Slotting Allowances and Manufacturers' Retail Sales Effort Author(s): Øystein Foros, Hans Jarle Kind and Jan Yngve Sand Source: Southern Economic Journal, Vol. 76, No. 1 (Jul., 2009), pp. 266-282 Published by: Southern Economic Association Stable URL: http://www.jstor.org/stable/27751463 Accessed: 25-08-2014 07:57 UTC

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Southern Economic

Journal 2009, 76(1), 266-282

Slotting Allowances Retail Sales Effort 0ystein Foros,* Hans

and Jan Yngve SandJ

JarleKind,t

on the profit to undertake noncontractible investments depend can facilitate such incentives by to the retailer, and slotting allowances to conclude unit wholesale it is tempting that slotting prices. At first glance for product the manufacturer's should be particularly prevalent categories where

A manufacturer's margin

and Manufacturers'

on her

increasing allowances

incentives

sales

sales effort is relatively large. At odds with this, the noncontractible scope for undertaking Federal Trade Commission among other organizations, reports that slotting allowances (FTC) are more commonly used for product categories where the scope for noncontractible effort by the manufacturer one

with

model

noncontractible with market JEL

relatively small. To scrutinize one and retailer, where

is presumably manufacturer

investments.

demand-enhancing observations.

Classification:

L21,

LH,

The

predictions

this puzzle we set up a simple the manufacturer undertakes from the model

are consistent

L42, M31

1. Introduction Slotting allowances, which are fixed fees that manufacturers pay to retailers, are 1997; Bloom, Gundlach, and widespread in the grocery industry (Lariviere and Padmanabhan Cannon 2000). Such fees have also become common in bookstores, drugstores, and record stores (Wilkie,Desrochers, and Gundlach 2002; Klein andWright 2007). There are two schools of thought that dominate the debate on their effects.The market power school argues that slotting allowances are anticompetitive: for instance, bymitigating competition among retailers (Shaffer 1991) or by reducing product variety through foreclosure of smaller suppliers and/or retailers (Shaffer 2005; Marx and Shaffer 2008). The efficiency school, on the other hand, argues that slotting allowances are efficiency enhancing in the sense that they solve channel coordination

problems.

The

two

schools

of thought

are

not

necessarily

inconsistent,

however.

First, anticompetitive and efficiency rationales for using slotting allowances may certainly coexist. Second, they share the prediction that slotting allowances are more likely to occur the is the retailers1

larger

*

bargaining

power

over

the manufacturers.

School of Economics

and Business Administration, Helleveien

30, N-5045

Bergen, Norway;

E-mail

[email protected]. t Norwegian School of Economics

and Business Administration, Helleveien

30, N-5045

Bergen, Norway;

E-mail

Norwegian

[email protected]. I University [email protected]; We would

of Tromso,

Department

of Economics

and Management,

N-9037

Tromso,

Norway;

corresponding author. like to thank three anonymous

E-mail

referees,Derek Clark, seminar participants at theUniversity of Tromso, participants at the European Association for Research in Industrial Economics 2007 inValencia, and those at the 14th International Conference on Retailing and Service Science, San Francisco, 2007, for valuable comments. Received December 2007; accepted August 2008.

266

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267

Slotting Allowances and Sales Effort

(FTC) accentuates threepotential efficiency rationales for (i) signaling the quality of a new product, (ii) screening among

The Federal Trade Commission the use of slotting allowances: new

several

and

products,

(iii)

manufacturers'

increasing

to make

incentives

demand-enhancing

investments (FTC 2003). A number of papers analyze the effect of asymmetric information, where slotting allowances are used as a signaling or screening device (Chu 1992; Lariviere and Padmanabhan 1997; Desai 2000, among others). In this article we address how slotting allowances

may

help

to

reduce

retailers.

Such

by Lai A

are by

investments

1990; Desai

channel

coordination

when

problems

can

manufacturers

investments that are difficult to observe and/or verify for the

undertake demand-enhancing

more

their very nature

or

less noncontractible

(see discussion

1997).

manufacturer's

incentives

to undertake

noncontractible

investments

depend

on

the

profitmargin on its sales to the retailer and not on total channel profit per se. According to the FTC (2003), "Slotting allowances can facilitate these incentives by allowing manufacturers to charge higher wholesale prices (thus higher variable margins for the manufacturer) while compensating the retailer through the slotting fee." Along the same line, Farrell (2001, p. 2) uses contract theory to argue that the combination of slotting allowances and relatively high wholesale prices may be used to facilitatemanufacturers' choice of, for example, advertising, and

packaging,

warehousing.

(2001) reports that the use of slotting allowances varies significantly across product categories. Slotting allowances are heavily used for nonperishable product categories, such as frozen food and dry groceries, while they are less frequently employed for perishable The FTC

product categories like fresh food, produce, and deli. Sudhir and Rao (2006) analyze new product introductions and find variations in the use of slotting allowances across product categories that are largely consistent with the FTC findings.1 Interestingly,manufacturers' noncontractible effort is presumably more important for perishable than for nonperishable product categories (for perishable products like fresh food, a significantpart ofmanufacturers'

demand-enhancing effortcannot be observed and verified).2The empirical findings by theFTC and Sudhir and Rao are thus puzzling and seemingly inconsistent with the prediction that noncontractible

manufacturers' slotting

investments

an

are

rationale

important

behind

the usage

of

allowances.

