Upfront Payment, Renegotiation and (Mis)coordination in Multilateral - PowerPoint PPT Presentation

Upfront Payment, Renegotiation and (Mis)coordination in Multilateral Vertical Contracting by IGOR Mouraviev

Upfront Payment Manufacturer Key features � Paid at signature of contract Payment Payment � Not related to volume of per unit of before any purchases (lump ‐ sum) purchase purchase � Term: slotting allowances Retailer Examples � Grocery stores � Drug stores � Book stores, record stores

Upfront Payment Why do manufacturers (unwillingly) pay slotting fees? � To get access to retailers’ (limited) shelf space ‐ just placement on shelves ‐ premium placements (eye ‐ level shelves, special displays) � To have new products introduced in their stores � To stay in retailer’s list of potential suppliers

Upfront Payment Main issues to address � If retailers are capable to demand slotting fees, why don’t they ask for lower wholesale prices instead? � Why do manufacturers agree (perhaps unwillingly) to pay slotting fees? � What is the impact of slotting fees on prices, and how do they affect market structure?

Literature Inter ‐ brand competition only Intra ‐ brand competition only M A M A M B R 1 R 1 R 2 Miklos ‐ Thal et al. 2010, Bedre 2009: Caprice and Schlippenbach 2010 (consumer shopping costs): 1. There always exist CA equilibrium 1. There always exist CA ‐ SPNE 2. Monopoly prices are sustained 2. No marginal cost pricing Marx and Shaffer 2008: 3. Exclusion of less efficient R is always equilibrium 4. Prices are still at monopoly levels

Aim of paper Question Do we obtain the same results in a situation where oligopolistic competition exists both upstream and downstream?

Set up One link is missing; technical but M A M B � R 2 delist M A and launch its own ‐ label imitation � entry of R 2 was initiated by M B R 1 R 2 provided exclusivity � negotiations between M A and R 2 ended in break ‐ down Key features � Toy R Us Inc. v. FTC (1996) � intra ‐ brand competition Remark � inter ‐ brand competition � No asymmetry of information � inter ‐ brand competition between � No shopping costs retailers

Main Findings In all equilibria firms fail to sustain industry ‐ wide 1. monopoly profit Use of slotting fees in equilibrium 2. ‐ M B may use them to dampen intra ‐ brand competition ‐ M A may use them to compensate for negative impact of sales of its product on total profits from selling product B There do not always exist equilibria in which retailers carry 3. products of all their respective suppliers

Modeling Assumptions A1 Each pair Mk ‐ Ri negotiates three ‐ part tariffs contract w q + F + S for q > 0 ki ki ki ki ki T (q ) = ki ki S for q = 0 ki ki where w ki is price per unit of good purchased by Ri is conditional fee related to volume of purchases by Ri F ki S ki is unconditional fee (slotting fee, if negative) unrelated to volume of purchases by Ri

Modeling Assumptions A2 Both manufacturers and retailers have differentiated and balanced bargaining power A3 Negotiation in each pair Mk ‐ Ri is alternating ‐ offer bargaining game á la Binmore et al. (1986) 1 – λ ki ( u ( C ) – d λ ki M k | R i Ri Ri Max ( u ( C ) – d M k ) |Mk ) ki ki C ki where C ≡ ( w ,F ,S ) ki ki ki ki d M k | R i d Ri |Mk and are disagreement payoffs

Modeling Assumptions A4 Disagreement payoffs are obtained using approach of Stole and Zwiebel (1996) � if Mk and Ri fail negotiations, they cannot renegotiate at another time � all contracts signed earlier are renegotiated from scratch Motivation � Firms can renegotiate contracts at any time before retail competition � Renegotiation in case of material change of circumstances d M k | R i d Ri |Mk Implication do not depend on C and ki

Order of Negotiations Stage 1 M A and R 1 negotiate M A M B Stage 2 M B and R 1 negotiate R 1 R 2 Stage 3 M B and R 2 negotiate If all negotiations succeeded, then Stage 4 � Each Ri decides on quantities to purchase from Mk � Retail competition takes place � All payoffs are realized If negotiations in some Mk ‐ Ri fail, then Stage 4’ � Mk and Ri will never renegotiate � Negotiations start from beginning preserving same order

First Result In any SPNE in which all links are active, firms fail to implement monopoly outcome. Contrast with literature M A M B M B R 1 R 1 R 2 Inter ‐ brand competition only Intra ‐ brand competition only Main Result Fully monopoly outcome can be sustained

First Result: Intuition M A is in active Variable profits w ≡ ( w , w ) B1 B2 M B M B π (w) = ( w – c ) q (w) + ( w – c ) q (w) B1 B B1 B2 B B2 Ri π (w) = R ( q (w), q (w)) – w q (w) B i B i B i B1 B2 R 1 R 2 Main Results (Bedre, 2009) � Wholesale prices are set at levels generating monopoly profits m m M B R 1 R 2 ( w , w ) = argmax П (w) ≡ π (w) + π (w) + π (w) B1 B2 B1B2 w � M B pays slotting fee to R 1 only λ (1 – λ ) m m m B2 B1 S = – λ П + П – П B1 B2 B1 B1B2 B1 (1 – λ ) B2

