|
Article Excerpt
Economic theory does not provide sharp predictions on the welfare effects of banning wholesale price discrimination: if downstream cost differences exist, then discrimination shifts production inefficiently, toward high-cost retailers, so a ban increases welfare; if differences in price elasticity of demand across retailers exist, discrimination may increase welfare if quantity sold increases, so a ban reduces welfare. Using retail prices and quantities of coffee brands sold by German retailers, I estimate a model of demand and supply and separate cost and demand differences. Simulating a ban on wholesale price discrimination has positive welfare effects in this market, and less if downstream cost differences shrink, or with less competition.
1. Introduction
Wholesale price discrimination means that an upstream firm sets different prices for the same product for various downstream retailers. Wholesale price discrimination is commonly practiced in many markets. Examples include markets such as petroleum distribution, steel, heavy trucking, tobacco, and pharmaceuticals. In several countries, milk and other dairy products are sold using government-administered or -sanctioned discriminatory pricing schemes. Wholesale price discrimination practices are also used for services such as loans, insurance, and advertising. (1) Competition authorities have been concerned with wholesale price discrimination. The European Union Treaty's Article 82 (c) prohibits practices where a dominant firm "would place trading partners at a competitive disadvantage." The U.S. Robinson-Patman Act forbids "discriminat[ing] in price between different purchasers" where the effect "may be to lessen competition" unless the price differences are based on costs, or price differences were needed to meet competition. (2) As I discuss below, theory does not provide clear prediction about the welfare effects of wholesale price discrimination. The goal of this article is to empirically assess the welfare effects of eliminating the possibility of wholesale price discrimination.
Wholesalers price discriminate for several reasons, such as to take advantage of differences in downstream demands and differences in downstream costs, forces which have opposing welfare effects. To exploit differences in retail demands, it is optimal for the upstream firm to discriminate by setting a lower wholesale price in the more price-sensitive downstream markets and a higher price in the less price-sensitive ones (Schmalensee, 1981; Varian, 1985; Ireland, 1992). Bork (1978) posits that, as a result of such discrimination, total welfare will increase if new markets are served due to wholesale price discrimination. This effect is similar to the welfare test of a total increase in quantity in the case of third-degree price discrimination in final goods markets.
If downstream firms' costs differ, the upstream firm sets a higher wholesale price to the more efficient, lower-cost, retailer (Katz, 1987; DeGraba, 1990; Yoshida, 2000) and price discrimination will lower total welfare. By wholesale price discriminating, the manufacturer shifts quantity from the more efficient retailer to the less efficient retailer. Moreover, in this context, the usual result that an increase in quantity sold increases welfare is no longer true. In the presence of downstream cost differences, an increase in quantity sold may actually be a symptom of a welfare decrease due to wholesale price discrimination because the "wrong" retailer is selling more" (Yoshida, 2000). (3)
Because the welfare effects of price discrimination cannot be determined theoretically, I estimate the effect empirically. In particular, I estimate the effects of uniform wholesale price legislation, which bans wholesale price discrimination, in a German grocery retail market where manufacturers wholesale price discriminate among retailers. As a first step, I estimate a flexible demand system using detailed price and quantity data. Using the demand estimates, I am able to investigate whether differences exist in demand for a brand sold at different retailers in this market. Given the demand estimates, and a supply model of linear pricing of manufacturers and retailers, I compute price-cost margins for retailers and manufacturers. (4) By subtracting the estimated retail and manufacturer margins from observed prices, I am able to recover the sum of retail and manufacturer costs for each brand sold at each retailer as a residual. To recover retail cost differences in this market, I assume that a brand sold at two different retailers has the same manufacturer costs. Subtracting the differences in estimated retail and manufacturer margins from price differences of the same brand sold at two different retailers, I estimate there to be retail cost differences, that is a force toward welfare to improve with the ban on wholesale price discrimination. Next, I estimate the welfare effects of a ban on wholesale price discrimination by computing the counterfactual Nash equilibrium when the manufacturers are not allowed to wholesale price discriminate and the estimates suggest that banning price discrimination has positive welfare effects in the market. Finally, I show through counterfactual simulations that the estimated positive welfare effects are smaller if downstream cost differences are smaller, or if there is less competition in the market.