In this article we tryto give an explanation for thepuzzle through a simple two-stage game between

a downstream

firm

("retailer")

and

an

upstream

firm

At

("manufacturer").

the

last

stage the retailer sets the end-user price, and themanufacturer decides if and how much to invest innoncontractible sales effort.At the firststage there is a Nash bargaining game between the manufacturer

and

the retailer

over

the wholesale

contract.

The

wholesale

contract

consists

of a linearwholesale price in addition to either a slotting allowance (a fixed payment from the manufacturer to the retailer) or a franchising fee (a fixed payment from the retailer to the manufacturer).

prediction, we show that itmay be in the retailer's own interest a unit wholesale price above marginal costs. Otherwise the

Consistent with theFTC's to pay

the manufacturer

1 See also Kuksov

~

and Pazgal (2007) and Klein and Wright (2007). is likely to be true also for the delivery phase. Perishable goods are for instance commonly distributed through direct store delivery (DSD) and are often sensitive to, e.g., temperature, storage, and the driving style during transportation. The manufacturer's effort to ensure high quality along such dimensions is typically difficult to verify

This

and make

contractible. Nonperishable goods, on the other hand, are more regularly distributed through the system of the retailer than through DSD, leaving less discretion to themanufacturer.

warehouse/logistics

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Foros, Kind, and Sand

268

manufacturer

will

have

no

incentives

to make

demand-enhancing

investments.

noncontractible

in contrast to conventional wisdom we find that the unit wholesale

price is not them. the than without with allowances Indeed, opposite may be slotting necessarily higher true.The reason for this is that if thewholesale contract specifies only a unit price and no fixed

However,

fee, the retailer has no incentives to care about total channel profit.He cares only about his own profit, that is, how much he sells in the end-user market and at which profitmargin. He may, therefore, find it profitable to pay such a high unit wholesale price that themanufacturer

undertakes larger demand-enhancing investments thanwhat is optimal from a channel point of view.

a two-part wholesale tariff the aggregate profit will be distributed between the retailer and themanufacturer according to theirbargaining power. They will consequently have a common interest inmaximizing channel profit, and neither of the parties will have incentives With

to stimulate demand wholesale

above what maximizes

price?and

aggregate profit. This explains why the unit noncontractible

thus demand-enhancing

investments?may

be

lower with

two-part tariffs than without them. We emphasize that our focus is on noncontractible sales effort.Obviously, sales effort, like promotion frommanufacturers, potentially plays an important role in stimulating demand for

most kinds of goods. What matters for our analysis is not the size of sales effortas such, but whether demand is sensitive to noncontractible sales effortby themanufacturer.

2. Some Related

Literature

Shaffer (1991), who may be considered the founder of themarket power school, analyzes competition between two retailers in the end-user market. He assumes that the retailers have

complete bargaining power overmanufacturers and shows that a high wholesale price may help to soften

retail

competition

and

increase

end-user

prices.

Consumers

are

harmed,

but

channel

profit increases and is captured by the retailers through slotting allowances.3 By the same token, in the present context slotting allowances may increase both thewholesale and the end user price. Other things equal, this has a negative effect both on the retailer and on the consumers.

However,

the

higher

wholesale

price

increases

the manufacturer's

investment

incentives in, for example, quality control, and we show that this effectmay be so strong that both retailer profit and consumer surplus are higher with slotting allowances than without them.4

3

In an extension of Shaffer (1991), Foros and Kind (2008) show that when retail chains are forming buyer groups for procurement activities, slotting allowances may be used to dampen intra-retailer competition even if rival retail chains

cannot observe the wholesale contracts. As mentioned above, there have also been concerns that slotting allowances may have anticompetitive effects through foreclosure of smaller suppliers and/or retailers; see Shaffer (2005) and Marx and Shaffer (2008). 4 Under asymmetric information, where themanufacturer has private information about, e.g., product quality, slotting allowances may be used as a signaling or screening device (Chu 1992; Lariviere and Padmanabhan 1997; Desai 2000). new products to and risk between manufacturer retailers balance the also be used allowances may regarding Slotting

and Cannon (2003) find no support for slotting (2000) and Rao and Mahi (Sullivan 1997). Bloom, Gundlach, allowances as a signaling device in the grocery industry. In contrast, Sudhir and Rao (2006) and Sullivan (1997) find some empirical support for the signaling rationale.

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269

Slotting Allowances and Sales Effort

The present analysis ismost closely related to the strand of literature that analyzes how vertical

can

restraints

channel

solve

coordination

Since

problems.

power

bargaining

conventionally has been assumed to be in the hands of the manufacturer (the franchisor), themajority of papers focus on noncontractible sales effortby the retailer (the franchisee). If the manufacturer has all the bargaining power, and the retailer is the one who makes sales effort,we will, in absence of vertical restraints, have a standard double

unobservable marginalization

In this case

problem.

the manufacturer

achieve

may

the same

outcome

as under

channel integration by using a two-part tariff,that is, a franchising fee in addition to a unit wholesale price (see, e.g., Lai 1990). Lai (1990), Desai (1997), and Rao and Srinavasan (1995) assume that both the retailer and themanufacturer undertake value-adding sales effort that cannot be observed by the other party. Lai (1990) argues that an ancillary restraint (in addition to a two-part tariff) is needed only if both the manufacturer and the retailer undertake

noncontractible sales effort.Below we show that this need not be the case: A two-part tariffis unable to achieve the outcome with channel integration even if only the manufacturer a noncontractible

undertakes

sales

effort.

