1

By Zhiqi Chen* Carleton University August 21, 2001

The growing dominance of powerful big-box retailers in recent years has enhanced the interests in Galbraiths (1952) hypothesis of countervailing power. The objective of this paper is to assess rigorously this hypothesis using a theoretical model that captures the main ingredients of Galbraiths arguments as well as some of the important features of retail industry. It is demonstrated that consistent with the hypothesis an increase in the amount of countervailing power possessed by a dominant retailer can indeed lead to a fall in retail price for consumers. But this fall in retail price is not the result of a benevolent retailer acting on behalf of consumers but of a self-interested supplier trying to offset the reduction in profits caused by the rise in countervailing power. Total surplus does not always increase with the rise of countervailing power because of the possible efficiency loss on production side. Furthermore, the presence of fringe competition is crucial for countervailing power to benefit consumers and that there is a limit to how far a dominant retailer will go in its pursuit of countervailing power. The analysis in this paper, therefore, does not support the contention that countervailing power can replace competition as the regulatory mechanism of the economy. Correspondence: Department of Economics Carleton University 1125 Colonel By Drive Ottawa, Ontario Canada K1S 5B6

E-mail: ________________________
* For comments and discussions I thank Aidan Hollis, Robin Lindsey, Leslie Marx, Nicholas Schmitt, Lasheng Yuan, and seminar participants at University of Alberta, University of Calgary, Simon Fraser University, and Queens University. Financial assistances from the Social Sciences and Humanities Research Council of Canada and Carleton University are gratefully acknowledged.

The growing dominance of powerful big-box retailers in recent years has enhanced the interests in Galbraiths (1952) hypothesis of countervailing power. The objective of this paper is to assess rigorously this hypothesis using a theoretical model that captures the main ingredients of Galbraiths arguments as well as some of the important features of retail industry. It is demonstrated that consistent with the hypothesis an increase in the amount of countervailing power possessed by a dominant retailer can indeed lead to a fall in retail price for consumers. But this fall in retail price is not the result of a benevolent retailer acting on behalf of consumers but of a self-interested supplier trying to offset the reduction in profits caused by the rise in countervailing power. Total surplus does not always increase with the rise of countervailing power because of the possible efficiency loss on production side. Furthermore, the presence of fringe competition is crucial for countervailing power to benefit consumers and that there is a limit to how far a dominant retailer will go in its pursuit of countervailing power. The analysis in this paper, therefore, does not support the contention that countervailing power can replace competition as the regulatory mechanism of the economy.

In his controversial book

, Galbraith

argues that economic power on one side of a market begets countervailing power on the other side. In his words (Galbraith 1952 page 119),
The fact that a seller enjoys a measure of monopoly power, and is reaping a measure of monopoly return as a result, means that there is an inducement to those firms from whom he buys or those to whom he sells to develop the power with which they can defend themselves against exploitation. It means also that there is a reward for them, in the form of a share of the gains of their opponents market power, if they are able to do so. In this way the existence of market power creates an incentive to the organization of another position of power that neutralizes it.

One important manifestation of countervailing power, according to Galbraith, was that of large and powerful retail organizations such as the major chain stores (e.g. A&P) at that time. By exercising countervailing power, these retailers were able to lower the prices they pay their suppliers and pass on these savings to their customers. Hence these large retailers developed the

countervailing power which they have used, by proxy, on behalf of the individual consumer... (Galbraith 1952 page 131). Such countervailing power, Galbraith argues, is socially desirable.

Despite the popularity of his book, theoretical support for the countervailing power hypothesis has been scarce. Critics such as Stigler (1954) and Hunter (1958) point out that Galbraiths arguments do not have a rational explanation to why the retailers would have incentives to pass on the cost-savings to consumers. This weakness is particularly glaring in situations where a supplier and a retailer can write contracts based on two-part tariffs. Take, for example, the case 4

of bilateral monopoly. It is easy to show that the supplier and retailer can achieve joint-profit maximization through the use of two-part tariff. A shift in bargaining power between the two merely redistributes the joint profits but has no impact on the retail prices paid by consumers. This led the critics to express serious doubts that anyone can devise a rational explanation for Galbraiths proxyminded oligopolists (Stigler 1954 page 10).

In recent years the growing dominance of powerful big-box retailers such as Walmart and Toys R Us has enhanced the interests in the countervailing power hypothesis. 1 The tremendous success of these big-box retailers has been partially attributed to their sizes and the resulting buyer power that allows them to obtain more favourable trade terms from their suppliers (see, for example, Vance and Scott 1994 page 92). At the same time their success has led to the exit of many small- and medium-sized retailers, resulting in significantly increased concentration in the retail industry. Antitrust authorities, charged with the responsibility to protect and promote competition, are struggling to understand the implications of rising buyer power.2 To this problem of anti-trust authorities the countervailing power hypothesis seems to provide a ready-made answer: The market power of these big-box retailers, just like that of A&P in the first half of the twentieth century, is really

See Stern and Weitzer (1997 pages 826-827) for a discussion of the growing dominance by large retailers. For example, both the OECD and the European Union have recently commissioned studies to examine the impact of buyer power on competition (OECD 1998 and European Commission 1999). In the US, the Federal Trade Commission held a public workshop in May 2000 to discuss enforcement policy regarding slotting allowances, a major buyer power issue in grocery retailing. See also Dobson and Waterson (1999) for a discussion of the policy implications of retailer buyer power. 5
2

countervailing power exercised on behalf of consumers and as such is socially desirable. 3 However, the lack of theoretical support for the hypothesis means that one has to view such assertions with some degree of skepticism. After all, it would not be prudent to formulate antitrust policy solely based on a hypothesis not yet confirmed by economic theory. To fill this gap rigorous assessments of the countervailing power hypothesis are needed.

