1 THE ECONOMICS OF SLOTTING CONTRACTS Joshua D. Wright George Mason University Silicon Flatirons Law and New Institutional Economics Workshop June 4, 2009

2 This paper is co-authored with Benjamin Klein and appears at 50 J.L.E. 421 (2007) Empirical follow up piece for those interested: Slotting Contracts and Consumer Welfare, 74 Antitrust Law Journal 439 (2007).

3 Slotting arrangements: per unit time payments made by manufacturers to retailers for shelf space. usually bind the grocer to provide shelf placement for a six month to one year period can cover both new and established products arose in grocery retailing around 1984 over the past 20 years, have become more pervasive, increasing in size and covering a larger number of grocery products have attracted a considerable amount of antitrust scrutiny including numerous Congressional and FTC hearings, litigation, and proposed legislation

4 Anticompetitive theories grounded in retail bargaining power and/or manufacturer exclusion of rivals do not explain the growth and prevalence of slotting contracts: Frequently used by manufacturers and with small market shares Most involve only short-term shelf space commitments Significant economies of scale in manufacturing are absent for many grocery products where we observe slotting contracts Anticompetitive theories do not explain the growth of supermarket slotting contracts in the 1980s

5

6 Two key economic questions that must be answered with respect to slotting fees are: 1)Why must manufacturers explicitly contract with retailers for the provision of shelf space? 2)Why does the shelf space contract often involve a per unit time payment to retailers rather than a wholesale price reduction?

7 Slotting contracts solve incentive incompatibility involving retailer undersupply of promotion when there are little or no inter-retailer competitive effects from the supply of promotional shelf space

8 A Promotional Services Theory of Slotting Contracts Retailers supply less than the joint profit-maximizing level of promotion because they do not consider the manufacturer profit margin on incremental sales For many products the retailers incremental profit (P R – MC R ), is a small fraction of the manufacturers incremental profit (P W – MC M )

9 inter-retailer competitive effects offset the relatively small retail margin to approximately produce the optimum amount of retail price competition (1) (P R – MC R ) = (P W – MC M ) For Price Competition:

10 is much greater than because there are inter-retailer competitive effects in addition to inter-brand competitive effects

11 However, because promotional shelf space creates impulse sales, there are small inter- retailer demand effects (2)

12 Therefore (3) (P R – MC R ) < (P W – MC M )

13 The distortion is not present on all forms of non- price competition. If consumers value the non-price service and will switch retailers in response to its supply, e.g., free parking, the joint profit- maximizing quantity will be supplied. (P R – MC R ) = (P W – MC M )

14 In these fairly general circumstances, the manufacturer will want the retailer to provide more promotional shelf space for its products than the retailer would otherwise provide and a separate contract for shelf space will be necessary. The greater the manufacturer margin compared to retailer margin, the greater is this distortion.

15

16 Because retailers do not adequately take account of manufacturer profitability on incremental sales in deciding on product shelf space allocation. retailers will allocate shelf space across products so that retailer incremental profi t, or (P R – MC R ), is approximately the same across all products. 1.Retailers will not have the incentive to stock the right products, i.e., the products that maximize the joint profit of the manufacturer and retailer.

17 2.Even if every product had the same manufacturer margin and the same effect of shelf space on its impulse sales, each manufacturer would desire that increased promotional shelf space be provided for its products, increasing the value of retailer shelf space. This does not mean that retailers will earn extra profit.

18 1.a retailer premium to cover the cost of supplying the promotional shelf space must be created easier to accomplish with per unit time payment but possible with lower wholesale price 2.there may be large manufacturer efficiencies associated with a lower wholesale price 3.shelf space and exclusivity The Efficient Form of Slotting Contracts

19 Conclusions This paper provides a pro-competitive justification – resolving incentive conflicts over the provision of promotional services -- for manufacturer purchase of retail shelf space The antitrust experience with slotting contracts in the United States appears to confirm the historical tendency to condemn business practices before they are sufficiently well understood