The channel coordination problem is thusmore complex if themanufacturer is the one thatmakes noncontractible effort,compared to the case where the retailermakes such effort. reason is that when

the retailer makes noncontractible effort, he will internalize the effect of this effortwhen he sets the end-user price. A two-part tariffis then demand-enhancing sufficient to replicate the outcome under channel integration (see Lai 1990). In contrast, a manufacturer can only be induced tomake noncontractible effort to the extent that the unit The

wholesale price is set above marginal production costs. However, thiswill at the same time induce a double marginalization problem, and a two-part tariff is not sufficientto achieve the same

as under

outcome

channel

integration.

In a recent paper Kuksov

and Pazgal (2007) discuss the role of retail competition and bargaining power. They abstract from manufacturer investments and show that slotting allowances cannot arise in equilibrium in the absence of retail competition. Similar to our study, they scrutinize the puzzle that slotting allowances are more perishable products. In their model tougher retail competition and

allowances,

Pazgal

is more

competition

for nonperishable

intense

frequently used for less leads to more slotting

products.

Hence,

Kuksov

(2007) and the present article may offer complementary and mutually for the above

explanations

mentioned

and

reinforcing

puzzle.

3. The Model We manufacturer

consider may

a

channel undertake

model

one

with

noncontractible

retailer sales

one

and efforts

that

where

manufacturer, increase

the

the

consumers'

willingness to pay for the good sold by the retailer in the end-user market.5 The

retailer

faces

the

linear

demand

curve

q

=

v+

x

?

p +

8, where

v is the market

potential, x is the level of sales effort by themanufacturer, p is the retail price, and 8 is an = q, expected demand can be written as uncertainty termwith mean zero. Defining E[q] abstract from the possibility that the parties undertake contractible sales effort, since themodel otherwise becomes more complex without adding any new insight.The consequences of allowing the retailer to undertake noncontractible sales effort are discussed in the Introduction.

We

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270

Foros, Kind, and Sand =

q

v+

x

-

p.

(1)

The manufacturer's cost of providing sales effort is given by C(x) = <\>x2l2 and is independent of the quantity sold in the retailmarket. This specification corresponds to the case where the sales effort,for instance, consists of differentkinds of promotion activities, advertising outlays, and product quality controls. Our interpretationof the parameter ? is related to the degree towhich noncontractible effort can be undertaken. A low value of dp is taken to imply that there is substantial scope for noncontractible effort;whereas, a high value implies that it ismore We difficult to exert such effort. manufacturer's

sales

thus interpret cj)as the sensitivityof demand with respect to the

In the formal

effort.

model,

however,

dpaffects

the manufacturer's

cost

of

sales effortbut does not affect consumer demand directly.We do this for the sake of simplicity, and the qualitative results would be similar ifwe had put restrictions on consumers' utility rather than on the cost of effort.6

In order to ensure positive output and that the second-order conditions are satisfied in all the cases we consider below, we shall make the following assumption: 1% Assumption, cj)> cj)= ^~ 0.62. Upstream marginal

c, and we normalize the channel's unit costs at the

costs equal

to zero.

downstream

level

Benchmark:

The Integrated Channel

Channel profit ismaximized by solving the optimization problem =

maxKic p, x 2

(p

-

c)q-?,

(2)

where subscript ic is short-hand for integrated channel. The integrated channel's first-orderconditions (FOCs)

^

= 0= > ifx= 0 and (p c) ^

read

= 0= > q+ (p

c)|

= 0,

(3)

where we note for later use that dnicldp = 0 can be reformulated as p Solving the expressions inEquation

1

2<\> The FOCs

6

v+

?=

x

+

c

(4)

-2

3 simultaneously we find

,

v 10'

"

n c).

v (v+ c)
1U = -^t-:- Pic 2<\>

1(5)

> 1/2, inwhich case channel profit equals describe an equilibrium if <\>

If themanufacturer's sales effort is observed and verified by the retailer, the level of effortmay be agreed on directly in a contract. For some type of advertising the level of outlays may be observed, but itmay nonetheless be difficult to verify the effort level (see the Introduction). In general, it is unlikely that it is possible towrite complete and enforceable contracts on retail sales efforts.

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Slotting Allowances and Sales Effort

77?^ Disintegrated

271

Channel

In the rest of the article we consider a disintegrated channel, such that the retailer and the manufacturer

maximize

noncooperatively

profit.

Total

channel

profit

in

the

disintegrated

channel is given by n We

the following

analyze

=

7Cr+

Km.

(6)

game:

two-stage

At stage 1 there is a Nash bargaining game over a wholesale tariffT Or, S) = wq S, where w is the unit wholesale price and S? 0 is a fixed fee. IfS > 0, themanufacturer pays the retailer a slotting fee,while we have a franchising fee ifS < 0. At stage 2 themanufacturer's sales effort (.v) and the retailer's choice of end-user price (p) are determined simultaneously.7 The profits of the retailer (subscript r) and the manufacturer (subscript in) are consequently given by, respectively, nr =

{p-

n')(v + x p) + S (7)

and

nm =

(w

-

c)(v + x p)

^x2

- S.