First Result: Intuition M A is in active Intuition M B m m * � Start with w , w > c B1 B2 B w m w B2 m B1 � Suppose that M B and R 1 set w B1 R 1 R 2 m � M B and R 2 always wish to free ‐ ride on w B1 * m m m MB R w = argmax П ( w , w ) ≡ π ( w , w ) + π ( w , w ) 2 B2 B1 B2 B1 B2 B1 B2 B2 w B2 m m m R1 w B2 = argmax П ( w , w ) – π ( w , w ) < B1B2 B2 B1 B2 B1 w B2

First Result: Intuition M A is in active Intuition M B m m * � Set wholesale prices at levels w , w w m B1 B2 w m w B2 B2 B1 � R 1 protects itself against opportunistic R 1 R 2 move of M B ; gives up all its variable profit m m m m F = R ( q (w ), q (w )) – w q (w ) B2 B1 B1 B1 B1 B1 � If R 2 and M B decrease w then they loose F and get B2 B1 m П m d П < П = B2 B1B2 B2 � R 1 gets its share of gains from trade with M B through slotting fee!

First Result: Intuition M A is active Clear: Slotting fees and renegotiation imply that in any SPNE M B , R 1 and R 2 M A M B * maximize their joint trilateral profits : * w w B1 * * B2 ̃ ( w , w , w ) ( w , w ) = argmax П B1B2 A1 B1 B2 R 1 R 2 B1 B2 ( w , w ) B1 B2 but because of M A they do it subject that M B and R 2 cannot gain from decreasing w : B2 ̃ d – π R1 П B1B2 ( w , w , w ) A1 ( w , ∞ , w ) ≥ П B2 A1 B1 B2 A1 B2

First Result: Intuition By decreasing w , M B and R 2 can induce two continuation equilibria: B2 M A M B M A M B or R 1 R 2 R 1 R 2 R 1 removes only B R 1 removes both A and B Depending on ( w , F ), joint bilateral profit from deviation is A1 A1 d m [ [ П , П B2 Є B2 П B2 (since A and B are imperfect substitutes) ̃ ∂П B1B2 Assumption A5 < 0 for all w A1 ∂ w ∂ w B2 B1 (since B1 and B2 are imperfect substitutes)

First Result: Intuition M A is active (continued) Lemma Suppose that A5 holds, then the solution to problem * * ̃ d d ( w , w , w ) ( w ( w , П ), w ( w , П )) = argmax П B1B2 A1 A1 B1 B2 B1 A1 B2 B2 B2 ( w , w ) B1 B2 d ̃ – π R1 s.t. П B1B2 ( w , w , w ) A1 ( w , ∞ , w ) ≥ П B2 A1 B1 B2 A1 B2 * * ̃ d d ̃ w ( w , П ) ≤ w ( w ) w ( w ) ≤ w ( w , П ) and implies B1 B2 B2 A1 B1 A1 A1 B2 A1 B2 m m m m ̃ ̃ Property w ( w ) < w w ( w ) < w and A1 B1 A1 B2 B1 B2 Intuition M B , R 1 and R 2 have incentives to free ‐ ride on M A ’s margin

Second Result If intensity of inter ‐ brand rivalry between retailers is sufficently strong, then M A may need to pay R 1 a slotting fee. M A M B Remark M A pays upfront M A M B to compensate for negative impact of A R 2 R 1 on total sales of B R 1 M B pays upfront to suppress intra ‐ brand competition Slotting fees between R 1 and R 2 are irrelevant

Second Result: Intuition � Negotiations between M A and R 1 imply M A M B ( w , w , w ) max П A1 B1 B2 w , F A1 A1 R 1 R 2 subject to following constraints 1. M B , R 1 and R 2 cannot jointly gain from excluding M A ̃ F ≤ П ( R carries A) – П ( R removes A) A1 1 B1B2 1 B1B2 Implication F should be lower A1 2. Impact of ( w , F ) on w and w in continuation equilibrium B1 B2 A1 A1 * * d w and w ( w , F ) П B2 П ( w , w , w ) B1 A1 A1 B2 A1 B1 B2

Second Result: Intuition Key points M A M B � w and w are strategic complements w B1 A1 B1 w B2 � w and w are strategic substitutes w A1 A1 B2 R 1 R 2 (from point of view of maximizing total profits) Implication M A and R 1 jointly prefer for M B and R 2 to set higher w B2 Gain for M A � reduce competitive pressure on its product Gain for R 1 � reduce incentives of M B to free ‐ ride on its contract with R 1

Second Result: Intuition Result When intensity of inter ‐ brand rivalry between retailers is strong, it is optimal to set F = 0 A1 � this relaxes constraint ̃ F ≤ П ( R carries A) – П ( R removes A) A1 1 B1B2 1 B1B2 Implication Exclusion of M A is no longer possible � this reduces joint profits of M B and R 2 from deviating d M A M B � П is lower B2 � The effect is stronger, R 1 R 2 the stronger A and B compete at R 1 and R 2 R 1 removes only B