Solving Shelf Space Incentive Conflicts With Vertical Integration and By Contract in the Soda Market

Josh Wright —  22 June 2010

There is a nice example in the WSJ concerning the economics of vertical contractual arrangements.  I’ve noted previously the apparent trend in the soda industry toward vertical integration and the link to the economics of promotional shelf space.  In particular, incentive conflicts between manufacturers and retailers of differentiated products over the use of promotional shelf space are pervasive.

Like most vertical contracts, the key here is to understand how the incentives of the prospective transacting parties do not coincide and therefore must be controlled contractually rather than left to unrestrained competition and self-interest.  A common incentive incompatibility, identified by Klein & Murphy (1988) and later analyzed by Klein (1995), occurs when: (1) manufacturers sell a product at a significant markup over marginal cost, (2) the retailer provides some input like marketing activity or promotion that has a significant impact on demand for the product, and (3) consumers have heterogeneous demand for these promotional services, i.e. different value placed on placement of the product on eye-level shelf space, product demonstrations, etc.

Under these conditions, the retailer does not have adequate incentive to supply the efficient level of promotion or marketing activity because the retailer does not take into account the manufacturer’s (relatively large) profit margin on additional sales induced by provision of promotional services. These conditions are most likely to hold for differentiated products where manufacturer incremental profit margins are large relative to retailer profit margins.

Economic theory tells us that firms will use a variety of contractual measures to mitigate these incentive conflicts and exploit gains from trade.  For example, firms enter into slotting contracts, category management arrangements, and sometimes partial or full exclusive dealing contracts to control the transacting parties incentives in favor of non-performance and facilitate self-enforcement of the contract.   The trend towards vertical integration, as reported, appears to suggest that integration has become a more efficient solution for assuring supply of the desired distribution services than contracting.

Today’s WSJ article gives a nice example of how this theory applies in practice:

“Our [retail] customers really want to be able to differentiate themselves from their competitors,” says Mr. Foss. PepsiCo benefits when stores sell its snacks and drinks together, but it was harder to coordinate such promotions before PepsiCo bought its bottlers.

It is interesting to note that while the Pepsi and Coke have acquired bottlers recently, the article also discusses how Pepsi is tightening up its contractual relationships with retailers in order to align incentives with respect to promotions:

Mr. Foss says retailers he has visited have told him they would like to run more promotions that combine PepsiCo products, such as displaying six packs of Pepsi and bags of Doritos tortilla chips side by side, and offering discounts for purchasing them together.

Obviously, the costs of a multi-product retailer such as a gas station, convenience store, or supermarket granting an exclusive to Pepsi or Coke are higher than those of the bottler because of consumer demand for product variety in these settings.  In these settings, Pepsi and Coke rely on the contractual solutions described above to align incentives and induce the supply of efficient promotional services.

As a side note, slotting contracts and RPM are two ways to compensate the retailer for the supply of those services.  From there, one is only a step away from understanding why the Leegin decision was correctly decided, what Justice Breyer doesn’t understand about the economics of RPM, and why the “inherently suspect” approach to RPM is misguided.