At his new blog Management R&D, Luke Froeb writes about the strategy of downstream firms reducing capacity in order to increase competition among suppliers:
To gain bargaining power, some firms reduce capacity to increase competition among their suppliers. For example, health insurers restrict the number of drugs on their formularies or the number of hospitals in their network to to increase competition among health care providers to get onto the formulary or into the network. Similarly, grocery stores limit shelf space to extract bigger payments from the brands they do carry; and airports limit the availability of gates or runways to encourage competition among airlines for gates or landing slots.
I don’t know much about the use of this strategy in other settings, but I’ve looked quite a bit at shelf space contracts in supermarkets and I don’t think a reduction in downstream capacity is the best way to understand shelf space payments conceptually. Froeb is referencing a variant of the argument that shelf space payments are explained by retail bargaining power. The argument is made in the FTC Report on slotting and is quite common in the marketing literature concerning shelf space payments generally. So, do grocery stores really limit shelf space to extract bigger payments? Ben Klein and I address this argument in The Economics of Slotting Contracts (forthcoming in JLE this month).  Our answer: No (with an important caveat I’ll talk about at the end of this post). At least not in the sense meant here, i.e. that slotting fees are a function of supermarkets extracting rents from manufacturers as a result of increased bargaining power.Â
A detailed explanation appears below the fold.
Contrary to the retailer bargaining power theories, slotting payments are the consequence of the competitive process between manufacturers to induce retailers to create highly profitable incremental sales for the manufacturer’s product through the allocation of premium shelf space. Essentially, slotting contracts solve a pervasive incentive incompatability between manufacturers and retailers concerning the supply of promotional shelf space. In other words, slotting contracts are best viewed as vertical restraints in an economic sense. This competition between suppliers for promotional shelf space can be expected to have two main effects: (1) to increase the shelf space they will supply relative to that they would have without the payments, and (2) a change in the distribution of products on the shelves themselves.
The data support the theory that shelf space payments result in an increase in retailer shelf space supply despite the fact that payment sized has increased over time. Shelf space payments proliferated in magnitude and frequency in the early 1980s, from which time we have seen a dramatic growth in total supermarket shelf space from 4.48 square feet per $1,000 real sales in 1983 to 6.20 square feet per $1,000 real sales in 2000 (a 38% increase). More details on these calculations are available in the paper (especially Figure 1), available here.
Another implication of the retailer bargaining power theory is the increase in slotting payment frequency and size should be correlated with an increase in supermarket profitability over the same time period. Again, the data do not support the retailer bargaining power theory. However, these is absolutely no evidence of a positive effect of slotting fees on retailer profits. Figure 2 in the Klein and Wright analysis shows that supermarket profitability did not increase after 1981 as slotting fees increased. Although shelf space contracts became more prevalent over time, both supermarket net profits after taxes as percentage of sales and as a percentage of measured assets exhibit no significant positive time trend. These data suggest that these payments are the process of a robust competition for distribution and are passed on to consumers. The data also show that large manufacturers make shelf space payments not only to large retailers, but also small niche players with trivial market shares, which is inconsistent with the retailer bargaining power theory of slotting.
In another way, slotting contracts in fact do allow supermarkets to limit shelf space and increase payments by increasing competition by suppliers. Specifically, retailers may grant a specific manufacturer an exclusive or partial exclusive contract (say, e.g., committing 85% of the shelf space to Coca-Cola) in exchange for increased payments. But it is important to distinguish limiting overall product category shelf space (which has increased during the time period that slotting has become prevalent) from the shelf space committed to any particular product in and particular supermarket (which may decrease).Â
Exclusivity or partial exclusivity for retailers are an important mechanism to commit to peforming the services necessary to promote the manufacturer’s product and can increase the value, and equilibrium price, of supermarket shelf space. Exclusivity might also serve a number of other pro-competitive purposes in this setting. Again, the key antitrust point here is that this exclusivity can generate higher payments that are passed on to consumers and are therefore presumably pro-competitive. There is an extended discussion of this point in my recently updated analysis of category management contracts as partial exclusives, available here.