In this regard the analyses of countervailing power by von Ungern-Sternberg (1996) and Dobson and Waterson (1997) are particularly relevant.4 The main insight from their analyses is that increased concentration at the retail level does not necessarily lead to lower prices for consumers; under certain conditions it may in fact lead to higher prices. However, their models, while adequate for their purposes, do not capture a number of salient features of the retail industry. First, an

important trend in the retail industry in the past few decades is the polarization of store size (Griffith and Krampf 1997 page 849). Increasingly mid-sized general merchandise retailers are squeezed out by large-scale retailers and small specialty stores. This trend is not captured by their models where all firms are symmetric. Second, countervailing power in their papers is modelled as a reduction in the number of symmetric firms at the retail level. In reality, however, the evolution of the retail

Indeed, Britains Monopolies and Mergers Commission (MMC 1981 page 68) and Office of Fair Trading (OFT 1985 page 60) were of the view that the benefits of lower buying prices extracted by large retailers from manufacturers had been substantially passed on to consumers in one form or another. A third related paper is by Marx and Shaffer (2001) who consider the role of upfront payments in vertical contracting. They demonstrate that upfront payments can emerge as an equilibrium outcome when downstream firms have bargaining power. Their focus, however, is not on the competitive effects of downstream bargaining power , but on those of upfront payments. 6
4

industry in the past century was not characterized by this kind of symmetric reduction in the number of firms. Rather it was featured by the entry of new firms that, because of their innovative ways of doing business and superior technology, had lower costs that allowed them to achieve dominance and acquire buyer power against their suppliers. The A&P in the first half and the Wal-Mart in the second half of the twentieth century are examples of this type of innovative retailers. 5 Third, they assume that the firms use linear pricing, which makes their analyses irrelevant to many retail sectors where non-linear pricing are part of the contracts between a supplier and a retailer. More importantly, a major criticism of the countervailing power hypothesis is that a retailer can share profits with its supplier and consequently it has no incentives to pass on any cost-savings to consumers (Stigler 1954). By restricting the contract space to linear prices, they artificially rule out the possibility of profit-sharing between the retailer and the supplier. As a result, their analyses are susceptible to the same criticism as that on the original countervailing power hypothesis.

The objective of this paper is to examine the countervailing power hypothesis using a theoretical model that captures the main ingredients of Galbraiths arguments as well as some of the important features of retail industry. To be more specific, I consider a situation where an upstream supplier sells to a group of downstream retailers. To capture the phenomenon of polarization of store size, I assume that the downstream market is characterised by a dominant firm facing a competitive fringe. The dominant retailer in this model can be considered as a representative of the major chain stores such as A&P discussed in Galbraiths book or of the big-box retail giants such as Wal-Mart

For a brief history of the US retail industry and a detailed account of the rise of WalMart, see Vance and Scott (1994) or Ortega (1998). 7

today. To allow the possibility of profit-sharing between a retailer and its supplier, two-part tariffs are used in the contracts between the supplier and the retailers. The countervailing power is

modelled as the ability of the dominant retailer to extract, through either a lower wholesale price or a lower fixed fee or both, a higher percentage of the joint profits from their transaction.

In sections 3 and 4 of this paper I use this model to examine the effects of an increase in the amount of countervailing power possessed by the dominant retailer. It is shown that such a rise in countervailing power indeed leads to a lower retail price for consumers, as predicted by Galbraith. The reason for such a fall, however, is very different from what he envisioned. The lower retail price is not initiated by a proxy-minded dominant retailer passing on a lower wholesale price that it has wrested from the supplier. To the contrary, given that the contract is based on a two-part tariff the wholesale price paid by the dominant retailer is independent of the amount of countervailing power.

In fact, the fall in retail price is achieved through a different mechanism that, to my knowledge, has not been articulated in the literature on countervailing power. It works as follows. A rise in the power of the dominant retailer reduces the share of joint-profits accrued to the supplier. In an attempt to make up the lower profits earned from the dominant retailer, the supplier boosts the sales to fringe retailers by lowering their wholesale price. The fall in the cost of fringe retailers intensifies the competition at the retail level, leading to lower retail price. Therefore, the fall in retail price is not the result of a dominant retailer acting on behalf of consumers but of a self-interested supplier trying to offset the reduction in profits caused by a more powerful dominant retailer.

