Slotting allowances and manufacturers' retail sales effort.

• Author: Foros, Oystein

1. Introduction

   Slotting allowances, which are fixed fees that manufacturers pay to retailers, are widespread in the grocery industry (Lariviere and Padmanabhan 1997; Bloom, Gundlach, and Cannon 2000). Such fees have also become common in bookstores, drugstores, and record stores (Wilkie, Desrochers, and Gundlach 2002; Klein and Wright 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, by mitigating 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 larger is the retailers' bargaining power over the manufacturers.

   The Federal Trade Commission (FTC) accentuates three potential efficiency rationales for the use of slotting allowances: (i) signaling the quality of a new product, (ii) screening among several new products, and (iii) increasing manufacturers' incentives to make 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 channel coordination problems when manufacturers can undertake demand-enhancing investments that are difficult to observe and/or verify for the retailers. Such investments are by their very nature more or less noncontractible (see discussion by Lal 1990; Desai 1997).

   A manufacturer's incentives to undertake noncontractible investments depend on the proft margin 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 facilitate manufacturers' choice of, for example, advertising, packaging, and warehousing.

   The FTC (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 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 significant part of manufacturers' demand-enhancing effort cannot be observed and verified).2 The empirical findings by the FTC and Sudhir and Rao are thus puzzling and seemingly inconsistent with the prediction that manufacturers' noncontractible investments are an important rationale behind the usage of slotting allowances.

   In this article we try to give an explanation for the puzzle through a simple two-stage game between a downstream firm ("retailer") and an upstream firm ("manufacturer"). At the last stage the retailer sets the end-user price, and the manufacturer decides if and how much to invest in noncontractible sales effort. At the first stage there is a Nash bargaining game between the manufacturer and the retailer over the wholesale contract. The wholesale contract consists of a linear wholesale 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).

   Consistent with the FTC's prediction, we show that it may be in the retailer's own interest to pay the manufacturer a unit wholesale price above marginal costs. Otherwise the manufacturer will have no incentives to make demand-enhancing noncontractible investments. However, in contrast to conventional wisdom we find that the unit wholesale price is not necessarily higher with slotting allowances than without them. Indeed, the opposite may be true. The reason for this is that if the wholesale contract specifies only a unit price and no fixed 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 profit margin. He may, therefore, find it profitable to pay such a high unit wholesale price that the manufacturer undertakes larger demand-enhancing investments than what is optimal from a channel point of view.

   With a two-part wholesale tariff the aggregate profit will be distributed between the retailer and the manufacturer according to their bargaining power. They will consequently have a common interest in maximizing channel profit, and neither of the parties will have incentives to stimulate demand above what maximizes aggregate profit. This explains why the unit wholesale price--and thus demand-enhancing noncontractible 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 from manufacturers, potentially plays an important role in stimulating demand for most kinds of goods. What matters for our analysis is not the size of sales effort as such, but whether demand is sensitive to noncontraetible sales effort by the manufacturer.

2. Some Related Literature

   Shaffer (1991), who may be considered the founder of the market power school, analyzes competition between two retailers in the end-user market. He assumes that the retailers have complete bargaining power over manufacturers 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 the wholesale and the enduser 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 effect may be so strong that both retailer profit and consumer surplus are higher with slotting allowances than without them. (4)

   The present analysis is most closely related to the strand of literature that analyzes how vertical restraints can solve channel coordination problems. Since bargaining power conventionally has been assumed to be in the hands of the manufacturer (the franchisor), the majority of papers focus on noncontractible sales effort by the retailer (the franchisee). If the manufacturer has all the bargaining power, and the retailer is the one who makes unobservable sales effort, we will, in absence of vertical restraints, have a standard double marginalization problem. In this case the manufacturer may achieve 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., Lal 1990). Lal (1990), Desai (1997), and Rao and Srinavasan (1995) assume that both the retailer and the manufacturer undertake value-adding sales effort that cannot be observed by the other party. Lal (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 tariff is unable to achieve the outcome with channel integration even if only the manufacturer undertakes a noncontractible sales effort.

   The channel coordination problem is thus more complex if the manufacturer is the one that makes noncontractible effort, compared to the case where the retailer makes such effort. The reason is that when the retailer makes noncontractible effort, he will internalize the demand-enhancing effect of this effort when he sets the end-user price. A two-part tariff is then sufficient to replicate the outcome under channel integration (see Lal 1990). In contrast, a manufacturer can only be induced to make noncontractible effort to the extent that the unit wholesale price is set above marginal production costs. However, this will at the same time induce a double marginalization problem, and a two-part tariff is not sufficient to achieve the same outcome as under 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 frequently used for less perishable products. In their model tougher retail competition leads to more slotting allowances, and competition is more intense for nonperishable products. Hence, Kuksov and Pazgal (2007) and the present article may offer complementary and mutually reinforcing explanations for the above mentioned puzzle.

3. The Model

   We consider a channel model with one retailer and...