(8)

Stage 2 We

solve the game by using backward induction. Since the outcome of the second stage depends neither on the sign or size of S nor on the distribution of bargaining power, the FOCs for stage 2 are found by solving cnnJcx = cn,Jcp = 0 inEquations 7 and 8.We thus have ^

-

0 = >

(w

-

c)

-

= ((XY 0 and r.v^

= 0 = > q +

(p dp

~ {]?

"')^

= 0.

(9)

The retailerwill never sell the good below hismarginal costs. This means thatwe must have /;> ir.Comparing Equations 3 and 9 we therefore immediately see that the effort level in the disintegrated channel is (weakly) lower than the one which maximizes total profit for a given p. The reason is that the integrated channel makes effort investments until the entire channels c) is equal to marginal investment costs (<\>x).while the disintegrated marginal profit (p '

Ifwe had

included contractible sales effort, itmight be natural to assume that this activity takes place at stage 1. sales effort, on the other hand, should be modeled as taking place in the last stage, since it has no commitment value. Note also that it is reasonable to assume that the wholesale tariff is decided before retail prices.

Noncontractible

is due to the fact that retailers do not have long-term contracts with their customers, while the wholesale contractual arrangements are often fixed for no less than one year (see. e.g., discussion by Rey and Stiglitz 1995).

This

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272

Faros, Kind, and Sand

channel invests only up to the point where themanufacturer's marginal profit (if marginal

costs

investment

Solving cKylcp

-

c) equals

(?x).

= 0 we find p

=

(u<+ x +

v)/2, (10)

which means that the retailer sets an end-user price which is increasing inhis marginal costs Or). In contrast, for the integrated channel it follows from cnjcp = 0 thatp = (c + x + v)/2.Other > c things equal, the end-user price will thereforebe higher in the disintegrated channel ifw v will be relatively low in the (double marginalization). However, since the effort level we

channel,

disintegrated

cannot

at the outset

ascertain

whether

the end-user

price

will

be

lower

in the disintegrated or the integrated channel. Solving the two FOCs in Equation 9 simultaneously yields /x = *(? )?+

v+

n'

u'

?

c

-24;-

1

andx^

.

.

ir

= ?-

-

c



1.

The simple expressions inEquation 11 indicate that therewill be a trade-offwhen thewholesale tariff is determined at stage l: A higher value of w increases the retailer's marginal costs and may lead to an excessively high end-user price but will also give themanufacturer stronger incentives

to make

effort

investments.

Indeed,

the manufacturer

will

not make

any

investments

unless the profitmargin is positive; if ir< c she will optimally set x* = 0. Combining Equations 7, 8, and ll we find that the FOCs at stage 2 give rise to the following profit levels: (V

-

H-)(j)+

(if

-

c)

+ 5

=

and

("

~ "

~ )2(lr

C) - S.

(12)

Stage 1 We assume a Nash bargaining game, where the bargaining power of themanufacturer is ot g [0, 1] and the retailer's bargaining power is 1 - a. At stage 1we thus solve " = ?\ argmax(ti,;,)7^,.)1 {u\ S) where te,?and nr are the profits ifboth parties accept the agreement. The disagreement point is assumed to be zero. The FOCs with respect to S and w are given by, respectively, =0, +

+ (i =?- (14) -y.)n?,?r

c/ir mr

Using Equations

7 and 8 we can solve Equations

"' = '-

N{(\>) + M^'-'>

(j)

13 and 14 to find that

(,5)

and

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(13)

Slotting Allowances and Sales Effort

S*= ( NW +

W) *

- ^ +M 2

273

(v-0"n61 1j

7 2(#(<|>)+ (t))'

= 1.The variable N(<\>) is positive in the relevant area, that is, for * > (?>. where yV((j)) ())2+ ? With a two-part tariff,the fixed feewill be used to distribute aggregate profit between the manufacturer and the retailer according to their bargaining power (the higher is the the smaller is the slotting fee: dS*/dy <

manufacturer's bargaining power, consequently

have

a common

in choosing

interest

the unit wholesale

so as

price

0). The

firms

to maximize

total

channel profit.This explains why ir* is independent of the distribution of bargaining power x *? c= From Equation 15we furtherhave u (j)NX^J+^ which shows that theunitwholesale costs is for finite value of (j).The parties are thereforenot able to than any marginal price higher even This implies that avoid thedouble marginalization problem though theyuse a two-part tariff.

total channel profit is lower thanwhat can be achieved under channel integration (only in the limit

4>

??

^

do

we

ir*

have

=

reason

c). The

is set above

ir*

costs

marginal

is simply

that

the

manufacturer will otherwise have no incentives to invest in effort,and in equilibrium we have

andg*

=

?K,J+t

xJy~c).

