Vertical Restraints

1
Vertical Restraints Effects of Upstream
Horizontal MergersDoes the Retail Sector
Matter?

• Luke Froeb
• April 12, 2002
• University of Florida

2
Related work

• Pass Through rates and the Price Effects of
  Mergers
• mba.vanderbilt.edu/luke.froeb/papers/
• Coauthors, Steve Tschantz Greg Werden
• Views are my own, do not purport to represent
  those of my co-authors or Justice or FTC.

3
Talk Outline

• Policy Theory Background
• I will go over fast unless I get questions
• 3 Games of retailer-manufacturer behavior
• Empirical Example of a Chicago Bread Merger in
  each Game
• Conclusions Unanswered questions

4
Background Retail Sector is Consolidating in US

• In US, Wal-Mart, Kmart, Target, Costco, and
  Searsaccount for 60 percent of
  general-merchandise sales
• General-merchandise is 15 of all retail sales
• Productivity advantage over smaller retailers
• Economies of scale
• Economies of purchasing
• Economies of distribution

5
Productivity Gains Associated with Industry
Consolidation
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Retail consolidation also in Europe

• In EU, top 10 grocery stores forecast to increase
  share to 50-60
• Currently at 38
• Wal-Mart entering Europe
• Also entering South America

7
Policy Reaction to Retail Consolidation

• FTC challenging some retail mergers
• Blocked Kroger Winn-Dixie
• Blocked Staples Office Depot
• Competitive analysis based on increase in local
  (within-city) horizontal market power
• standard horizontal analysis

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Standard Horizontal Analysis Benefit-Cost of
Merger

• Goal quantitative estimate of merger effect.
• Necessary to weigh efficiencies against loss of
  competition
• Two methodologies
• Model-based simulations
• Natural experiments, e.g. Staples-Office Depot

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Model-based simulation

• Model current competition
• Estimate model parameters
• Simulate loss of competition using estimated
  parameters
• Merger effects modeled as difference between pre-
  and post-merger Nash equilibria

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Model-based SimulationKroger Winn Dixie

• Estimate Gravity choice model
• Survey density in Charlotte, NC
• Dots represent grocery stores

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Pre-merger EquilibriumShare of Kroger
Winn-Dixie
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Post-merger EquilibriumShare of
KrogerWinn-Dixie
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Empirical Comparisonse.g., Staples-Office Depot

• Prices 6 higher in 1-superstore cities
• 15 pass through
• 406/.15 compensating MC reduction
• big pass-through ?? big merger effect,
• Both depend on demand curvature
• So estimate merger effects and pass-through rates
  together.

14
Theory Policy Towards Horizontal vs. Vertical
restraints

• Horizontal
• Widespread consensus on how to model horizontal
  restraints.
• Collusion or unilateral effects
• Policy debate is empirical
• Vertical
• No consensus on how to model vertical restraints.
  
• Policy debate is theoretical
• Or on necessary conditions, e.g., market-share
  screens

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Questioning the Consensus on Horizontal Restraints

• How do vertical restraints change standard
  horizontal merger analysis which ignores retail
  sector?
• Focus of paper
• How do vertical restraints affect our
  understanding of retail consolidation?
• Does standard horizontal analysis suffice?
• Not going to answer this one.

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Methodology put Monopoly Retail sector on top
of Bertrand Manufacturing Oligopoly

• Strategic form bargaining game (n1 players)
• Upstream Bertrand oligopolists (n) make
  take-it-or-leave-it offers to retail monopolist
  (1)
• Retailer chooses the best set of offers
• ?Pre-merger Nash equilibrium
• Then, two upstream manufacturers merge
• Merger effect is difference between pre- and
  post-merger equilibria
• What happens to retail prices and quantities?

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Results the retail sector matters--a lot.

