Revenue Sharing, Demand Uncertainty, and Vertical Control of Competing Firms

Abstract

This paper argues that revenue sharing is a valuable instrument in vertically separated industries when there is intrabrand competition among the downstream firms, demand is stochastic or variable, and downstream inventory is chosen before demand is realized. In these environments, the upstream firm would like to simultaneously soften downstream competition and encourage efficient inventory holding. Traditional two-part tariffs cannot achieve both objectives in the presence of downstream competition. Raising the price of the inputs softens price competition but distorts the downstream firms' inventory decisions. We argue that revenue sharing, combined with a low input price, aligns the incentives in the vertical chain. The use of revenue sharing in video rental retailing is discussed. Blockbuster in particular has used revenue sharing in conjunction with heavy marketing of availability to grow significantly in the video rental retail industry. Many other outlets use revenue sharing as well. Some antitrust concerns have been raised by smaller firms suggesting that revenue sharing might be an anticompetitive vertical restraint. Although our model does not address retailer market power, we show that revenue sharing contracts can be used by upstream firms increase inventory holding and consumer welfare.