08/12/2009
(In)efficient Trading Forms in Competing Vertical Chains

(In)efficient Trading Forms in Competing Vertical Chains

We study competing vertical chains where upstream and downstream firms bargain over their form and terms of trading.

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We study transactions between firms that operate at different stages of a vertical supply chain, such as input producers and final good manufacturers or wholesalers and retailers - “upstream” and “downstream” firms in general. A standard assumption in the existing literature is that downstream firms play a passive role in these transactions. We assume instead that the downstream firms are large players that participate actively not only in setting their final market prices, but also in determining how they trade with their upstream suppliers. Within this framework, a number of fundamental issues arise: How is vertical trading organized? How do bilateral negotiations between large upstream and downstream firms affect their form and terms of trading? How do final market outcomes depend on the distribution of bargaining power between the upstream and the downstream firms? Do final consumers benefit from the “countervailing” power of large downstream firms? What is the role of strategic competition across chains? This set of questions is not only of theoretical interest but also of practical importance.

Downstream firms are in many cases large players, actively involved in shaping their contracts with their suppliers, as the widespread evidence of increased concentration in the downstream sectors of many industries suggests. The food industry, in which large “supermarkets” become increasingly stronger in trading with their suppliers, is one of the examples that have recently received significant attention. The picture is similar in many other industries: large tour operators trading with airlines and hotels, car manufacturers purchasing car parts, large book retailers (e.g. Barnes & Noble) dealing with publishers, large clothing retailers or, indeed, general retailers in both the U.S. (e.g. Wal-Mart) and Europe (e.g. Carrefour).

We employ the simplest model that allows us to study transactions in competing vertical chains when both the upstream and the downstream firms participate actively in the determination of their form and terms of trade. There are two vertical chains, each consisting of one upstream and one downstream firm. The firms play a three- stage game with observable actions. At the first stage, within each vertical chain the upstream and downstream firm bargain in order to determine their form of trading. The possible trading forms, or contract types, are: a (linear) wholesale price contract, a two-part tariff contract, and a price-quantity “bundle” (or “package,” specifying the total input quantity and its corresponding total price). At the second stage, the upstream and downstream firm in each chain bargain over the contract terms of their previously selected contract types. Finally, at the third stage, downstream firms produce differentiated final goods and compete in quantities.

We show that upstream-downstream bargaining plays an important role in vertical trading not only because it affects the terms of trade but, more importantly, because it can also affect the form of trade emerging in different industries. Since different trading forms can appear in the presence of bargaining than in its absence, our analysis highlights the role of bargaining power distribution for vertical supply chains outcomes. We show that, while in the absence of bargaining, i.e. when all power is either upstream or downstream, “conditionally efficient” contracts are dominant, in the presence of bargaining, “conditionally inefficient” contracts such as (linear) wholesale price contracts may arise. Also, within the set of conditionally efficient contracts, two-part tariffs are always dominated by price-quantity bundles, and thus, never arise in equilibrium (though socially optimal). Our analysis thus reveals that price-quantity bundle contracts, which have been largely ignored in the literature, consist a significant form of trading within vertical chains.

The intuition for these results lies on the features of the different contract types. As mentioned above, both price-quantity bundles and two-part tariffs are conditionally efficient contracts, that is, lead to the maximization of the “pie” (i.e. the vertical chain’s joint profits), given the rival chain’s strategy. Yet, price-quantity bundles are preferred to two-part tariffs, due to their superior commitment value. In particular, a vertical chain, by using a price-quantity bundle contract, is able to commit to a certain final output level before reaching the final market competition stage. On the other hand, wholesale price contracts do not lead to the maximization of a chain’s joint profits (conditional on rival behavior), since in the absence of fixed fees there is double marginalization. However, they may arise in equilibrium, as they turn out to be an attractive choice for non-very powerful downstream firms. Due to the absence of transfers, a wholesale price plays a double role: not only controls how aggressive the downstream firm in the final good market is, but it also determines how the surplus is shared within the chain. As a result, a downstream firm with little power is allowed to keep a larger share of the (otherwise smaller) pie under a wholesale price contract than under a price-quantity bundle contract. An implication of the above is that product differentiation, by shifting the emphasis from strategic competition vis-à-vis the rival chain to how the surplus is divided within the chain, makes wholesale price contracts more likely to appear.

Since a change in the distribution of bargaining power may lead to the adoption of different trading forms, it can also lead to drastic changes in the levels of firm’s profits, consumers’ surplus, and total welfare. Interestingly, we find that a firm - upstream or downstream - might benefit from a reduction in its own bargaining power. The intuition comes from the fact that a change in the allocation of the bargaining power between the upstream and the downstream firms can affect the equilibrium outcomes not only through changes in the contract terms but, more importantly, through changes in the contract types. In particular, from the viewpoint of a downstream firm, although a reduction in its bargaining power means that it captures a smaller share of the pie, it can also mean a more favourable way of dividing the pie due to the possible appearance of wholesale price contracts. From the viewpoint of an upstream firm, while an increase in its bargaining power leads to an increase in its share of the pie, it can also lead to a smaller pie and a less favourable way of dividing it, through the appearance of conditionally inefficient contracts.

An analysis along the above lines also allows us to address the following important question: since in an increasing number of markets “countervailing” power of large retailers becomes a significant factor, does such a force operate in the benefit of consumers and total welfare? We find that an increase in the “countervailing” power of downstream firms can, under certain conditions, be beneficial both for the consumers and welfare. This is so because wholesale price contracts, that imply high final market prices, do not appear in equilibrium when the downstream bargaining power is sufficiently high. Interestingly enough, we also find that a more even distribution of bargaining power may turn out to be harmful both for the consumers and total welfare. When the distribution of bargaining power within chains is extreme, conditionally efficient contracts, that due to the absence of double marginalization lead to lower final prices, tend to arise.

Some important modifications of our basic model are also considered in the paper. First, we enlarge the set of possible trading forms, by allowing each vertical chain to vertically integrate. We show that this option is strategically weaker than trading via a price-quantity bundle contract (because such contracts have a commitment value). Second, we relax the assumption made in the main body of the analysis that the price- quantity bundles have direct “downstream quantity commitment” (that is, the downstream firm’s final output is directly dictated by the input quantity specified in the contract). We show that our main results hold true, independently of whether the price-quantity bundles are with or without downstream quantity commitment, at least as long as the marginal production cost of the input is not too low. Intuitively, a vertical chain can still commit (indirectly) to aggressive downstream behavior by employing such a contract, because it can induce its downstream firm to act as a zero marginal cost competitor (up to the specified input quantity) during the final market competition stage. Third, we exclude by assumption price-quantity bundles (as most of the related literature has also done) and analyze the case in which the choice of contracts is only between two-part tariffs and wholesale prices. We find that, in the absence of price-quantity bundles, the appearance of wholesale price contracts becomes more likely. 

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