract, under some conditions on the model's parameters such as the marginal costs, the degree of product differentiation, and the degree of the asymmetric information problem, R may offer both H and L even if L is unprofitable under full information. In this case, although L is a poor substitute for H, the degree of freedom that selling L provides R forces M to increase R's information rents.
This result indicates that under asymmetric information, retailers will expand their product variety by offering brands that are unprofitable under full information, because it enables them to gain informational leverage over manufacturers.
The result also provides an explanation for why M may use the additional instrument of exclusive dealing. The model reveals that if M can use the exclusive dealing contract but not a market share contract, then in equilibrium M will impose exclusive dealing whenever L is unprofitable under full information, and, under some parameters of the model, M will impose exclusive dealing even if L is profitable. The intuition for this result is that because selling L increases R's information rents, M will impose exclusive dealing even though doing so reduces total industry profits. Clearly, exclusive dealing increases M's profit, while reducing total industry profits and consumer surplus. As far as antitrust policy is concerned, the model provides an intuitive condition on market parameters under which a dominant manufacturer will use exclusive dealing for the sole purpose of foreclosing competing brands.
Next, I consider the case where M can use a market share contract, which has the advantage over the exclusive dealing contract of enabling M to restrict but not completely prohibit R from selling L. Nonetheless, the model reveals that if L is inefficient, then in the equilibrium market share contract M requires R to completely exclude L, because by doing so M both reduces R's information rents and prevents R from selling an inefficient brand. Thus, in the case of an inefficient L, the market share contract does not provide M with any advantage over the exclusive dealing contract. If L is efficient, then M prefers the market share contract over the exclusive dealing contract because it can reduce R's information rents by conditioning the quantity of L that R can sell on R's report without the need to exclude L completely. Although the market share contract is no more than a softer version of exclusive dealing, on average, it nevertheless has a more ambiguous effect on consumers and welfare.
The rest of the article is organized as follows. The next section surveys related literature. Section 3 presents the model. Section 4 considers a full-information benchmark. Section 5 considers asymmetric information when the manufacturer can only use a nonexclusive contract. Sections 6 and 7 consider the case of exclusive and market share contracts, respectively. Section 8 offers concluding remarks. All proofs are in the Appendix.
2. Related literature
* Previous literature on exclusive dealing has focused on three main questions. The first question is whether manufacturers and retailers will organize in competing exclusive manufacturer-retailer hierarchies or two (or more) manufacturers will prefer to sell through a common retailer. Bernheim and Whinston (1985) show that manufacturers choose to deal with a common retailer because doing so enables them to reduce intrabrand competition. Subsequent papers by Gal-Or (1991a), Besanko and Perry (1993), Dobson and Waterson (1996), Martimort (1996), and Moner-Colonques, Sempere-Monerris, and Urbano (2004) have provided explanations for why manufacturers may nevertheless prefer to organize in exclusive manufacturer-retailer hierarchies. Gal-Or (1991a) and Martimort (1996) are closely related to this article because they show that two competing manufacturers will organize in two competing exclusive manufacturer-retailer hierarchies because of retailers' private information. The main difference between their results and the results of this article are that in their papers the exclusive contract is a channel distribution choice that does not involve a binding restriction excluding competing brands from the market, which is the main focus of this article. Thus, in their papers the motivation for exclusive hierarchies is to enhance competition between retailers, whereas in this article the motivation is to exclude a competing brand.
The second question is whether an incumbent with a first-mover advantage will exploit its position by offering a contract that forecloses competing brands. In a closely related paper, Aghion and Bolton (1987) consider an incumbent and a buyer facing entry by an entrant with unknown cost. They show that the incumbent will use its first-mover advantage to offer the buyer a contract that extracts some of the surplus of a more efficient entrant but excludes some types of efficient entrants. Although both papers predict market foreclosure, there are several differences between their paper and the present one. First, in their model, the buyer wishes to buy one indivisible unit from only one of the firms. Therefore, the incumbent cannot endogenously choose between an exclusive and a nonexclusive contract, as in this article. Second, in this article, the dominant firm does not have a first-mover advantage in that the competing brand is already available to R at marginal cost, which makes foreclosure more difficult for M. Third, in their paper, foreclosure emerges because the incumbent and the buyer sign a contract committing themselves to act as a monopoly with respect to the entrant and therefore charge a high price from low-cost entrants while losing the sales of high-cost entrants. Consequently, in their paper, the contract increases the joint profit of the incumbent and buyer, with the incumbent being better off while the buyer is no worse off. In contrast, in this article, because the motivation for foreclosure emerges from M's need to reduce R's information rents, exclusive dealing decreases R's profit as well as the joint profit of R and M and consumers' surplus.
Rasmusen, Ramseyer, and Wiley (1991), Segal and Whinston (2000), Fumagalli and Motta (2006), and Spector (2007) consider an entrant that needs to sell to a certain number of buyers to profit from entry. The incumbent offers an exclusive contract that excludes a more efficient entrant, and buyers accept it because given that all other buyers accept, a single buyer cannot encourage entry by refusing to enter into the contract. The present article contributes to this literature by showing that exclusive contracts can emerge in the absence of coordination failure between buyers and when the competing brand does not need to fulfill a minimum efficient scale. That is, in this article, exclusive dealing is an equilibrium behavior even though L is already available to R at marginal cost.
The third and most closely related line of literature on exclusive dealing asks why a dominant manufacturer should impose exclusive dealing when competing manufacturers simultaneously compete for the services of a single retailer. Mathewson and Winter (1987) show that a dominant firm may impose exclusive dealing under full information when firms can only use linear pricing. O'Brien and Shaffer (1997) show that Mathewson and Winter's assumption of linear pricing is essential: exclusive dealing does not offer the manufacturers any advantage that cannot be obtained with nonlinear contracts. Bernheim and Whinston (1998) show that if a dominant manufacturer and a risk-averse retailer are uncertain about the demand when they sign the contract, then the dominant manufacturer will find it optimal to provide insurance to the retailer against demand shocks. In the extreme case in which the two brands are perfect substitutes, the dominant manufacturer will also impose exclusive dealing in order to prevent the competing manufacturer from free-riding on this insurance. Thus, exclusive dealing has the welfare-enhancing property of achieving a better allocation of risk between the manufacturer and the retailer. By contrast, in this article, exclusive dealing is more likely to occur if products are more differentiated, instead of less differentiated as in Bernheim and Whinston, and it is welfare reducing.
Turning to recent contributions on market share contracts, Marx and Shaffer (2004) consider two sellers that sequentially compete for a common buyer, showing that a market share contract enables the first seller to shift rents from the second seller. In their model, the market share contract only serves for rent shifting and does not affect total industry profits and consumer surplus. Greenlee and Reitman (2006) show that when two firms compete in a single market, then compared with the case where the two firms compete in linear prices, the presence of loyalty programs that make payments contingent on market shares has an ambiguous effect on consumers. The present article contributes to their analysis by highlighting the role of asymmetric information as a motivation for a market share contract, and by comparing the market share contract to nonlinear pricing. This comparison leads to somewhat different conclusions in that compared with nonlinear prices, the market share contract always decreases consumer surplus and total welfare. Mills (2006) considers a somewhat similar setting with a dominant manufacturer that competes with a competitive fringe for the services of a common retailer. The main difference is that whereas the...
|