• Upstream horizontal mergers can have a variety of
  effects when filtered through retail sector
• Transparent retail sector
• Opaque retail sector
• Double marginalization
• Can amplify merger effects, or
• Attenuate them

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Three Different Games

• Game 1 retailer must carry all profitable
  products
• ?Transparent retail sector
• Game 2 retailer has option of exclusive dealing
• ?Opaque retail sector
• Game 3 manufacturers limited to offering
  wholesale unit prices independent of quantity
• ?Double marginalization
• Can amplify or attenuate merger effects

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Game 1 retailer must carry all profitable
products

• Retailer
• internalizes price effects between products
• Manufacturer
• Set w to maximize profitability on own product
• Wholesale price below marginal cost to induce
  Bertrand prices

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Game 1 continued

• Manufacturers set wholesale prices below mc to
  induce Bertrand (non-cooperative) pricing at
  retail level
• Collect all profit (rev.) with fixed fees
• Pricing Merger effects are same as would occur
  if Manufacturers sold directly to consumers.

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Game 2 Retailer has Option of Exclusive Dealing

• Retailer has four options
• Exclusive dealing with Mfg. 1, total profitT1
• Exclusive dealing with Mfg. 2, total profitT2
• Joint dealing with Mfg. 1 and 2, total profitTJ
• Neither, total profit 0
• Mfg.s make contingent offers to retailer using
  two-part prices
• OBrien Shaffer (1997) and Bernheim Whinston
  (1998).
• Equilibrium is efficient in that Mfgs transfer
  at mc, and retailer maximizes joint profitability

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Game 2 Continued

• Profit split winner must outbid next best
  alternative
• 1 is most valuable alternative T1max(T2,TJ)
• 1s profitT1 - T2
• 2s profit0
• retailers profitT2
• 1 and 2 are substitutes T1T2 TJ max(T1,T2)
• 1s profitTJ - T2
• 2s profitTJ - T1
• retailers profitT1 T2 - TJ
• 1 and 2 are complements TJ T1T2 max(T1,T2)
• retailers profit0

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Game 2 continued

• Manufacturers set wholesale prices at marginal
  cost
• Retailer maximizes total profit
• Retailers paid their marginal contribution to
  total profit
• Mergers
• do not change retail prices
• But do transfer profit from retailer to merged
  manufacturers

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Game 3 Wholesale prices are independent of
quantity

• Retailer profit (same)
• internalizes price effects between products
• Manufacturers face derived demand, q
• Bertrand equilibrium with derived demand.
• Wholesale margins are functions of elasticity of
  derived demand
• Depends on pass-through rates from wholesale to
  retail

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Game 3 continued

• Prices too highdouble marginalization.
• Big wholesale margins
• Derived demand is usually less elastic than
  retail demand because
• Wholesale prices are lower (which makes
  percentage price changes bigger)
• Pass-through rates can be less than one
• Merger effects can be higher or lower

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3 Retail Games Illustrated White Pan Bread in
Chicago

• All calibrated to same prices, quantities,
  pre-merger elasticities (logit demand)

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Model Calibration
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Merger of Brands 12
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Merger of 12 w/AIDS Demand
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Logit vs. AIDS Demand

• Pass through rates for logit (95), linear (near
  50) demand are less than one.
• Relatively inelastic derived demand
• Pass through rates for AIDS (180), Constant Elas
  (near 200) demand are higher
• Relatively elastic derived demand

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Conclusions

• Retail sector matters a lot for standard
  horizontal merger analysis
• Constant mark-up or percentage mark-up usually
  assumed which is transparent case.
• Not correct if opaque or double
  marginalization.
• Empirical Identification of retail game
• Games have negative, zero, and positive wholesale
  margins, respectively.

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Unanswered Questions

• How do retailers behave?
• Sales agents compensated on revenue commission
• Positive wholesale margins
• Complex nonlinear contracts with promotional
  allowances, quantity discounts
• is two-part pricing a good metaphor?
• What about the n X k case (n manufacturers, k
  retailers)?
• Retailers compete on selection, price,
  convenience.
• Does opaque equilibrium hold for n X k case?