Price control in vertical relations

Pros and Cons of Vertical Restraints Stockholm, November 7 2008

Patrick Rey

Toulouse School of Economics and IDEI

based on joint work with Thibaud Vergé (CREST-LEI, Paris)

1

Introduction

Policy perspective: vertical restraints

Hot debates in practice and in the IO literature

Large divergence law/economics for price restrictions

Research agenda: vertical /horizontal interaction

Vertical coordination

Rivalry between vertical structures

Consumer goods: interlocking relationships

2

Resale Price Maintenance

Various forms

Imposed price

Maximum price (price ceiling)

Minimum price (price floor)

Recommended, advertised prices

Specific product markets

Drugs

Books, newspapers

3

Competition Law

Price restrictions are “bad”

RPM (price floors) is illegal per se in the EU (out of a blacklist of two)

Non-price restrictions are more tolerated (rule of reason)

Caveats

US policy over time1911: price floors are per se illegal (Dr Miles)

1968 : price ceilings are per se illegal (Albrecht)

1997: rule of reason for price ceilings (State Oil)

2007: rule or reason for price floors as well (Leegin)

France“Loi Lang”: RPM mandatory for books and press

“Loi Galland”: RPM de facto for supermarkets

4

Economics

Academic literature: not so clear-cut

(OECD report on Franchising, EC Green paper, Rey-Vergé 2008)

Intrabrand coordination

Price and non-price restraints can have similar effects

Interbrand competition

Not necessarily favourable to non-price restrictions

5

Economics

Intrabrand competition

Free-riding on retail services (Telser JLE 1960),

quality certification (Marvel-McCafferty Rand 1984)

→ welfare effect

ambiguous/positive (Comanor-Frech AER 1985, Caillaud-Rey 1987)

similar for price and non-price restrictions

Producer’s opportunism (Hart-Tirole Brookings 1990)O’Brien-Shaffer Rand 1992

Rey-Vergé Rand 2004

→ welfare effect

negative

similar for price and non-price restrictions

6

Economics

Interbrand competition

Competition-dampening: strategic delegation, not RPMRey-Stiglitz EER 1988, Rand 1995 (Bonanno-Vickers JIE 1988)

Gal-Or EER 1991

Caillaud-Rey EER 1995

Foreclosure: tying/exclusive dealing, not RPM

Tacit Collusion (Jullien-Rey 2000)

Here: interlocking relationships

(joint with Thibaud Vergé)

RPM eliminates both intrabrand and interbrand competition

Territorial restrictions would not achieve the same outcome

7

Interlocking relationships

Market structure

2 (differentiated) manufacturers A and B, constant marginal cost c

2 (differentiated) retailers 1 and 2, constant marginal cost (=0)

demand pattern for 4 “products” (monopoly prices pM, profit ΠM)

Manufacturer A Manufacturer B

Retailer 1 Retailer 2

Consumers

A-1B-1

B-2A-2

8

Interlocking relationships

Competition game

Upstream competition

manufacturers offer two-part tariffs, with or w/o RPM

retailers (observe all tariffs) and accept / reject

Downstream competition: retailers set retail prices

Note: Dobson and Waterson (2007) on linear tariffs

Retail market power

No retail bottleneck

Potential competition at each retail location: selection process (BW 1985)

Bypass: manufacturers set-up own their own outlets or sell directly

Retail bottlenecks: a single retailer at each retail location (confer rents)

9

No retail bottleneck (and no RPM)

Interbrand competition, then intrabrand competition

→ retail prices are (somewhat) competitive (pc < pM)

Intuition

Manufacturers recover retail margins through fixed fees

Internalize impact of (retail) prices on

the entire margin on sales of own brand

the retail margin on sales of rival brand

→ for A: max Σj=1,2(pAj - c)DAj(p) + (pBj - wBj)DBj(p) – FBj

10

No retail bottleneck

Manufacturer A Manufacturer B

Retailer 1 Retailer 2

Consumers

11

No retail bottleneck

Intuition (cont’d)

Retail prices are driven by wholesale (marginal) prices

Maintaining high retail prices requires high wholesale prices

Positive upstream margins

Free-riding on rival manufacturer’s upstream margin

12

Resale Price Maintenance

Retail prices are directly set by manufacturers

Recover as before retail margins through franchise fees

→ internalize as before the impact of (retail) prices on

the entire margin on sales of own brand

the retail margin on sales of rival brand

No need anymore to use wholesale prices to maintain retail prices

squeezing upstream margins yields monopoly outcome

wij = c → each manufacturer residual claimant on all margins

→ set retail prices at the monopoly level (p = pM)

13

Resale Price Maintenance

Continuum of equilibria

For any given wholesale prices, there exists an equilibriumgiven p, A and 1 can share profits through either wA1 or FA1

→ A and 1 are thus indifferent about wA1

but wA1 affects A’s dealing with 2, and 1’s dealing with B

Eq. wholesale and retail prices are negatively correlatedw ↗ → p ↘

free-riding on rival’s upstream margin

Only one equilibrium robust to (even small) retail effortretailers as residual claimant

wholesale prices at cost, retail prices at monopoly level

14

Retail bottlenecks

Retailers earn positive rents

(pA1 - wA1)DA1 – FA1 + (pB1 - wB1)DB1 – FB1 ≥ (pB1 - wB1)ĎB1 – FB1

→ (pA1 - wA1)DA1 – FA1 ≥ (pB1 – wB1)[ĎB1 – DB1] > 0

→ max Σj=1,2 (pAj - c)DAj + (pBj - wBj)[DBj – ĎBj]

Retailers indifferent wrt dealing with both or only one

→ manufacturers can easily deviate to exclusive dealing

Questions

is “double common” agency still an equilibrium?

