Supported by the Center for Energy Policy Research, M.I.T

Shepard, Andrea

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Pricing Behavior and Vertical Contractsin Retail MarketsbyAndrea ShepardMIT-CEPR 90-009WP April 1990PRICING BEHAVIOR AND VERTICAL CONTRACTS IN RETAIL MARKETSAndrea Shepard*Recent developments in the economic theory of multifirm markets and firmorganization have motivated several empirical studies of retail gasolinemarkets. A growing body of theoretical work suggests that the behavior offirms in markets once viewed as "workably competitive" can divergesignificantly from that characteristic of competitive markets. Static modelsof free-entry markets where firms are horizontally differentiated suggest thatthe equilibrium price structure will reflect local market power. Dynamicoligopoly models suggest that repeated interaction can sustain (tacitly)collusive outcomes in multifirm industries. Because gasoline stations arestrikingly simple firms and data are available on wholesale and retailgasoline prices, this market has proven to be a useful arena for testingpricing predictions from these models. These tests are discussed in SectionI.Another growth area in industrial organization is research on the natureof vertical contracts. This work suggests that the optimal contract between amanufacturer and a retailer will be sensitive to the nature of downstreamcompetition and the available control technology. Imperfect competitiondownstream can lead to double marginalization, and imperfect monitoring canallow shirking or free-riding. The manufacturer can be expected to choosecontractual forms that minimize these effects. Section II discusses effortsto assess the effect of competition and monitoring on the refiner's choice ofcontractual form for retail outlets.*Economics Department, Massachusetts Institute of Technology, Cambridge, MA02139. This research is supported by the Center for Energy Policy Research,MIT.-1- A~While examining contractual form is interesting in itself, policyinitiatives provide additional impetus for examining contracts in gasolineretailing. Refiners have long been a favorite target of antitrustenforcement, and complaints regarding restraints imposed on retailers havebeen viewed sympathetically by the courts. Court decisions have made unlawfulexclusive dealing clauses for gasoline and automotive products and variousarrangements through which the refiner can control the retail price atfranchise outlets. In the last decade, federal and state governments haveenacted legislation further restricting the nature of the contract betweenrefiners and the retail outlets for their gasoline. The growth in theserestrictions naturally leads to positive questions about the nature and effectof contractual relationships between refiners and dealers.I. PRICING BEHAVIOROne view of gasoline retailing is that stations compete in price andbehave approximately Bertrand, that is, prices are defined by cost. This viewis supported by the observation that stations post prices, competitors canrespond immediately to price changes, branded gasoline of a specified octanelevel is a homogeneous product, and there are many stations. Contrary to thisview, there is a growing body of empirical work that suggests these marketsdepart from the Bertrand paradigm in significant ways.Price behavior in an isolated market with thirteen stations has beenstudied by Slade (1986, 1987) using daily observations on price in a periodcharacterized by price instability induced by demand shocks. Slade (1986)estimates a conjectural variations model and finds that price taking behaviorcan be rejected. She also estimates station demand equations and finds thatboth own-price and cross-price demand elasticities show substantial variationacross stations even though these stations are located along the same heavilytraveled commercial strip. Using these data in a dynamic model to estimatethe slopes of linear intertemporal reaction functions, Slade (1987) findssupport for the hypothesis that the stations play supergame strategies. Inparticular, she finds that the estimated reaction function slopesare significantly different from single period best replies and result inhigher estimated profits. These results suggest that brand and locationprovide sufficient local market power to allow firms to price above marginalcost, and that station operators are sufficiently sophisticated to exploitrepeated play in order to increase profits.Gasoline is sold in a variety of grades (regular leaded, regularunleaded, etc.) and can be sold self-service (consumers pump their own gas) orfull-service (a station employee pumps the gas). In a perfectly competitivemarket, each grade and service level would be sold at marginal cost. In afree entry market in which gasoline revenues must cover a fixed cost, pricesmay be above marginal cost, but will reflect fully allocated fixed cost. Acursory examination of data on retail margins suggests that the pricestructure is more complex than these cost-based stories would suggest.Table 1 presents data on retail margins (retail prices minus wholesaleprices) by grade and service level. The retail price data are from across-sectional census of gasoline stations in Eastern Massachusetts in early1987 and include observations at over 1500 stations. The wholesale prices arethe average weekly fob prices for Boston.1 The first column reports thenumber of stations carrying the specified grade. There are, for example, 1232stations selling regular leaded gasoline. The retail margins reported in thetop three rows use the lowest price at the stations for the specified grade.At a station selling both full-service and self-service gasoline, this will bethe self-service price. The six rows at the bottom separate full-service andself-service prices. "Mini-service," in which an attendant pumps the gas butwill provide no other service, is treated as self-service.The retail margin is higher for full-service than self-service: thedifference in means is nine to ten cents per gallon for each grade.2 Sincefull-service sales involve a higher labor input than self-service,it would be surprising if this were not the case. More interesting is thedifference in margins by grade; the margin on premium unleaded is over fortypercent higher than the margin on regular leaded. This difference might becost-based