The model is also used to evaluate Galbraiths claim with regard to the social desirability of countervailing power. It is shown that while countervailing power makes consumers better off, it does not always improve the total welfare as measured by total surplus. Total surplus can decrease because countervailing power may cause efficiency losses on production side.

The results from this model further confirm the importance of competition and the limitation of countervailing power in protecting consumer welfare. It is shown that the presence of fringe retailers is crucial in ensuring that countervailing power lowers retailer price. In fact, total surplus is more likely to be increased by countervailing power when there is a larger number of fringe firms. The limitation of countervailing power is illustrated in section 5 through a chain store model that endogenizes countervailing power. It is shown that there is a limit to how far the dominant retailer will go in its pursuit of countervailing power. Contrary to conventional wisdom, the presence of countervailing power consideration may actually weaken, rather than strengthening, the retailers incentives to expand. Countervailing power, therefore, is not a substitute for competition.

The relationship among a supplier, retailers, and consumers are modelled as follows. There are two levels of markets. In the upstream market a supplier sells its product to a group of ( +1) retailers. In the downstream market these retailers re-sell the product to consumers at a price . Since the purpose of this paper is to examine the countervailing power of a retailer against its supplier, it is assumed that the supplier is a monopolist with original market power. 9

Different from the previous models of countervailing power (von Ungern-Sternberg 1996 and Dobson and Waterson 1997), here I assume that the industrial structure at the retail level is characterized by a dominant firm facing a competitive fringe. There are two reasons for assuming this alternative market structure. First, this assumption appears to be a more accurate representation of Galbraiths world in which large chain stores such as A&P competed against traditional, independent retailers.6 Second and related, this assumption captures an important trend in the retail industry in the past few decades, that is, the polarization of store size. Increasingly mid-sized general merchandise retailers are squeezed out by large-scale retailers and small specialty stores (Griffith and Krampf 1997 page 849). A dominant-fringe firm model appears to be a reasonable

representation of the situation where large-scale retail giants co-exist with small specialty stores.

In this model, therefore, there are one dominant retailer and fringe retailers. The dominant retailer sets the retail price while the fringe retailers are price-takers. In addition to paying the

supplier a wholesale price for each unit, the dominant retailer has to incur a constant marginal retailing cost, denoted by . Each fringe retailer, on the other hand, faces rising marginal retailing cost, denoted by ( f) with
N( f) > 0 and

(0) = 0. These assumptions imply that the fringe

retailers are more efficient at small scale of operations but the dominant retailer is more efficient at large scale. Let
d

and

denote the wholesale prices paid by the dominant retailer and a fringe
d

retailer, respectively. Then the all-inclusive cost of retailing an extra unit is +

6

for the dominant

In the words of Galbraith (1956 page 118), The small men can provide convenience and intimacy of service and give an attention to detail, all of which allow him to co-exist with larger competitors. The advantage of the larger competitor ordinarily lies in its lower prices ... Countervailing power in the retail business is identified with the large and powerful retail enterprises. 10

retailer and

( f) +

for a fringe retailer.

Since each fringe retailer is a price-taker, its supply function can be represented by the equation = ( f) +
f

, or

-1

( -

). Define ( f

)/
f

-1

( -

). Then the supply

function of a single fringe retailer can be written as

= ( -

) with (0) = 0 and N(@) > 0.

Furthermore, I assume that N(@) + ( - ) O(@) > 0 to ensure that the second-order condition of the
dominant retailers optimization problem is satisfied. The total supply of fringe retailers can be

written as

( -

).

The supplier produces the good at a constant marginal cost, normalized at 0. The consumer side in this market is represented by a demand function ( ). It is assumed that N( ) < 0 and N( ) + ( - ) O( ) < 0. The latter assumption is to satisfy the second-order condition of the dominant retailers optimization problem.

Another important feature of this model is that the contract between the supplier and a retailer takes the form of two-part tariffs. This assumption has both theoretical and empirical motivations. Theoretically, given the point raised by the critics of the countervailing power hypothesis that a retailer with countervailing power can share the joint profits with its supplier and consequently has no incentives to pass on any cost-savings to consumers (Stigler 1954), a credible model of countervailing power must allow the possibility of profit-sharing between the supplier and the retailer. Restricting the contract space to linear prices would artificially rule out this possibility. Empirically, contracts between retailers and suppliers rarely take the form of simple linear pricing. 11

Fixed fees such as slotting allowances are common place in the retail business (Shaffer 1991 and Tom 1999).

Let

and

be the fixed fees paid to the supplier by the dominant retailer and a fringe and ) can be

retailer, respectively. Then the contract between the supplier and retailer ( = expressed as ( i,
i

).

The focus of this paper is on, of course, retailer countervailing power. Consistent with Galbraith (1952), countervailing power is modelled as the ability of a retailer to receive, through either a lower wholesale price or a lower fixed payment or both, a larger share of the joint profits generated from the transaction between the retailer and the supplier. 7 Let denote the dominant retailers share of the joint profits. Then an increase in the amount of countervailing power possessed by the dominant retailer implies a larger . By assumption fringe retailers have no countervailing power.