(17)

that since ir* is independent of a, the same is true for a**. The distribution of the bargaining power thus only determines the sign and size of the fixed fee S. The dividing line between slotting allowances (S* > 0) and franchising fees (5* < 0) can be found by solving for S* = 0 inEquation 16: Note

S* = 0 We

oc=

if

=

0 + 2)(N(W +
can now state the following proposition:

Proposition

1. The market

equilibrium yields slotting allowances

if a <

and

franchising fees ifa > a(<\>). Using Equation

17we find that

+ 2{N{<\>)

flty

which shows that the optimal investment expenditures are higher the smaller is (j). Indeed, as cp approaches (j) it is optimal that themanufacturer undertakes such high effort that she cannot pay any slotting allowances. Neither can therebe any slotting allowances in the limit* ?> ^; the channel participants will clearly not want to induce any sales effort if the costs of doing so are infinitelyhigh. In thiscase the equilibrium unit wholesale price will consequently be set equal to

marginal

costs

(lim^

_

y-_ir* =

c),

leaving

no

operating

profit

to

the manufacturer.

The

possibility of positive slotting allowances can thereforearise only for intermediate values of <\>. Differentiating Equation 18we consequently find that a((j)) is hump-shaped, as illustrated ^ in Figure 1.The peak is at where (j)~ 1.48, such that therewill be no slotting (<4>) 0.37, allowances if ot> 5t (cj>). We will observe franchising fees above the curve a(^). To what extent we will observe slotting allowances below the curve depends on the bargaining power of the retailer. Suppose

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Foros, Kind, and Sand

274 ?

0.50i

0.40I

Figure

1. Occurrence

of Slotting Allowances

that a = 0.3, as indicated by the dotted horizontal line in Figure 1. Slotting allowances then occur only in the shaded area. Outside this area themanufacturer has a sufficiently strong bargaining position to require a franchising fee. From Proposition 1, and as illustrated in Figure 1,we have the following corollary:

1. Assume that the retailer's bargaining power is sufficiently high that Then slotting allowances occur for intermediate levels of <|).For polar cases, that is, a(<|>). high or low values of <|>,slotting allowances will not be observed. Corollary

oe<

There seems to be a broad consensus that channel bargaining power has shifted from upstream firms to downstream firmsinmany industriesover the last couple of decades, not least in

thegrocery sector.This generates a downward shiftof thedotted line inFigure 1. In the limitas a ?> 0 (full retailerbargaining power) we see that therewill be slottingallowances forall goods where > or low values of <|> (|>.Otherwise, slottingallowances will not be observed for sufficientlyhigh The present article is partly motivated by the FTC (2003) report on the use of slotting in the grocery sector. As discussed in the Introduction, the FTC states that with a retailer may find it optimal to offer relatively high wholesale prices. allowances slotting Thereby themanufacturer has incentives to investmore in noncontractible sales effort than would otherwise be the case, and the retailer can be compensated for the high wholesale prices allowances

through the slotting fee.While this is correct, itmay leave the impression thatwholesale prices and sales effort investmentsare higher with slotting allowances thanwithout them.That is not = 0. Then the retailer's necessarily true.To see why, letus impose the restriction thatS profit is ? = w)q. A higher unit wholesale price (p simply equal to his profit margin times sales, nr reduces the retailer's profit margin but will also expand sales. At the outset, it is thus ambiguous whether dnjdw

is positive or negative. Using Equations

1, 7, and 11we find

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Slotting Allowances and Sales Effort

275

= l/. To

the smaller is*, the larger is thepositive shift in thedemand curve that the retailercan generate by increasing vv.For * < 1 thiseffectis sufficientlystrong to outweigh thedrop in the retailer'sprofit

> 1). If themarginal effortcosts (as measured by (j))are margin (while the opposite is true for <\> = 0, the retailermay overstimulate demand compared towhat maximizes sufficientlylow, and S aggregate profit for the firms.More precisely, inAppendix A we prove the following: 2. For

Proposition

services

demand

where

is sensitive

to the manufacturer's

effort,

(j)

<

1,

unit wholesale prices and investmentsare lowerwith slotting allowances (S* > 0) thanwithout = 0). slotting allowances (S that slotting allowances will be observed under a two-part tariff if a < a((|>). Proposition 2 holds for any distribution of bargaining power between the retailer and the manufacturer where a < a(), and it is easily verified that aggregate channel profit is always at Recall

least as high with slotting allowances as without them. The general insight fromProposition 2 is that themanufacturer's choice of effort levelwill

become more efficient from a channel point of view (higher aggregate profit) ifwe go from a situation with only linear wholesale prices to one with slotting allowances. But in general we cannot say whether this leads to higher or lower investments.

Welfare The main focus of this article is on the occurrence of slotting allowances versus franchising fees when themanufacturer makes noncontractible sales effort.However, we will also briefly discuss welfare effectsof slotting allowances, since thishas been the subject of numerous public investigations and debates. Following the convention in the literature,we define welfare as the sum of consumer surplus (CS) and aggregate profit (n): w

= es

+ n.

(20)

It is clear that aggregate profit cannot be lowerwith a two-part tariff(tp) thanwith linear wholesale pricing (Ip), since the firmshave one additional instrument at their disposal in the former case. For any distributions of bargaining power we thereforehave nrp While necessarily

>

n,p. (2i)

the ranking of profits between tp and Ip is independent of a, the same is not true

for

consumer

surplus.

To

see

why,

note

that

bargaining power under Ip, the lower is the unit wholesale manufacturer,

other

things

equal.