This article is related to the literature cited above that studies the welfare consequences of banning price discrimination in intermediate goods markets. In terms of the empirical strategy, I follow the recent literature by modelling vertical relationships (see, e.g., Bonnet, Dubois, and Simioni, 2006; Brenkers and Verboven, 2006; Goldberg and Verboven, 2001; Hellerstein, 2008; Sudhir, 2001; Mortimer, 2008; Villas-Boas and Zhao, 2005; Villas-Boas, 2007a; Villas-Boas and Hellerstein, 2006). Two related studies combine the same scanner data with additional data sources to empirically examine the determinants of retail and manufacturer margins in the German coffee market. Draganska and Klapper (2007) relate estimated manufacturer conduct parameters, in a reduced-form setting, to exogenous factors related to retail competitive environment. Draganska, Klapper, and Villas-Boas (2008) estimate margins in a structural model of multiple Bertrand-Nash competing retailers. Assuming a certain retail model as given, they estimate a simultaneous bargaining model between each manufacturer and each retailer for each product. In doing so, their goal is to relate bargaining power parameters in the model, in a reduced-form setting, to potential determinants. Although the present article uses the same data as Draganska, Klapper, and Villas-Boas (2008), the contribution of this article is to provide the first empirical investigation of the economic forces at play behind wholesale price discrimination.
The article is organized as follows. The next section summarizes the economic forces at play behind the welfare effects of upstream price discrimination, whereas Section 3 presents the economic and econometric models of demand and supply to derive the equilibrium under the possibility of wholesale price discrimination; an outline of the simulation of uniform wholesale pricing is provided as well. Section 4 describes the coffee market, the data used, and the method of estimation. Section 5 presents the demand and the benchmark supply model results. Simulation results are presented and welfare effects along several counterfactual scenarios are investigated in Section 6. Conclusions and extensions of this research are presented in Section 7.
2. The economic forces at play
* In this section, I examine in a simple setting the main forces behind the welfare effects from banning upstream price discrimination. This section has two goals. The first is to understand the economics behind the welfare estimates I obtain in the empirical application. The second is to motivate economically meaningful counterfactual simulations. This enables me to generalize some of the findings and derive policy implications of banning wholesale price discriminations more generally.
Although the reason behind a final goods' monopolist to price discriminate is to take advantage of differences in demands to increase its profits, a manufacturer monopolist may improve his profits by wholesale price discriminating toward different retailers by taking advantage of (i) differences in demands and (ii) differences in retail costs. In particular, I show in this section that an upstream monopolist will set a higher wholesale price for the retailer serving a "better" demand (less elastic and/or higher willingness to pay), and he will set a higher wholesale price for the "better" retailer (the one who has lower marginal costs and is more efficient). These two actions result in two opposing forces at work, in terms of implied welfare effects.
I illustrate these forces at play using a simple model where an upstream manufacturer A, with zero marginal costs, sells to two downstream differentiated retailers, r = 0, 1, that have downstream marginal costs [c.sub.1] [greater than or equal to] [c.sub.0] = 0. The upstream manufacturer chooses wholesale prices, given retailers' retail pricing decisions, which are a function of wholesale prices. To start with, suppose that there is no substitution across retailers. Two products exist for the consumers and are defined as a brand-retail combination {A0, A1}. Consumers may differ in their preferences with respect to retailers. Let demands be given by
[p.sub.A1] = b - [q.sub.A1]
[p.sub.A0] = 1 - [q.sup.s0.sub.A0], (1)
where retail-level demand intercepts may differ by the parameter b and curvature of demand may differ by parameters [s.sub.0], where if [s.sub.0] = 1 both retailers face a linear demand.
Under the possibility of wholesale price discrimination, for general So, optimal wholesale prices are given by
[w.sub.A1] = (b-[c.sub.1])/2
[w.sub.A0] = [w.sub.A0]([S.sub.0]). (2)
Downstream differences in demand, captured by b and [s.sub.0], and downstream differences in costs [c.sub.1] determine whether upstream firms want to wholesale price discriminate. In particular, note that [partial derivative][w.sub.A1]/[partial derivative]b > and [partial derivative][w.sub.A1]/[partial derivative][c.sub.1] < 0.
If [c.sub.1] = there are no downstream cost differences, whereas if [s.sub.0] = 1 and b = 1 there are no demand differences. I solve the model under these two extreme cases to investigate the resulting welfare changes due to wholesale price discrimination.