One aspect of the model that has not yet been specified is the sequence of contract negotiations with different retailers. It has been shown in the literature on vertical contracting (in particular, McAfee and Schwartz 1994) that an upstream monopolist has an incentive to make upfront commitments to the contracts with all of its downstream buyers. In this model, it appears reasonable to assume that the supplier is able to commit to the contracts with the fringe retailers.

According to Galbraith (1952 page 119), the quest for countervailing power is motivated by the reward in the form of a share of the gains of their opponents market power. 12

However, the same cannot be said about the contract with the dominant retailer because the retailers countervailing power should enable it to force a renegotiation if it does not like the original contract terms.

Therefore, in this model I consider a situation where the supplier first announces a set of standard contract terms for retailers, but then the dominant retailer by virtue of its countervailing power is able to negotiate a separate deal with the supplier. Formally, the endogenous variables in this model, ( d,
d

), ( f , f ), and , are determined in a three-stage model.8 At stage one, the supplier

makes a take-it-or-leave offer to each of the fringe firms. At stage two, the contract between the supplier and the dominant retailer is determined through some negotiation process (explained below) that divides their joint profits according to the sharing rule . Finally, at stage three the dominant retailer sets and fringe retailers choose quantity to sell taking as given.

At stage three the dominant retailer sets the retail price. The residual demand function that the dominant firm faces is ( ) be written as: max p d  (  
d)[

- ). The profit-maximization problem of the dominant firm can

( )  (  f)] 

The first-order condition is:

In this section and next, the number of fringe retailers, , is taken as exogenously fixed. The number of fringe retailers is endogenized in sections 4 and 5. 13

[ ( )  (  f)]  (  

d)[

( )

(  f)]  0.

We can solve the above equation for comparative statics show that M /M
d

as a function of, among other things, > 0.

. Straightforward

At stage two, the supplier and the dominant retailer negotiate a contract ( d,

). In this

model I follow Nashs axiomatic approach to bargaining problems and suppose that the contract resulted from the negotiation process satisfies the following two properties: (1) the contract ( d, is maximized; (2) the surplus from this contract is divided according to the sharing rule . Property (1) is motivated by the fact that if the joint profits from this contract are not maximized, the dominant retailer will want to renegotiate. Property (2) represents Galbraiths idea of countervailing power.
d

) is efficient in the sense that the surplus (joint profits) from this transaction

The joint profits from the transaction between the supplier and the dominant retailer can be written as: D  (  )[ ( )  (  f)].

To satisfy property (1),

must maximize D, which implies



{[ ( ) (  f)](  )[

( )

(  f)]}

M M

 0.
d

14

Because M /M

0, (4) implies that [ ( ) (  f)](  )[



( )

(  f)]  0.

The supplier and the dominant retailer will write a contract in which the wholesale price of the good is set equal to its marginal cost of production, ,
d

= 0.

Proof: The equilibrium value of equations reveals that

d

must satisfy both (2) and (5). A comparison of these two

= 0. QED

Lemma 1 is not surprising because of the double marginalization problem (Spengler 1950). Since both the supplier and the dominant retailer have market power, any higher smaller joint profits.
d

will lead to

Since )D, and

= 0, property (2) of the negotiation solution and equation (1) imply that

= (1-

d  D  (  )[ ( )  (  f)].

The solution to equation (5) determines reveals that

as a function of

and . Comparative statics

15

M M

 
f

[ (@)  2




(@)(  )]

( )(  )



( )  [2 (@)  (  ) (@)]

> 0.

M M

(@)  (  ) (@) 2


( )(  )



( )  [2 (@)  (  ) (@)]

< 0.

At stage one the supplier chooses the contract offered to the fringe retailers. In so doing it wants to maximize the total profits it earns from the sales to both the fringe retailers and the dominant retailer: s  [
f

(  f)  f]  (1  )(  )[ ( ) (  f)].

At the same time the supplier faces the constraint that each fringe retailer earns non-negative profits, that is,
p w f 0

( )

$ 0.

Obviously, the supplier will offer a contract such that this constraint holds with equality. Using (10) in (9), we can write the suppliers optimization problem as:
maxw s  [
f

(  f)

p w f 0

( ) ]  (1)(  )[ ( ) (  f)].

Recall that is a function of

. The first-order condition is:

16

Ms M
f

 [

(  f)(

M M 1)  (  f)  (1)(  ) (  f)]  0. M f M f

The second-order condition requires that M2s/M equilibrium wholesale price for the fringe retailers, retail price .

2 f

< 0. The solution to (12) determines the

. This, through (5), determines the equilibrium

In this section the effects of countervailing power on consumer price and social welfare are studied. Recall that the countervailing power of the dominant retailer is measured by the parameter . Therefore, I consider how an exogenous change in affects the equilibrium in this model. 9 This section starts with an analysis of the general model, followed by a special case where demand and marginal cost functions are linear.