A

lower wholesale

price

the

larger

is

the

retailer's

price that he has to offer the

in turn

translates

into a

lower

end

user price. It can thus be shown that consumer surplus under Ip is decreasing in ot;dCSIda < 0. Specifically, thismeans that consumer surplus is higher if thewhole bargaining power belongs to the retailer (a = 0) than if itbelongs to themanufacturer (a = 1). In Appendix B we further show

that consumer

surplus

under

a two-part

tariff is somewhere

between

these

two extremes,

such thatwe have8 8 Note

thatwe do not need to specify who has the bargaining power with a two-part tariff;as shown above, the value of oconly determines the split of aggregate profit between the firms and does not affect prices or effort levels.

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Faros, Kind, and Sand

276

CSfp=?

> CS[p > CSJp=].

(22)

It is consequently unclear how consumers are affected by a change from Ip to tp\they are more likely to lose the stronger is the bargaining position of the retailer. = 1 The explanation of why CStp > CSf is that the double marginalization problem is

particularly pronounced if themanufacturer has the bargaining power and the firmsuse a linear wholesale tariff.Indeed, we will thenhave double marginalization even in the limit -? ^ because themanufacturer will always set w > c under Ip.Otherwise the firmwill make no profit. = 0 > CStp, recall that the only reason the retailermight prefer w > c is to To seewhy CSfp to make

the manufacturer

encourage

effort

investments.

However,

with

a linear wholesale

tariff

an increase inw has a direct negative effecton the retailer's profit.This isnot so with a two-part tariff,since a higher w then allows the retailer to charge a higher slotting fee, other things equal. This tends tomake the retailermore willing to offer themanufacturer a high unit wholesale

price. Indeed, he will be willing to increase w at the expense of a higher end-user price and lower downstream profit as long as total channel profit increases. In this sense the double marginalization problem ismagnified with a two-part tariffcompared to a linear wholesale

price where the retailer has the bargaining power; thereby, consumer surplus is lower in the former

case.

With respect to total welfare, we can state the following proposition: Proposition 3.Welfare with a two-part wholesale tariff (tp) is higher than welfare with linearwholesale pricing (lp) if (i) themanufacturer has the full bargaining power (a = 1) or (ii) e (0.72, 2.07). the retailer has the full bargaining power (a = 0) and <\> Proof.

4. How

B.

See Appendix

to Achieve

the Integrated Channel Outcome

The analysis above makes itclear that themanufacturer will not make any noncontractible effort investments unless w > c and that this generates a double marginalization problem, which implies that total profit is lower than in an integrated channel. In this section we shall briefly discuss revenue sharing, resale price maintenance, and delegation of retail pricing as ancillary restraints thatmay be used to solve thisproblem. In addition, we will discuss whether a disintegrated channel can achieve the same profit as an integrated channel if there are repeated

interactions

between

the retailer

and

the manufacturer.

Revenue Sharing Within the franchising literature it is often assumed that the franchisormay offer a three part

a

tariff to the franchisee:

sharing

rate

expressed

as

a

lump-sum fraction

franchising of

the

fee, a unit wholesale

franchisee's

gross

revenues

price, (see

and Lai

a revenue 1990).

An

= {S, analogous contract in thepresent case will be that the firmsuse a contract of the form Trs u\ 9}, where S is the slotting allowance, ivis the unitwholesale price, and 1 6 is the fraction of the gross retail sales revenue that the retailer pays to the manufacturer (the subscript rs We assume that 0 < 0 < 1. indicates that revenue sharing isused in addition to a two-part tariff).

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Slotting Allowances and Sales Effort

277

The timing structure is similar to thebasic model. The profits of the retailer and themanufacturer are given by TVr.v

=

(6/7

= Tlnurs

[(1

-

-

+

U')(V

-

a

p)

-

Q)P +

Holding A' fixed, and solving the FOC

+

S,

- S C](V + X p)

cnrjJdp

+

<\) . y

9 = 0 at stage 2, we find that

?.

Comparing Equations 4 and 23 we see that the retailer can ensure the same end-user price as under channel integration for any given a if he sets the unit wholesale price equal to 0c. = = 0, which implies that a Holding p fixed,we furtherfind from stage 2 that dn?hJdx \p(1 = 6c yields 6) + w c]l<\). Using Equation 23 and wrs

Ara From Equations under

This

channel

(,.

-

C)(l

6)

(Z4j

5 and 24 we note that the firms in the limitcan achieve the same effort level as integration

(a,,v

??

xic)

if 6 ?>

s, where

in turn implies that prs ?> pic. Consequently

instrument

-

? ? 24> (1 0)

to implement

the

integrated

channel

price;

s is an

arbitrary

small,

the unit wholesale whereas,

positive

number.

price is used as an

the revenue-sharing

parameter

is used to implement the integrated channel sales effort.The fixed feeS depends on a, as before. Resale

