Vanderbilt University1 Vertical Restraints & Effects of Upstream Horizontal Mergers: Does the Retail Sector Matter? Luke Froeb April 12, 2002 University of Florida

Vanderbilt University2 Related work Pass Through rates and the Price Effects of Mergers mba.vanderbilt.edu/luke.froeb/papers/ Coauthors, Steve Tschantz & Greg Werden Views are my own, do not purport to represent those of my co-authors or Justice or FTC.

Vanderbilt University3 Talk Outline Policy & Theory Background I will go over fast unless I get questions 3 Games of retailer-manufacturer behavior Empirical Example of a Chicago Bread Merger in each Game Conclusions & Unanswered questions

Vanderbilt University4 Background: Retail Sector is Consolidating in US In US, Wal-Mart, Kmart, Target, Costco, and Sears—account for 60 percent of general- merchandise sales General-merchandise is 15 % of all retail sales Productivity advantage over smaller retailers Economies of scale Economies of purchasing Economies of distribution

Vanderbilt University5 Productivity Gains Associated with Industry Consolidation

Vanderbilt University6 Retail consolidation also in Europe In EU, top 10 grocery stores forecast to increase share to 50-60% Currently at 38% Wal-Mart entering Europe Also entering South America

Vanderbilt University7 Policy Reaction to Retail Consolidation FTC challenging some retail mergers Blocked Kroger + Winn-Dixie Blocked Staples + Office Depot Competitive analysis based on increase in local (within-city) horizontal market power “standard” horizontal analysis

Vanderbilt University8 Standard Horizontal Analysis: Benefit-Cost of Merger Goal: quantitative estimate of merger effect. Necessary to weigh efficiencies against loss of competition Two methodologies Model-based simulations “Natural” experiments, e.g. Staples-Office Depot

Vanderbilt University9 Model-based simulation Model current competition Estimate model parameters Simulate loss of competition using estimated parameters Merger effects modeled as difference between pre- and post-merger Nash equilibria

Vanderbilt University10 Model-based Simulation: Kroger + Winn Dixie Estimate “Gravity” choice model Survey density in Charlotte, NC Dots represent grocery stores

Vanderbilt University11 Pre-merger Equilibrium: Share of Kroger + Winn-Dixie

Vanderbilt University12 Post-merger Equilibrium: Share of Kroger+Winn-Dixie

Vanderbilt University13 Empirical Comparisons e.g., Staples-Office Depot Prices 6% higher in 1- superstore cities 15% pass through 40%=6%/.15 compensating MC reduction big pass-through  big merger effect, Both depend on demand curvature So estimate merger effects and pass-through rates together.

Vanderbilt University14 Theory & Policy Towards Horizontal vs. Vertical restraints Horizontal Widespread consensus on how to model horizontal restraints. Collusion or “unilateral” effects Policy debate is empirical Vertical No consensus on how to model vertical restraints. Policy debate is theoretical Or on “necessary conditions,” e.g., market-share screens

Vanderbilt University15 Questioning the Consensus on Horizontal Restraints How do vertical restraints change standard horizontal merger analysis which ignores retail sector? Focus of paper How do vertical restraints affect our understanding of retail consolidation? Does standard horizontal analysis suffice? Not going to answer this one.

Vanderbilt University16 Methodology: put Monopoly Retail sector on top of Bertrand Manufacturing Oligopoly Strategic form bargaining game (n+1 players) Upstream Bertrand oligopolists (n) make take-it- or-leave-it offers to retail monopolist (1) Retailer chooses the best set of offers  Pre-merger Nash equilibrium Then, two upstream manufacturers merge Merger effect is difference between pre- and post- merger equilibria What happens to retail prices and quantities?