Galbraith (1952) conjectures that a retailer with countervailing power will use that power to obtain lower wholesale prices which it will pass on to consumers. In this model, however, Lemma 1 implies that a rise in countervailing power has no effect on the wholesale price. The supplier and the dominant retailer agree to set the wholesale price at marginal cost because it maximizes the joint profits from their transaction. A change in the countervailing power of the dominant retailer does not affect this wholesale price.
9

The countervailing power will be endogenized in section 5. 17

The failure by the dominant firm to bring its wholesale price down, however, does not necessarily mean that the rise in countervailing power has no impact on retail price. . An increase in the countervailing power of the dominant retailer has no impact on the wholesale price paid by this retailer, fringe retailers,
f d

, but reduces the wholesale price paid by the

f

. The reduction in

leads to a fall in the retail price and

consequently an increase in consumer surplus. Proof: The result about (12) reveals that
M M
d

follows from Lemma 1. Comparative statics on the first-order condition

(  )
2

(  f)
2 f

M s/M

< 0.

Then M /M = (M /M f)(M f/M) < 0. Let show that M

denote the consumer surplus. It is straightforward to

/M = - ( )(M /M f)(M f/M) > 0. QED

To help understand the mechanism through which countervailing power brings down the retail price, consider the change in the quantities sold in the retail market. . An increase in the countervailing power of the dominant retailer raises the total quantity sold as well as the quantity sold by the fringe retailers. Furthermore, the market share of the fringe retailers rises at the expense of the dominant retailer if
O( - f) # 0.

18

Proof: The results follow from that N( ) < 0 and

M M
f

(  f)(

M M 1) f > 0; M f M

M( f/ ( ))

 

 

d


(  ) (
 

(  )




)
2

] M
M

[2

(  )

 (2 (  ) )][ ( )]

The sign of (15) is positive if O( - f) # 0. QED

Therefore, in this model countervailing power has the same effect on retail price as predicted by Galbraith (1952). But this effect is brought about by a mechanism different from the one commonly envisioned. The lower retail price is not caused by a benevolent retailer passing on the cost-savings it has obtained from the supplier. To the contrary, an increase in countervailing power does not create any incentives for the dominant retailer to demand a different wholesale price.

Intuitively, the fall in retail price is achieved through the following mechanism. An increase in the power of the dominant retailer reduces the suppliers share of joint-profits. The supplier then responds to this reduction by boosting the sales to the fringe retailers, which leads the supplier to lower the wholesale price paid by the fringe retailers. The fall in the cost of the fringe retailers intensifies the competition at the retail level, leading to lower retail price. Therefore, the fall in retail price is not the result of a dominant retailer acting on behalf of consumers but of a self-interested
19

supplier trying to offset the reduction in profits due to a more powerful dominant retailer.

The following proposition confirms what happens to the profits of the supplier and retailers. . An increase in the countervailing power of the dominant retailer reduces the suppliers profits as well as the combined profits of the supplier and all retailers. The profits of the dominant retailer will increase if its countervailing power is not too large in the sense that

< 

d


(  f)(M f/M)

Proof: Differentiate d and s with respect to and apply the Envelope Theorem:
Ms M   (  )

< 0.

Md M

 (  )[

d

(  f)

M M

].

The sign of (18) is positive if and only if (16) holds.

Since the fringe retailers make zero profits, the combined profits of the supplier and all the
20

retailers are equal to s + d. Equations (17) and (18) imply that M(s + d)/M = ( - ) N( - f)M f /M < 0. QED

Proposition 3 implies that countervailing power is detrimental to the interests of the supplier and retailers as a whole, causing a reduction in total profits. What is more interesting, however, is that while an increase in the amount of countervailing power benefits the dominant retailer when it has little power to begin with ( = 0), its profits may be reduced when it acquires too much power. This, of course, will affect the retailers incentives to acquire countervailing power. I will return to this point in section 5 where the retailers countervailing power is endogenized.

An important contention of Galbraith (1952) is that countervailing power is socially desirable. In this model Proposition 1 suggests that Galbraith is right if social desirability is defined in terms of consumer surplus. 10 A natural question to ask is then whether this is still true if a broader measure of social welfare is used.

In a partial equilibrium framework such as the one used here, it is common to measure social welfare by total surplus:

Commenting on his own book, Galbraith (1954 page 2) states: In partial equilibrium situations, economics has long made the maximization of consumer welfare a nearly absolute goal. Any type of economic behavior which lowered the prices of products to the consumer, quality of course being given, is good. This standard weighs heavily on the conscience of the economist. 21

10

" p

( )

 (  )[ ( ) (  f)] 

(  f) 

pw f 0

( ) .

Propositions 1 and 3 suggest that an increase in countervailing power raises consumer surplus but reduces the combined profits of the supplier and all retailers. Based on a typical welfare trade-off analysis, one might conjecture that the loss in profits should be more than offset by the gain in consumer surplus. Such a conjecture, it turns out, is not right. The net effect on total surplus in fact depends on, among other things, the amount of countervailing power possessed by the dominant retailer. . An increase in the countervailing power of the dominant retailer raises total surplus if O $ if O #
O $ 0 and < (1/2)( ( )/ O # 0 and > (1/2)( ( )/
d

). On the other hand, it reduces total surplus

).