if gasoline were priced to cover grade-specific fixed cost and thesales volume of premium unleaded were much smaller than the sales volume ofregular leaded. Premium unleaded sales, however, were almost fifty percenthigher than regular leaded sales for the state as a whole in late 1986 (U.S.Department of Energy, Petroleum Marketing Monthly). The margin differencesmight also be cost-based if buyers of premium unleaded have a higher demandfor service. If, for example, a premium gasoline purchaser is more likely tohave the station attendant check her oil. But since service comes only withthe purchase of full-service gas, this would imply greater margin differencefor full-service purchases. As shown in Table 1, however, the difference isapproximately the same for full-service and self-service.Another possible explanation for this dispersion in retail margins isthat stations have sufficient local market power to price discriminate.Consumers of leaded and unleaded gas are segmented by law and by thetechnology embodied in automobiles. Premium versus regular unleadedpurchasers may also be segmented by technology--some producers of highperformance cars recommend premium fuel--but the segmentation seems lessclear. Consumers also might be separable based on willingness to pay forquality. If unleaded premium and regular gasolines are perceived asvertically differentiated goods, a higher margin on the superior product wouldallow the firm to extract additional consumer surplus.The hypotheses that the difference in leaded and unleaded regular marginsis due to price discrimination is investigated by Borenstein (1989), whoargues that purchasers of leaded gas have lower search costs (less brand/location loyalty) than purchasers of unleaded gas. The difference in standarddeviations reported in Table 1 is consistent with this argument; more searchshould reduce the variation in price. The difference in search cost impliesdiffering price elasticities, allowing stations with local market power toprice discriminate. Borenstein exploits the fact that in recent years anincreasing number of stations have stopped carrying leaded gas. As thedistribution of leaded gas outlets becomes relatively less dense, the cost ofsearch will rise and the difference in margins should decline. Using paneldata on average margins and surveys of consumer purchasing, he finds thedifference in retail margins was rising or constant until 1986 when it beganto decline, and the change in availability--controlling for differences inincome-- explains from one to two thirds of the drop in the margin differenceover the 1986-1989 period.Another way in which stations might be able to price discriminate isthrough willingness to pay for service. Shepard (1989) develops a model inwhich stations with local market power carrying both full- and self-servicegasoline are able to price discriminate while stations carrying onlyfull-service or only self-service gasoline cannot. As a result, thedifference in full-service and self-service prices will be larger at stationsoffering both service types than the difference across stations offering onlyone service type. This prediction is tested using the Eastern Massachusettscross-sectional data on station prices and characteristics. Controlling for avariety of station characteristics, these data indicate that the differentialis at least ten cents higher at stations with both service types. Since thewholesale price does not vary by station type, it is difficult to argue that adifferential this large can be cost-based. The data base includes locationinformation on each station that is used to control for local deviations ininput prices, demand, and competitive environment. The differential remainseven when the comparison is restricted to stations within a half mile radius.Because the larger differential comes from higher full-service prices, thepresence of both full-service-only and multi-service stations explains some ofthe difference in the variance in full-service and self-service prices evidentin Table 1.The results of Shepard and Borenstein lend support to the argument thatprice discrimination, although most commonly modeled in a monopoly setting,occurs in multi-firm markets in which market power comes from location andbrand preference.II. CONTRACTUAL FORMGasoline is sold in a mixed distribution system, that is a system wherethere are a variety of contractual forms for the vertical relationship betweenretailers and refiners. These forms are usually categorized by the industryas: open dealer (OD) contracts in which the station is owned and operated byan independent dealer who contracts with a refiner for her gasoline supply;lessee dealer (LD) contracts in which the capital at the station is owned bythe refiner and leased by the self-employed dealer; and company outlets (CO)at which the capital is owned by the refiner and the station operator isemployed by the refiner. Note that the only form in which the refiner candirectly control the retail price is the company outlet. The franchiseagreement and capital ownership at lessee dealer stations provide greaterscope for control of non-price attributes than does the supply contract signedwith open dealers. Ownership of capital allows the supplier to build-inauxiliary services (e.g., convenience stores, automotive service bays) anddetermine the capacity of the station (the number of pumps and islands).Ownership of capital also gives the supplier a convenient mechanism forimposing a franchise fee. The franchise contract gives the supplier someadditional rights to define the quality of service. Although the allowablescope of these contracts varies from state-to-state, suppliers can sometimesset the hours of operation, specify maintenance and cleanliness standards,enforce credit card policies and take some sorts of disciplinary action inresponse to violations of the contract.Both state and federal laws and regulations restrict the contractsrefiners can offer. These policies have been initiated and supported byorganizations representing dealers with LD or, to a lesser extent, ODcontracts. The context for this rise in dealer activism is a sharp decline inthe number of stations; from 1973 to 1982 the number of stations in the U.S.declined by over one third, and the remaining stations have higher salesvolumes (U.S. Department of Energy, Petroleum