Vanderbilt University17 Results: the retail sector matters--a lot. Upstream horizontal mergers can have a variety of effects when “filtered” through retail sector Transparent retail sector Opaque retail sector Double marginalization Can amplify merger effects, or Attenuate them

Vanderbilt University18 Three Different Games Game 1: retailer must carry all profitable products  Transparent retail sector Game 2: retailer has option of exclusive dealing  Opaque retail sector Game 3: manufacturers limited to offering wholesale unit prices independent of quantity  Double marginalization Can amplify or attenuate merger effects

Vanderbilt University19 Game 1: retailer must carry all profitable products Retailer internalizes price effects between products Manufacturer Set w’ to maximize profitability on own product Wholesale price below marginal cost to induce Bertrand prices

Vanderbilt University20 Game 1: continued Manufacturers set wholesale prices below mc to induce Bertrand (non- cooperative) pricing at retail level Collect all profit (rev.) with fixed fees Pricing & Merger effects are same as would occur if Manufacturers sold directly to consumers.

Vanderbilt University21 Game 2: Retailer has Option of Exclusive Dealing Retailer has four options Exclusive dealing with Mfg. 1, total profit=T 1 Exclusive dealing with Mfg. 2, total profit=T 2 Joint dealing with Mfg. 1 and 2, total profit=T J Neither, total profit =0 Mfg.’s make contingent offers to retailer using two-part prices O’Brien & Shaffer (1997) and Bernheim & Whinston (1998). Equilibrium is “efficient” in that Mfg’s transfer at mc, and retailer maximizes joint profitability

Vanderbilt University22 Game 2: Continued Profit split: winner must outbid next best alternative 1 is most valuable alternative: T 1 >max(T 2, T J ) 1’s profit=T 1 - T 2; 2’s profit=0 ; retailer’s profit=T 2; 1 and 2 are substitutes: T 1 +T 2 > T J > max(T 1, T 2 ) 1’s profit=T J - T 2; 2’s profit=T J - T 1; retailer’s profit=T 1 + T 2 - T J 1 and 2 are complements: T J > T 1 +T 2 > max(T 1, T 2 ) retailer’s profit=0

Vanderbilt University23 Game 2: continued Manufacturers set wholesale prices at marginal cost Retailer maximizes total profit Retailers paid their marginal contribution to total profit Mergers do not change retail prices But do transfer profit from retailer to merged manufacturers

Vanderbilt University24 Game 3: Wholesale prices are independent of quantity Retailer profit (same) internalizes price effects between products Manufacturers face derived demand, q* Bertrand equilibrium with derived demand. Wholesale margins are functions of elasticity of derived demand Depends on pass- through rates from wholesale to retail

Vanderbilt University25 Game 3: continued Prices “too high”—double marginalization. Big wholesale margins Derived demand is usually less elastic than retail demand because Wholesale prices are lower (which makes percentage price changes bigger) Pass-through rates can be less than one Merger effects can be higher or lower

Vanderbilt University26 3 Retail Games Illustrated: White Pan Bread in Chicago All calibrated to same prices, quantities, pre-merger elasticities (logit demand)

Vanderbilt University27 Model Calibration

Vanderbilt University28 Merger of Brands 1+2

Vanderbilt University29 Merger of 1+2 w/AIDS Demand

Vanderbilt University30 Logit vs. AIDS Demand Pass through rates for logit (95%), linear (near 50%) demand are less than one. Relatively inelastic derived demand Pass through rates for AIDS (180%), Constant Elas (near 200%) demand are higher Relatively elastic derived demand

Vanderbilt University31 Conclusions Retail sector matters a lot for standard horizontal merger analysis Constant mark-up or percentage mark-up usually assumed which is transparent case. Not correct if “opaque” or “double marginalization”. Empirical Identification of retail game Games have negative, zero, and positive wholesale margins, respectively.

Vanderbilt University32 Unanswered Questions How do retailer’s behave? Sales agents compensated on revenue commission Positive wholesale margins Complex nonlinear contracts with promotional allowances, quantity discounts is two-part pricing a good metaphor? What about the n X k case (n manufacturers, k retailers)? Retailers compete on selection, price, convenience. Does opaque equilibrium hold for n X k case?