No cost differences. Assume that there are no cost differences, that is, [c.sub.1] = 0. To have an explicit solution, let [s.sub.0] = 1/2. Under the possibility of wholesale price discrimination, the optimal wholesale prices are given by
[w.sub.A1] = b/2
[w.sub.A0] = 1/3. (3)
If b [not equal to] 2/3, the upstream firm wants to wholesale price discriminate. In particular, if b > 2/3, then [w.sub.A1] > [w.sub.A0]. Let [W.sub.D] denote the sum of consumer and producer surplus when prices are given by (3), and [q.sub.D] be total quantity sold in this case.
If the manufacturer has to charge the same wholesale price to both retailers, then he maximizes upstream profits subject to [w.sub.A0] = [w.sub.A1] = [w.sub.A], yielding
[w.sub.A] = 25 - [square root of (433 - 216b)]/24. (4)
Let [W.sub.ND] denote the sum of consumer and producer surplus with no discrimination and [q.sub.ND] be total quantity sold under nondiscrimination.
I compare the difference D(b) = [W.sub.ND] - [W.sub.D] along comparative statics in downstream demand differences due to b and relate it to changes in quantity sold in the following proposition.
Proposition 1. Let there be no upstream and downstream competition, no downstream cost differences([c.sub.1] = 0), and [s.sub.0] = 1/2. Define [b.sup.*] : [w.sub.A1]([b.sup.*] [c.sub.1] = 0) = [w.sub.A0]. Banning wholesale price discrimination leads to a decrease in welfare, D([s.sub.0] = 1/2, b, [c.sub.1] = 0) [b.sup.*], when both retailers sell post ban, as total quantity drops with the ban, that is [q.sub.ND] - [q.sub.D] [b.sup.*].
Proof. See the Appendix.
The intuition behind this result is as follows. As in third-degree final goods price discrimination, wholesale price discrimination may be welfare improving if, by doing so, quantity sold increases. As wholesale price discrimination results in consumers facing different retail prices, marginal utilities are not equal among consumers. A necessary condition to offset this inefficiency is that more consumers are reached with price discrimination. When there are no downstream retail cost differences, and demand differences are such that by wholesale price discriminating total output sold increases, then welfare may increase. In this case, banning price discrimination lowers welfare, and this is the usual result in final goods markets (as in Schmalensee, 1981; Varian, 1985; Ireland, 1992). If discrimination, on the other hand, does not result in more quantity being sold, then a ban results in welfare increase.
No demand differences. Let me consider the other extreme case now, where there are no demand differences, [s.sub.0] = 1 and b = 1. The reason why consumers are charged different prices relates to the fact that they are served by retailers that have different costs. Under the possibility of wholesale price discrimination, optimal wholesale prices are given by
[w.sub.A1] = 1 - [c.sub.1]/2
[w.sub.A0] = 1/2. (5)
Wholesale price discrimination results in higher prices to the more efficient retailer A0, who in turn passes higher prices to his consumers. Let [W.sub.D] denote the sum of consumer and producer surplus when prices are given by (5) and [q.sub.D] is the total quantity sold in this discrimination case.
If the manufacturer has to charge the same wholesale price to both retailers, then he maximizes upstream profits subject to [w.sub.A0] = [w.sub.A1] = [w.sub.A], yielding
[w.sub.A] = 2 - [c.sub.1]/4. (6)
Let [W.sub.ND] denote the sum of consumer and producer surplus with no discrimination. I compare the difference D(b = 1, [s.sub.0] = 1, [s.sub.1] = 1, [c.sub.1]) = [W.sub.ND] - [W.sub.D] along comparative statics in downstream cost differences [c.sub.1] in the following proposition.
Proposition 2. With no upstream competition, when downstream markets are separated, when there are no demand differences (b = 1, [s.sub.0] = 1), banning wholesale price discrimination leads to a welfare increase D([s.sub.0] = 1, b = 1, [c.sub.1]) > if both retailers are used.
Proof See the Appendix.
The intuition behind Proposition 2 is as follows. Welfare increases for moderate downstream cost differences (such that both retailers sell), given that by banning price discrimination the wholesale price of the more efficient retailer decreases and the wholesale price of the less efficient retailer increases (see Katz, 1987; DeGraba, 1990; Yoshida, 2000). Thus, by banning cost-only-based wholesale price discrimination, quantity is shifted from the less efficient to the more efficient retailer, and this is a force toward welfare to improve. I also note that, given that both retailers face linear demands, total output is unchanged with the ban. (5) The conclusion is that in the presence of retail cost differences, banning wholesale price discrimination involves a force toward welfare improvement, as it results in the more efficient retailer selling more and the less efficient retailer selling less.
Cost and demand differences. The interplay of downstream cost...
|
