vanderbilt university1 vertical restraints & effects of upstream horizontal mergers: does the...

Vanderbilt University

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Vertical Restraints & Effects of Upstream Horizontal Mergers:

Does the Retail Sector Matter?

Luke FroebApril 12, 2002

University of Florida


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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.


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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


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Background: Retail Sector is Consolidating in US In US, Wal-Mart, Kmart, Target, Costco,

and Sears—account 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


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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


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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 Simulation:Kroger + Winn Dixie

Estimate “Gravity” choice model Survey density

in Charlotte, NC

Dots represent grocery stores


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Pre-merger Equilibrium:Share of Kroger + Winn-Dixie


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Post-merger Equilibrium:Share of Kroger+Winn-Dixie


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Empirical Comparisonse.g., Staples-Office Depot

Prices 6% higher in 1-superstore cities

15% pass through 40%=6%/.15

compensating MC reduction

big pass-through big merger effect,

Both depend on demand curvature

So estimate merger effects and pass-through rates together.


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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 (n+1 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 profit=T1 Exclusive dealing with Mfg. 2, total profit=T2 Joint dealing with Mfg. 1 and 2, total profit=TJ Neither, total profit =0

Mfg.’s make contingent offers to retailer using two-part prices O’Brien & Shaffer (1997) and Bernheim &

Whinston (1998). Equilibrium is “efficient” in that Mfg’s

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: T1>max(T2,TJ)

1’s profit=T1 - T2;

2’s profit=0;

retailer’s profit=T2;

1 and 2 are substitutes: T1+T2 > TJ > max(T1,T2) 1’s profit=TJ - T2;

2’s profit=TJ - T1;

retailer’s profit=T1 + T2 - TJ

1 and 2 are complements: TJ > T1+T2 > max(T1,T2) retailer’s profit=0


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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 high”—double

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 1+2


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Merger of 1+2 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 retailer’s 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?

vanderbilt university1 vertical restraints & effects of upstream horizontal mergers: does the...

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