best equilibrium? (industry profits / manufacturers’ profits)

15

Retail bottlenecks

Standard linear demand

Dij = 1 - pij + αphj + βpik + αβphk (α + β + αβ < 1)

Two-part tariffs

Double agency may cease to be an equilibrium

This happens for “low degrees” of substitutability (low β)

16

Retail bottlenecks

RPM

For ranges of parameters

continuum of double agency equilibria

including monopoly pricing (p = pM for some w < c)

As w ↗, p and retailers’ profits ↘ , manufacturers’ profits ↗

manufacturers prefer lowest retail prices

retailers prefer highest retail prices (even above pM)

17

Retail bottlenecks

0.2 0.4 0.6 0.8 1

0.2

0.4

0.6

0.8

1

No Double Common Agency

Equilibrium with Two-Part Tariffs

Equilibrium with RPM and

Monopoly Prices

18

Illustration: France

Current debate

1996 Laws (Galland, Raffarin)

Merger wave (5 large retailers)Carrefour, Auchan, Casino; Leclerc, Intermarché

Price evolution (Germany/France)

Proposed reformCanivet commission

Dutreil and Chatel laws

19

Illustration: France

Empirical evidence

France – Germany: branded products in supermarkets

Biscourp, Boutin and Vergé: market concentration and prices

Bonnet-Dubois-Simioni 2004French market for bottled water

Structural econometric model– Berry-Levinson-Pakes Eca 1995

– Berto Villas-Boas 2004

Linear prices / two-part tariffs / RPM

→ best fit: two-part tariff + RPM, monopoly prices

20

Research agenda

Inexistence of (double) common agency eq.

Source of the problemone side (the manufacturers) has “all” the bargaining power

by construction, in equilibrium the other side (retailers) is indifferent betweenaccepting all / rejecting some offers

generates many different types of deviation, difficult to rule all of them out

Possible solutionsMore balanced bargaining power– “Nash-bargaining” / cooperative game theory approaches

– Non-cooperative approaches: Stole-Zwiebel (RES 1996), …

Secret / public offer and acceptance decisions

Reacting to rejections– Small vs. drastic changes / dynamics

– renegotiation / contingent offers

21

Research agenda

Illustrations

De Fontenay – Gans (Rand forth, 2005)

secret contracts / observable acceptance-rejection decisions

contingent offers or renegotiation in case of rejection

→ no exclusion, no complete coordination

Rey – Vergé – Thal (work in progress)

public contracts, offers contingent on market structure

→ integrated monopoly outcome

Questions

Minimal flexibility needed for monopoly outcome / no exclusion ?

Role of contingent offers?

→ go back to “simpler” market structures

22

Interbrand competition (common agency)

2 manufacturers, 1 retailer

→ monopoly prices

(Bernheim-Whinston 1986)

IntuitionEach manufacturer sells “at cost”

→ retailer becomes residual claimant

→ sets retail prices at appropriate monopoly level

Manufacturers retrieve (part of) the profits

e.g. through franchise fees

RemarksDoes not depend on bargaining power

no need for contract observability

A B

R

Consumers

23

Intrabrand competition

1 manufacturer, 2 retailers

If bargaining power is upstream: monopoly

outcome

Wholesale prices above marginal cost

(maintain high retail prices despite intrabrand

competition)

Fixed fees to recover retail profits

Remark: Observability of wholesale contracts

Hart-Tirole Brookings 1990, O’Brien-Shaffer Rand 1992,

McAfee-Schwartz AER 1994, Rey-Vergé Rand 2004

1 2

M

Consumers

24

Intrabrand competition

Retailers’ bargaining power

Non-contingent contracts: exclusion (Marx-Shaffer Rand 2007)

Can be achieved through explicit ED or “three-part tariffs”

Upfront payments by manufacturers (slotting fees)

Conditional fixed fees (conditional on trade)

Contingent contracts: integrated monopoly outcome

(joint work with Thibaud Vergé and Jeanine Thal)

Can be achieved by “three-part tariffs”

But

– Can also be achieved without any slotting fees

– Slotting fees not required to generate exclusion in MS context

25

Intrabrand competition

Downstream Bargaining power and non-contingent

contracts (Marx-Shaffer Rand 2007)

Suppose there exists a double common agency equilibrium, and let Пim

denote the monopoly bilateral profit of M and Ri

M must be indifferent between accepting both or only one contract

… otherwise, rival retailer could increase its fixed fee

If M accepts only Ri’s offer, Ri obtains more than its equilibrium profit πi

M and Ri together gain from excluding the other retailer

26

Intrabrand competition

Contingent contracts

(work with Thibaud Vergé and Jeanine Thal)

Two-part tariffs

Directly of through fixed fees, each retailer internalizes the whole margin on itssales, and the upstream margin on the rival’s sales

Sustaining monopoly retail prices requires wholesale prices above cost

Each retailer has an incentive to free-ride on the rival’s downstream margin

Equilibrium wholesale prices w* yield lower prices and profit: p* < pM, П* < ПM

Double common agency only if П* > max {П1m,П2

m}

27

Intrabrand competition

Three-part tariffs

Upfront payments and conditional fixed fees

(the upfront payment can be replaced with a “free” quota)

Retailer i cannot gain more than its contribution to profits: ПM – Пjm

… otherwise, the others would exclude it

There exists an equilibrium

With integrated monopoly outcome (monopoly retail prices)

Giving each retailer the maximal profit

28

Concluding remarks

Concerns raised by RPM

Strategic lessening of competition

Sham agreements (horizontal in nature)

Upstream collusion (price transparency)

Interlocking relationships

Pervasive, visible, price floors

Policy implications

Potential benefits of RPM in the form of enhanced verticalcoordination

Per se illegality versus hard-core restriction (81.3)