Market Shares). While manyanalysts view this shift toward fewer and higher volume stations as arationalization of the distribution system, dealers are understandablyunhappy. One result of their efforts is the federal Petroleum MarketingPractices Act (1978) disallowing unilateral dealer terminations (even atcontract renewal) except in specifically defined circumstances and limitingthe refiner's ability to extract downstream rents with station- specificfranchise fees. To the extent that these restrictions bind, a clear effectwould be to push refiners toward company outlets as the preferred contractualform. Perhaps in recognition of this effect, dealer organizations haveconvinced several states to prohibit company outlets.Shepard (1990) uses the cross-sectional, Eastern Massachusetts data totest for relationships between station price and quality characteristics andthe choice of contractual form. The refiner's problem is treated as a twostage decision. First, she chooses the station price and qualitycharacteristics that maximize profit at any given location; she then choosesthe contractual form that maximizes profit conditional on the desired stationtype. Because local market power will lead to double marginalization3 whensome of the rent must be extracted via the wholesale price, stations intendedto be high-volume, low-price stations can be run optimally as company outlets.Stations intended to provide complex services that are difficult to monitorbut affect the brand's reputation will be run optimally under an LD contractwhich gives some control over quality to the refiner but makes the dealer aresidual claimant for service income. Using a multinomial choice model,Shepard finds that a low price increases the probability that the station willbe a company outlet relative to either other type but has no effect on theprobability ratio of LD to OD. Stations that provide automotive service, onthe other hand, are less likely to be company outlets and more likely to beLD outlets relative to OD outlets.Another line of research exploits the regime change when legislationprohibiting company outlets goes into effect. Barron and Umbeck (1984), forexample, use data on prices at outlets that were company stores prior to theprohibiting legislation in Maryland and became LD or OD outlets after theprohibition went into effect. They compare these prices to those at nearbystations over approximately the same time periods. They find that prices atCOs were lower relative to nearby stations before prohibition than they wereafter prohibition. They interpret this result as evidence of doublemarginalization at stations where refiners cannot control the retail price.III. DIRECTIONS FOR FURTHER RESEARCHThe sparse empirical work on vertical organization suggests that refinersare choosing vertical contracts that minimize total organizational costs(monitoring costs plus the cost of retailers failing to internalize therefiner's profit). It also suggests that one effect of prohibiting companyoutlets might be to increase the average retail price. It is less clear whatother effects these prohibitions and other restrictions have on the structureand behavior of the retail sector. It may be possible to identify theseeffects by exploiting the variation in the nature of the restrictions acrossstates.The studies of retail pricing rely on product differentiation as a sourceof market power, but they do not directly investigate the nature of spatialand brand competition. The effect on pricing of station density relative todemand could be investigated. Models of differentiation suggest thatsuppliers of a homogeneous product will want to soften price competition byspatially differentiating, but also want to locate at high demand areas. Itmight be that these opposing forces lead stations to cluster in high demandareas but differentiate with respect to brand and type of service. Becausegas stations (and other retail outlets) have clearly defined locations theyappear to be particularly well-suited for investigating these issues.TABLE 1: RETAIL MARGINS(in cents)GasolineAll gasoline:Regular LeadedRegular UnleadedPremium UnleadedSelf-service gasoline:Regular LeadedRegular UnleadedPremium UnleadedNumber ofStations123215121441472518500AverageMargin*28.4(0.21)35.6(0.22)40.0(0.24)24.5(0.21)30.7(0.24)35.1(0.27)StandardDeviation7.28.69.04.55.36.1Full-service gasoline:Regular LeadedRegular UnleadedPremium Unleaded969123011749.233.3(0.29)40.7(0.29)44.8(0.29)10.210.1*Standard errors in parentheses.ENDNOTES1Although prices at any given station in the census were reported onlyonce, data collection extended over thirteen weeks. The wholesale price usedto construct retail margins is the price for the week in which the retailprice was observed.2All differences in means or variances mentioned in the text satisfystatistical significance at the 0.001 level.3Mathewson and Winter (1984) argue that in free entry markets, excessiveentry will lead to dealers choosing prices that are too low from themanufacturer's perspective, not prices that are too high. In gasolineretailing, however, refiners can directly control entry.REFERENCESBarron, John M. and Umbeck, John R. "The Effects of Different ContractualArrangements: The Case of Retail Gasoline Markets," Journal of Law andEconomics, October 1984, 27, 313-328.Borenstein, Severin, "Selling Costs and Switching Costs: Explaining RetailGasoline Margins," Working Paper #305, Institute of Public PolicyStudies, University of Michigan, September 1989.Mathewson, G.F. and Winter, R. A., "An Economic Theory of VerticalRestraints," Rand Journal of Economics, 1984, 28-38.Shepard, Andrea, "Price Discrimination and Retail Configuration, "WorkingPaper #526, MIT Economics department, June 1989., "Choice of Contractual Form in Retail Markets," MIT EconomicsDepartment, 1990.Slade, Margaret E., "Conjectures, Firm Characteristics, and Market Structure:An Empirical Assessment," International Journal of IndustrialOrganization, 1986, 4, 347-369., "Interfirm Rivalry in a Repeated Game: An Empirical Test of TacitCollusion," Journal of Industrial Economics, June 1987, 34, 499-516.

Pricing behavior and verticle contracts in retail markets

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Pricing behavior and verticle contracts in retail markets

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