Proof: Differentiating (19):

 M f [(  )  (2 d )][  ]  d(  )[ M  ( ) M M [2 (  )  (2 (  ) )][  ] 



Recall that M f/M < 0, 2 N + ( - ) O < 0, and 2 N + ( - ) O > 0. Equation (20) is positive if O $
O $ 0 and < (1/2)( ( )/
d

), and is negative if O #

O # 0 and > (1/2)( ( )/

). QED

Intuitively, the reason that the gain in consumer surplus does not always offset the loss in profits in this model is the possible efficiency loss on production side. Recall that the fringe retailers 22

are more efficient at small scale of operation while the dominant retailer is more efficient at large scale. When the supplier boosts sales to the fringe retailers in response to rising countervailing power, it may be, at the margin, awarding sales to the less efficient retailers. Indeed, this will be the case if ( f) > at the margin.

To further illustrate the effects of countervailing power, I consider a special case where both demand and the marginal cost of fringe firms are linear functions. That is, suppose that the demand function is = and the marginal cost of each fringe firm is
f

( f) =

. Then the total supply by

d

fringe firms is

= ( / )( - f) and the residual demand of the dominant retailer is

= -( + / )

+ ( / ) f. To ensure that the residual demand is positive when prices are equal to marginal costs, I assume that >( + / ) .

In Propositions 3 and 4 the conditions regarding involve endogenous variables such as and
d

. With the linear demand and cost functions, I can add more specificity and express these

conditions in terms of exogenous variables only. . Suppose demand and marginal cost functions are linear. The profits of the dominant retailer decreases with its countervailing power if and only if > and [3 4(1)2] . 21

>

23

The total surplus decreases with countervailing power if and only if > 1- (1/2) where [2
2

 2 ( / )( / )2]  2[ 2  3 ( / )  ( / )2](  / ) . 2(  / )(2  / )[  (  / ) ]

Proof: See Appendix.

Note that since < 1, a necessary condition for > 1 - (1/2) to hold is that > 0. This requires that demand is sufficiently large in the sense that / 2( 2
2 2

> where

 3 /  ( / )2)  2 /  ( / )2

(  / ).

If demand is relatively small (in the sense that

< ), a rise in countervailing power always

improves social welfare as measured by total surplus.

Before concluding this section, it is worth noting the important role played by the fringe competition in driving the welfare effects of countervailing power. In his own discussions of the 1952 book, Galbraith (1954 page 4) reluctantly acknowledges that competition at retail level is

24

needed for the countervailing power hypothesis to work.11 Indeed, in my model the presence of fringe competition is crucial. First, compare this model with the alternative situation where there is no fringe retailers, , a case where the supplier and the dominant retailer are bilateral monopoly.

It is straightforward to show that in the latter case the supplier and the retailer will write a contract in such a way that the retail price is set according to the standard monopoly pricing rule, ( - )/ = ( )/[
N( )], and is independent of the parameter of countervailing power . What affects is only

the distribution of profits between the supplier and the retailer. Second, Propositions 4 and 5 imply the size of the fringe retailers can influence whether a rise in countervailing power can improve welfare. From Proposition 4 we can see that a larger market share by the fringe firm, which implies a larger ( )/ d, makes it less likely that > (1/2)( ( )/ d ) and hence less likely that countervailing power will reduce welfare. A more rigorous statement can be made for the linear case considered in Proposition 5. In fact,

. Suppose demand and marginal cost functions are linear. There exists an increase in countervailing power raises total surplus as long as > Proof: See Appendix.
c

such that

In other words, as long as there is a sufficiently large number of fringe retailers, countervailing power always improves welfare.

In this context Galbraith (1954 page 4) said, it is a bit embarrassing after one has just murdered his mother-in-law to disinter the lady and ask her to help do the cooking. 25

11

So far the number of fringe firms has been held fixed. In some instances, however, it may be more reasonable to assume that the number of fringe firms changes as a result of rising countervailing power. Hence, in this section I extend the model to allow an endogenous number of fringe firms.

Suppose that entry is free for fringe retailers. In this case the supplier is able to control the equilibrium number of fringe firms through its choice of the contract terms ( f , f ): A lower ( f , f ) will induce more fringe retailers to enter. Accordingly, I modify stage one of the model as follows. In the suppliers optimization problem (11), in addition to the wholesale price offered to the fringe retailers ( f) the supplier also determines the number of fringe firms ( ). To ensure that the secondorder optimization conditions are satisfied, I assume that M2s/M >
N(@)(M2s/M M f ), and 2 f

< 0, M2s/M

< 0, - (@)(M2s /M

2 f

N(@)(M2 /sM 2 ) > (@)(M2 /M Mf ). These assumptions imply that the s

f

suppliers profits, s, is a concave function of

and .

In addition to (12), the new optimization condition with respect to is:

Ms M  (1)(  ) (  f)

(  f)

p w f 0

( ) [

(  f) (  f)]

M M

 0.

