Vertical collusion

• DOI: http://doi.org/10.1111/1756-2171.12308
• Author: Yaron Yehezkel,David Gilo
• Published date: 01 March 2020
• Date: 01 March 2020

RAND Journal of Economics

Vol.51, No. 1, Spring 2020

pp. 133–157

Vertical collusion

David Gilo∗

and

Yaron Yehezkel∗

Wecharacterize collusion involvingsecret vertical contracts between retailersand their supplier—

who are all equallypatient (“vertical collusion”). We show such collusion is easier to sustain than

collusion among retailers. Furthermore, vertical collusion can solve the supplier’s inability to

commit to charging the monopoly wholesale price when retailers are differentiated.The supplier

pays retailers slotting allowances as a prize for adhering to the collusive scheme and rejects

contract deviations. In the presence of competing suppliers, vertical collusion can be sustained

using short-term exclusive dealing.

1. Introduction

This article asks what are the features of ongoing collusion involving not only retailers, but

also their joint supplier (all of whom are strategic playerscaring about future profits), and whether

such collusion is more sustainable than collusion among retailers that does not involvea forward-

looking supplier. Retailers (or other intermediaries) would prefer to collude at the expense of

consumers, but competition among them is often too intense to support such collusion. Retailers

typically buy from a joint supplier, where all firms interact repeatedly. The supplier is typically

a strategic player too, who, like retailers, cares about future profits. This raises the question: can

including the supplier in the collusive scheme improvethe prospects of collusion, and if so, how?

We consider an infinitely repeated game involving competing retailers and a joint supplier

(we later extend the model to multiple suppliers). In everyperiod, retailers offer secret, one-period

two-part tariff contracts to the supplier,and then play a game of incomplete information by setting

retail prices without observing the contract offer their rival made to the supplier. All three firms

∗TelAviv University; gilod@tauex.tau.ac.il, yehezkel@tauex.tau.ac.il.

We thank Ayala Arad, Giacomo Calzolari, Chaim Fershtman, Bruno Jullien, David Myatt (Editor), Markus Reisinger,

Patrick Rey, Tim Paul Thomes, Noam Shamir, Yossi Spiegel, and three anonymous referees as well as participants at

the MaCCI 2016 conference in Mannheim, the CRESSE 2016 conference in Rhodes, the D¨

usseldorf 2017 workshop

on Vertical Chains, The STILE 2017 law and economics workshop, the ALEA 2018 annual meeting, and seminar

participants at Tel-Aviv University, the Hebrew University, the Interdisciplinary Center in Hertzelia, Bar-Ilan University

and the University of Bergamofor helpful comments. We thank the Israeli Science Foundation, the Cegla Institute, the Eli

Hurvitz Institute for Strategic Management and the Henry Crown Institute for Business Research in Israel for financial

assistance and AylaFinberg, Lior Frank, Michael Leshem, Noam Lev, Hadar Shaked Itzkovitz,Yogev Sheffer,Haim Zvi

Yeger and Nofar Yehezkel, for research assistance.

C2020, The RAND Corporation. 133

134 / THE RAND JOURNAL OF ECONOMICS

have the same discount factor,so that retailers cannot rely on a more patient supplier to assist them

in colluding. As vertical contracts are secret, retailers cannot use observable vertical contracts as

a commitment device in order to raise the retail price.1

We find that the retailers and the supplier can engage in a collusive scheme involving all of

them. We refer to such a scheme as “vertical collusion.” Each of the three firms has a short-run

incentive to deviate from collusion and increase its own current-period profit at the expense of

the other two, yet they collude because they all gain a share of future collusive profits, should

they adhere to the collusive scheme in the current period. The three firms manage to do so even

when retailers are too shortsighted to maintain standard horizontal collusion between themselves.

Hence, vertical collusion is easier to sustain than horizontal collusion.

The collusive mechanism works as follows.In every period, each retailer asks the supplier to

pay the retailer a fixedfee. The fixed fee implicitly rewards the retailer for adhering to the collusive

price in the previous period, and increases the retailers’ future gains from collusion. Retailers

expect that the supplier will continue rewarding them in the future only if they maintain the

collusive scheme. The supplier, for his part, does not agree to pay retailers fixed fees unless they

offer him a higher wholesale price than the one he would receive absent collusion: the supplier

expects that retailers will continue rewarding him in the future with a high wholesale price only

if he maintains the collusive scheme. Hence, the collusive mechanism involves transferring some

of the retailers’ collusive profit in a current period to the supplier (through higher wholesale

prices paid to the supplier), and receiving part of these profits back in the future, conditional on

colluding in the current period. The higher wholesale price, too, has repercussions on the retailers’

incentives to collude: although it lowerstheir profits from deviating from collusion, it also lowers

their profits from colluding. Wederive a general condition under which these repercussions either

further increase, or do not substantially decrease, the retailers’ incentive to collude, and show that

this condition holds at least when retailers are close substitutes.

For vertical collusion to be sustainable, parties need to be induced not to deviate from these

collusive vertical contracts. This is challenging when vertical contracts are secret, because one

retailer does not observe whether the other retailer made a side-deal with the supplier in order

to deviate from collusion. We show that when a retailer attempts to deviate from the collusive

price by offering the supplier a different vertical contract without compensating the supplier, the

supplier rejects the retailer’s offer and refuses to sell him the product. Having to compensate the

supplier to avoid such rejection renders the retailer’s deviation unprofitable.

We then extend the analysis to the case of multiple suppliers competing over selling a

homogeneous product to homogeneous retailers. We show that there is a vertical collusion

equilibrium in which retailers endogenously offer, in every period, to buy exclusively from the

same supplier. Hence, the collusive equilibrium is sustained with single-period exclusive dealing

commitments. The supplier is induced to assist this vertical collusive scheme, because otherwise

he makes no profits, due to intense competition from other suppliers. We assume a retailer can

renegotiate the contract when the supplier informed him, in the form of cheap talk, that the

competing retailer did not offer to buy exclusively from the supplier. We show that the supplier

is induced to reveal the truth.

Our results have several policy implications. In particular, we identify practices that may

have the potential, in appropriate market circumstances, to be harmful to competition. Our results

can be used as a factor that can shed new light on the antitrust treatment of these practices, and

that can be balanced against their possible virtues.

First, the article sheds a new light on exclusive dealing arrangements, where a retailer

promises to buy from a single supplier. We show that exclusive dealing agreements between

1Importantly, exchangeof infor mation among retailers competing in a downstreammarket regarding the terms of

their contracts with a supplier is likely to be an antitrust violation. See Department of Justice/Federal Trade Commission

(2000); European Commission (2011); Federal Trade Commission (2011); OECD (2010); and New Zealand Commerce

Commission (2014).

C

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