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
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact
[email protected].
Southern Economic Association is collaborating with JSTOR to digitize, preserve and extend access to Southern Economic Journal.
http://www.jstor.org
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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.
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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.
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
(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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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.
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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).
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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).
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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).
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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 =
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
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.
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
(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.
References Bloom, Paul N., Greg T. Gundlach, and Joseph P. Cannon. 2000. Slotting allowances the view of practicing managers. Journal ofMarketing 64:92-108.
signaling and screening in channels of distribution. Marketing Science 11(4):324-47. 1997. Advertising fee in business-format franchising. Management Science 43( 10): 1401-19. to retain retailers: Signaling new product demand. Marketing Science Preyas. 2000. Multiple messages 1992. Demand
Chu, Wujin. Desai, Desai,
and fees: Schools of thought and
Preyas.
19(4):381-89. Farrell, Joseph. 2001. Some of Justice.
thoughts on slotting allowances
and exclusive dealing. Washington,
DC:
U.S. Department
(FTC). 2001. Report on theFederal Trade Commission Workshop on slotting allowances and other marketing practices in thegrocery industry.Washington, DC: U.S. Government Printing Office. Federal Trade Commission (FTC). 2003. Slotting allowances in the retail grocery industry: Selected case studies infive product categories. November. Washington, DC: U.S. Government Printing Office. Federal Trade Commission
Foros. Oystein, and Hans J. Kind. 2008. Do slotting allowances harm retail competition? Scandinavian Journal of Economics 110(2):367-84. Foros, Oystein, Hans J. Kind, and Greg Shaffer. 2008. Resale price maintenance and restrictions on dominant firm and industry-wide adoption. Working paper, Norwegian School of Economics and Business Administration. James. 1971. A non-cooperative equilibrium for supergames. Review of Economic Studies 38:1-12. 1988. Incomplete contracts and renegotiation. Econometrica 56:755-85. Hart, Oliver, and John Moore. Friedman,
Hirshleifer, Jack. 1956. On economics of transfer pricing. Journal of Business 29:172-84. 13:324-40. Holmstrom. Bengt. 1982. Moral hazard in teams. Bell Journal of Economics Klein,
Benjamin,
and Joshua D. Wright.
50(3):421-54. Kuksov, Dmitri, and Amit Pazgal. 26(2):259 67.
2007. The
economics
of slotting contracts. Journal of Law
and Economics
2007. The effects of cost and competition on slotting allowances. Marketing
Science
Lai, Rajiv. 1990. Improving channel coordination through franchising. Marketing Science 9(4):299-318. 1997. Slotting allowances and new product introductions. Marketing Lariviere. Martin, and V. Padmanabhan. 16(2): 112-28..
Science
Marx.
Leslie M., Economics
Mathewson,
and Greg Shaffer. 2008. Up-front payments and exclusion
in downstream markets. RAND
Journal of
38(3):823-43.
Frank, and Ralph A. Winter. 13:405-27.
Organization Overstreet, Thomas.
1998. The
law and economics of resale price maintenance.
1983. Resale price maintenance: Economic
Review of Industrial
theories and empirical evidence. Washington,
DC:
Bureau
of Economics. Rao.
Akshay
R..
and Humaira
Mahi.
affecting the relative magnitude
2003. The price of launching a new product: Empirical of slotting allowances. Marketing Science 22(2):246-68.
evidence on factors
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions
282 Rao.
Faros, Kind, and Sand Ram C. Economics
and Shubashri
Srinavasan.
1995. Why
are royalty rates higher in service-type franchises? Journal of
and Management
Strategy 4(1):7-31. Rey, Patrick, and Joseph Stiglitz. 1995. The role of exclusive territories in producers' Economics 26:431-51.
competition. RAND
Journal of
Rey, Patrick, and Jean Tirole. 1986. The logic of vertical restraints. American Economic Review 76(5):921-31. in supergames with the overtaking criterion. Journal of Economic Theory 21:1-9. Rubinstein, Ariel. 1979. Equilibrium 1996. A model of price determination for fresh produce with application to Sexton, Richard, and Mingxia Zhang. California iceberg lettuce. American Journal of Agricultural Economics 78(4):924-34. Shaffer, Greg. 1991. Slotting allowances and retail price maintenance: A comparison of facilitating practices. RAND Journal of Economics 22(1): 120-35. Shaffer, Greg. 2005. Slotting allowances and optimal product variety. B.E. Journals in Economic Analysis & Policy 5(3):l-26. and Vithala R. Rao.
2006. Do slotting allowances enhance efficiency or hinder competition? Journal of 137-55. Research 43(2): Marketing and the market for new products. Journal of Law & Economics 1997. Slotting allowances Sullivan, Mary W.
Sudhir, K.,
40(2):461-93. Wilkie, William L., Debra M. Desrochers, and Gregory T. Gundlach. 2002. Marketing case of slotting fees. Journal of Public Policy & Marketing 21(2):275-88.
research and public policy: The
This content downloaded from 140.109.160.40 on Mon, 25 Aug 2014 07:57:38 UTC All use subject to JSTOR Terms and Conditions