It turns out that the endogenization of countervailing power.

does not qualitatively change the effects of

. Suppose the supplier can control the number of fringe retailers through its choice of
26

( f, f). An increase in countervailing power reduces the wholesale price paid by the fringe firms and increases the number of fringe firms. As a consequence, the retail price falls and consumer surplus increases. Proof: Comparative statics on (12) and (24) reveal that
M M

(  )[ (Ms /M
2

(@)(M2s/M 2) (@)(M2s/M fM )]

2 2 2 )(M2s/M f )(M s/M 2 fM )

< 0.

(  )[ (@)(M2s/M f ) (@)(M2s/M fM )] M > 0.   2 2 M (Ms /M f )(M2s/M 2)(M2s/M fM )2

Then (25)-(26), along with (7)-(8), imply that

M M M M M )( f ) ( )( ) < 0.  ( M M f M M M

Consumer surplus increases as

falls. QED

The endogenization of , of course, does have quantitative effects. Now the supplier has two ways to respond to an increase in countervailing power: reducing re-enforces the effects of lower
f f

and raising . The increase in

. As a result, it can be shown that the fall in retail price is larger

when is endogenous. This also suggests that an increase in countervailing power would generate
27

smaller benefits to the dominant retailer. Consequently, while the sign of M d/M can be either positive or negative (as in Proposition 3), it will be negative for a larger set of when endogenous. is

The objective of this section is to endogenize the source of countervailing power. At the time of Galbraith (1952 page 124) the practical manifestation of retailer countervailing power is that of large retail chains. When negotiating with a national manufacturer, an independent retailer operating in a single local market rarely has any bargaining power. A large retail chain, on the other hand, is in a much stronger bargaining position against such a manufacturer because its large volume of purchase, derived from its business in multiple geographic markets, makes it an indispensable customer of the manufacturer. Their large volumes of business may also make it feasible for them to develop their own source of supply, their ultimate sanction against the market power of their suppliers (Galbraith 1952 page 126).

In this model, therefore, I formalize Galbraiths chain store idea and assume that the dominant retailer is a retail chain operating in many local markets. Specifically, the dominant retailer operates in local markets. The cost of establishing and operating stores is ( ), with

N( ) > 0 and O( ) > 0. To endogenize the countervailing power, suppose that the amount of

countervailing power possessed by the dominant retailer is an increasing function of , > 0.

., N( )

28

The model in section 4 is then extended by adding one more stage, stage zero. At this stage the dominant retailer chooses the number of geographic markets it wants to enter, . For each

market that the dominant retailer enters, the supplier and the retailers play the three-stage game studied in section 4.

As a benchmark, I first consider the case where countervailing power is independent of . Then the dominant retailers optimization problem at stage zero is:

max m

(  )[ ( )  (  f)]  ( ).

The first-order condition is: (  )[ ( )  (  f)] 



( )  0.

Let

denote the solution to (29).

The issue of particular interest here is how the addition of countervailing power consideration affects the dominant retailers decision to expand the chain. Conventional wisdom is that countervailing power adds to the competitive advantage of a retailer. Consequently if countervailing power is an increasing function of the number of stores it operates, the dominant retailer should have stronger incentives to expand aggressively and open more stores. In other words, one might expect that with countervailing power the new equilibrium is not necessarily the case. 29 should be greater than
0

. This, it turns out,

. The equilibrium number of stores operated by the dominant retailer is less than if and only if Md/M evaluated at = (
0

) is negative.

Proof: Replacing with ( ) in (28), we obtain the new optimization problem of the dominant retailer. The first-order condition is: (  )[ ( )  (  f)] 


( )

Md M

( )  0.

A comparison with (29) shows that the solution to (30) is less than at = (
0

if and only if Md/M evaluated

) is negative. QED

As has been discussed in sections 3 and 4 (see, for example Proposition 5), Md/M can indeed be negative for large enough. Proposition 8 then implies that there is a limit to how far the dominant retailer will go in its pursuit of countervailing power. Contrary to conventional wisdom, the presence of countervailing power consideration may actually weaken, rather than strengthening, the retailers incentives to expand the number of stores in the chain.

A recurring theme in the history of US retail industry in the last century is the rise of ever larger retail organizations which, because of their superior technology and innovative ways of doing business, had lower costs and consequently were able to capture large market shares by offering lower prices. Their dominance in the retailing markets also conferred them countervailing power 30

against their suppliers, allowing them to obtain more favorable trade terms than other retailers. This further re-enforces their competitive advantage.

In this paper it is demonstrated that an increase in the amount of countervailing power possessed by a dominant retailer can indeed lead to a fall in retail price for consumers, as predicted by Galbraith (1952). But retail price falls not because the dominant retailer is able to obtain a lower wholesale price. Rather, it is because the supplier, in an attempt to counter the rise in the power of the dominant retailer, reduces the wholesale price to other retailers.

Such a response by the supplier can weaken the dominant retailers incentives for acquiring countervailing power. As a result, there is a limit to how far countervailing power can go in lowering the retail price. Furthermore, it is shown that the presence of fringe competition is crucial for countervailing power to benefit consumers. Therefore, while confirming Galbraiths conjecture that countervailing power can improve consumer welfare, the analysis in this paper does not support the contention that countervailing power can replace competition as the regulatory mechanism of the economy.