Price Maintenance

Under resale price maintenance (RPM) the retail price is decided by themanufacturer. A combination ofRPM and a wholesale pricemay then be used to achieve the channel integration outcome.10 The fixed fee determines the distribution of the total channel profit. The double marginalization problem is then avoided by limiting the retailer's control over the retail price. Until recently, therehave been general per se bans toward RPM both in theUnited States and in Europe. However, in June 2007 the U.S. Supreme Court overruled the nearly 100-year old Like other vertical per se ban on RPM (Leegin Creative Leather Products, Inc. v.PSKS2007).u now to RPM is be the rule of RPM and then be an available reason, restraints, may judged by instrumentto solve the typeof channel coordination problems considered in thepresent article.12 However, despite theLeegin case there isreason to believe thatRPM raisesmore antitrustconcerns compared to alternative vertical restraints,and theper se ban is still ineffect inEurope. Besides, in practice, it is potentially a problem that under RPM the retail price is not decided by the player with

the most

Delegation

hands-on

market

experience

(see, e.g., Rey

and Tirole

1986).

of Retail Pricing

Delegation of retail pricing may be an alternative solution to the double marginalization problem, and we shall briefly discuss how thismay work out. To this end, assume that the 9

Since c2nr rJcp2 = -29, the second-order condition is fulfilled if0 > 0. 10 We would like to thank one of the referees for proposing this alternative. " See Foros, Kind, and Shaffer (2008) for a discussion of some implications of the Leegin decision. 12 For an overview of the literature on RPM see Overstreet (1983) and Mathewson and Winter (1998).

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278

Foros, Kind, and Sand

retailer splits his activities between a headquarter (HQ) and a retail subsidiary, where the former is responsible for procurements (the bargaining with themanufacturer) and the latter for end-user

We

pricing.

the same

maintain

basic

timing

as we

structure

have

used

This

earlier.

means

thatHQ bargains thewholesale contract with themanufacturer at stage 1.The good is then sold from theHQ to the retail subsidiary at a unit transferprice t that is possibly different

from iv.The retail subsidiary thus perceives t as the realmarginal costs when itdetermines the end-user

its own

that maximizes

price

at stage

profit

manufacturer

her

decides

sales

effort,

2 (simultaneously

with

the manufacturer's

can credibly commit to the size of t before the

choice of sales effort). If the retailer HQ

the firms may

the same

achieve

outcome

as under

channel

integration (where the fixed fee S depends on oc). What begs a question is in particular whether the HQ has the ability to commit to an observable arm's length transferprice before themanufacturer decides the level of sales effort. If not, then the best theHQ can do is to set t = u\ and delegation will not solve the double marginalization problem. This resembles the result inHirshleifer (1956).

Interaction

Repeated

to

Due

the

nature

noncontractible

of

the manufacturer's

sales

there

effort,

a

exists

commitment problem for the disintegrated channel in a one-shot game with a simple two-part tariff.From the well-known "Folk theorem" in repeated games, we know that the use of appropriate trigger strategies to punish deviations from the joint profitmaximization outcome can help solve the problem, provided that there is not too much discounting of futureprofits in an infinitelyrepeated game.13 Note, however, that we do not have to rely on tacit collusion

between

the

parties,

since

we

a

consider

vertical

where

relationship

contracts

formal

are

unlikely to raise any legal concerns from competition authorities. Note also that in the present model themanufacturer is the only firm that has an incentive to deviate from the joint profit maximization solution. Any sharing of surplus according toNash bargaining with oc< 1 results

in the manufacturer receiving a share oc of the ex post surplus, while the full cost of the noncontractible retail sales effort is carried by themanufacturer ex ante. This is similar to the problem ofmoral hazard in teams, and a possible solution could be to specifya contract where the manufacturer sufficiently

a

receives

from

its expected

inspired by Hart and Moore possible

after

5. Concluding A

the retailer

share

disadvantageous value

in one

or

several

of

the

surplus

periods.14

An

if demand alternative

deviates approach,

(1988), could be to investigate the case where renegotiation is

and manufacturer

have

chosen

prices

and

sales

effort.

Remarks

manufacturer's

incentives

to undertake

noncontractible

investments

depend

on

the

profitmargin on her sales to the retailer. Slotting allowances can facilitate such incentives by increasing unit wholesale prices. It is therefore tempting to conclude that slotting allowances 13 See, e.g., Friedman

(1971) or Rubinstein (1979). Similarly, the joint profit maximization outcome can be supported by trigger strategies if, in a finite game of uncertain duration, there is sufficiently high probability that the game continues to the next period. 14 See, e.g., Holmstrom (1982).

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279

Slotting Allowances and Sales Effort

should be particularly prevalent for product categories where themanufacturer's scope for undertaking noncontractible sales effort is relatively large. However, this is at odds with the FTC's finding that slotting allowances are more commonly used for nonperishable products? where demand presumably

is relatively insensitive to noncontractible sales effort?than for

perishable products. In this article we have set up a simplemodel with one manufacturer and one retailerwhere the predictions from themodel are consistent with the observations reported by theFTC. For product categories where there is significant scope for stimulating demand through noncontractible sales effort by themanufacturer, slotting allowances will not occur. On the other hand, we are more likely to see slotting allowances for goods where the scope of effort

noncontractible

relationship between

is more

limited.

Our

thus accentuates

model

retailers' bargaining power and

that

there

the frequency and

is no

one-to-one

size of slotting

allowances.

our knowledge there are few empirical analyses of whether the distribution of bargaining power differs between product categories. One exception is Sexton and Zhang (1996), who find support for high retail bargaining power for agricultural products due to the To

severe inelasticityof supply. Furthermore, we observe that retailerswith significantbargaining power provide support for product innovation to manufacturers, and such support may be interpretedas a fixed fee (i.e., a franchising fee). However, the empirical literatureon slotting allowances (e.g., Bloom, Gundlach, and Cannon 2000; Sudhir and Rao 2006) typically restricts the attention to cases with positive slotting allowances. There is thus a need for empirical analysis investigating the distribution of bargaining power and the use of slotting allowances versus

franchising

fees

across

product

categories.

it clear that unit wholesale prices?and

Finally, this article makes

be

investments?may

demand-enhancing

lower

with

two-part

wholesale

thus noncontractible tariffs

than without

them.The total channel profitwill obviously be higherwhen two-part tariffsare used compared to the case with linearwholesale pricing. However, in contrast to the case where it is the retailer who undertakes noncontractible sales effort,a two-part tariff is not sufficient to resemble the outcome under channel integration in the case at hand. The coordination problem is thusmore difficultwhen it is themanufacturer who undertakes noncontractible sales effortcompared to the case where the retailer determines both price and effort. for vertical merger incentives. Since it ismore difficult to

This may have consequences resemble

the channel

integration

outcome

when

the manufacturer

undertakes

noncontractible

effort thanwhen the retailer undertakes such effort, the incentives for vertical mergers may, all other things equal, be higher in the former than in the latter case.

Appendix

A: Proof of Proposition

2

Let us consider

the outcome under linear wholesale pricing and introduce the constraint 14 becomes bargaining game at stage 1.The FOC with respect to ir in Equation -

0 on

the

_ _ _ "i) + (?, ?.)(1 f)(1. f) (A1) -] [(*?,)'<*,)' I To indicate how a restriction on pricing structurewould influence prices and effort,we compare the outcome with in 15 into Equation Al, the FOC linear wholesale pricing and a two-part tariff. By inserting for ir = w* in Equation Equation Al becomes =

_a(^o(..'->

-?[

that 5 =

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280

Foros, Kind, and Sand

= ^

^\(nmr(nr)]

-

2(1

tp;.V*. (A2)

where 5 is given by Equation 16.When Equation A2 is positive, the unit wholesale price (and consequently the level of manufacturer's sales effort)will be higher under linear wholesale pricing than with a two-part tariff.This is the case if a < i((J)). such that S* > 0, and (j)< 1. QED.

Appendix With

B: Proof of Inequality 22 and Proposition the demand

1we can express consumer surplus as

function in Equation

CS =

(A3)

^.

A3 we find that consumer surplus under a two-part tariffequals

17 into Equation

Inserting for Equation

3

l / (Ki + 4>)

=

CS?

12 and 15we further find that Ulp = can tariff be part expressed as

Using Equations

iv

4^^+'c^

?

+

?i^-.4

)- (A4)

(v-<

,

welfare under a two <7- Summing CSlp and TI//?,

3+3)(l.-0=. (A5)

8[A/((t))+ (|)] The outcome of the second stage, where themanufacturer chooses the effort level and the retailer chooses the end user price, is given by Equation 11, independent of whether we have a two-part wholesale tariffor only linear wholesale pricing. Suppose that we have a linear wholesale price, and that the manufacturer has the whole bargaining power. = Solving \vlp arg max ttm in this case yields

?%'=

CSl=


'=

L^S ~

and4=

1=

- < ): (A6)

^(r

'= rf and lp WV /;' !?^?^1(?

_

32(j)2

32(j)2 If instead the retailer has the bargaining power, we solve \vlp= arg max nR.We

? 4>> 1 : ?r = 4 4>e(V l)

"= 0; = CSr{) JO' ^ : /;'

^ cj) 8(()2

^

(A7)

cf.

then find

= ?=

0' ~ f (A8)

8(})2

For consumer surplus we now find a =

CS?,

1 : -

7. =

cs

_

a = es

_

CSJ 0

<= + 2ci)2jrii= i1_ (l = cj>2n^((i>).+ (? ll2l3 ?-^r>,,x + 32[iV(4>) (MV

and (j)g

CSJr''' 0

-d

o=

and (J)>

cs*

1 : ^(j), ^

=<> =

~

8c|)2[W((j)) +

4>)(4>2

+

d>-

(j)]2 [A/((j))+

>

0-

0

l)(r-r)+
(J)2+

<

Q

(|)3]'"'

1 : ~

~

r)2 " '< + + + (J)2] 2cj) 8[/V(cl)) (|)]2[N{
o.

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(A9)

281

Slotting Allowances and Sales Effort inequalities in Equation For welfare we have * =

1 :

~ ~ * ) (V -^ C)-r+ (t>]>2(5())2 + 6ct) 32[iV((j)) 3)

= Wtp Wl=x

oc= 0 and (j)g M/

= o_

??

a =

0

H/ -

Proposition

22.

A9 prove Equation

The

^(j),1^ (34>4

= ?=

: 7*3-9*

+

3)(v-c)2

+ (t)Sc^A^) + cf)]2(ct)2

and (j)>

H/?

+

<

l)~

(A10) 0forcj)6 U,

0.72

1 :

2(b3 + 8d> ^ (d)2 f -y-A-^

3)(v

8[^(d>)+ (j)]2

3 follows from Equation

> 0 for4 * 1

-

c)2 <

0 for (j)>

2.07.

A10. QED.

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