31

Adams, W.A. (1953) Competition, monopoly, and countervailing power, , 67 Adams, W.A. (1987) Countervailing power, in ed. J. Eatwell, M. Milgate, and P. Newman, London: Macmillan Blair, R. D. and J.L. Harrison (1993) Princeton University Press , , Princeton:

Dobson, P.W. and M. Waterson. (1997) Countervailing power and consumer prices, , 107: 418-430 Dobson, P.W., M. Waterson, and A. Chu (1998) The welfare consequences of the exercise of buyer power, Office of Fair Trading Research Paper 16 Dobson, P.W. and M. Waterson (1999) Retail power: Recent developments and policy implications, , 28: 135 - 164 European Commission (1999) , Luxembourg: Office for Official Publications of the European Communities Galbraith, J.K. (1952) Houghton Mifflin Galbraith, J.K. (1954) Countervailing power, , 44 (May 1954) 1 - 6 Galbraith, J.K. (1956) New York: Houghton Mifflin Griffith, D.A. and R.F. Krampf (1997) Emerging trends in US retailing, 30 (December 1997) 847 - 852 Hunter, A. (1958) Notes on countervailing power, , March 1958, 89 - 103 , revised edition, , , New York:

Marx, L.M. and G. Shaffer (2001) Upfront payments in vertical contracting, mimeo, University of Rochester McAfee, R.P. and M. Schwartz (1994) Opportunism in multilateral vertical contracting: Nondiscrimination, exclusivity, and uniformity, , 84, 210-230 32

MMC (1981)

, London: Monopolies and Mergers Commission , Report of the

OECD (1981) Committee of Experts on Restrictive Business Practices, Paris: OECD

OECD (1998) Roundtable on buying power: Background paper by the Secretariat, DAFFE/CLP(98)23 OFT (1985) Ortega, B. (1998) , New York: Random House Scherer, F.M. and D. Ross (1990) 14, Boston: Houghton Mifflin Company , Chapter , London, Office of Fair Trading

Shaffer, G. (1991) Slotting allowance and resale price maintenance: A comparison of facilitating practices, , 22 (Spring 1991) 120 - 135 Spengler, J. (1950) Vertical integration and anti-trust policy, 347 -52 , 58:

Stern, L.W. and B.A. Weitz (1997) The revolution in distribution: Challenges and opportunities, , 30 (December 1997) 823 - 829 Stigler, G.J. (1954) The economist plays with blocks, , 44 (May 1954) 7 - 14 Tom, W.K. (1999) Slotting allowances and the antitrust laws: Testimony of the Federal Trade Commission, presented before the Committee on the Judiciary, U.S. House of Representatives Vance, S.S. and R.V. Scott (1994) York: Twayne Publishers von Ungern-Sternberg, T. (1996) Countervailing power revisited, , 14:507-20 , New

33

In this appendix I prove Propositions 5 and 6 in the text. Both propositions are for the special case of linear demand and marginal cost functions. In this special case it is straightforward to derive the equilibrium wholesale price for a fringe retailer:


[2(1)(  / ) / ] (  / )[ / 2(1)(  / )] . (2  / )(2 3 / )2(1)(  / ) /

(A1)

. The profits of the dominant retailer as a function of d  [  ( / ) f  (  / ) ]2. 4(  / )

f

can be written as: (A2)

Differentiate (A2) with respect to , recognizing that

Md M 

is also a function of :

[4 2(12)( / )2(62) ( / )],

(A3)

where [ ( / ) f(  / ) ][( (  / ) )(2  / )(2 3 / )( (  / ) )( / )2] 4(  / )[(2  / )(2 3 / )2(1)(  / ) / ]2

> 0. (A4)

Equation (A3) implies that Md/M < 0 if and only if [4 is true if and only if > and (21) holds.

+ (1-2)( / )2 +(6-2) ( / )] < 0. The latter

34

The total surplus as a function of

can be written as:

[( 2 / )  ( / ) f (  / ) ]2 [ ( / ) f(  / ) ]2   4(  / ) 8 (  / )2 ( / )[ (2  / ) f(  / ) ][ (2 3 / ) f(  / ) ]  . 8(  / )2

(A5)

Then
M M  ( M M M M
f

)(
f

) 

( / )(  / )[ (4  / ) f(  / ) ] M f ( ), M 4(  / )2

(A6)

which is negative if and only if equilibrium

f

< [ - ( + / ) ]/(4 + / ). Using (A1) I can show that the

satisfies this condition if and only if > 1 - (). QED

. From (22) we see that < 0 holds if and only if < where is defined in (23). It is clear that > ( + / ). Hence it is possible to have both < and > ( + / ) hold simultaneously. It can be shown that
M 2[2 / ( /  M
2

)][2 22 / ( / )2]2[(  / ) 2(6 4 / )] [2 2 / ( / )2]2

> 0.

(A7)

Note that if = 0, = ( + / ) = and hence > . On the other hand, approaches infinity and thus < as goes to infinity. Hence, there exists a unique all >
c c

such that = . Then < for QED

. 35