New Product Introduction and Slotting Fees Preliminary Draft

Transcription

1 ew Product Introduction and Slotting Fees Preliminary Draft Claire Chambolle and Clémence Christin April 8, 016 Abstract The availability of a product in a given store is a form of informational advertising that may go beyond the store itself. We show that each retailer is able to extract a rent in exchange for this informational advertising service on the new product. This slotting fee is paid once, at introduction. It may discourage innovation by a manufacturer and in turn harm consumer surplus and welfare. We further show that this informational spillover facilitates the use of pay-to-stay fees by an incumbent manufacturer to deter new product entry. The amount of slotting fees depends on the characteristics of manufacturers and retailers. A manufacturer is likely to pay lower fees when it can heavily advertize its new product or when it faces a larger buyer. KeyWords: Buyer Power, Innovation, Slotting allowances, Informational externality. JEL codes: L13, L4, M37. We thank Marie-Laure Allain, Stéphane Caprice, Laurent Linnemer, Joao Montez, Jorge Padilla, Sylvaine Poret, Patrick Rey, Andrew Rhodes, Jeanine Thal, Christian Wey, participants at EARIE 015, Jornadas di Economia Industrial 015, AFSE 015 as well as participants at LEI lunch seminar and the TSE Food seminar. We gratefully acknowledge support from the Agence ationale de la Recherche (AR) and the Deutsche Forschungsgemeinschaft (DFG) for the French-German cooperation project Competition and Bargaining in Vertical Chains. IRA UR1303 ALISS, 65 boulevard de Brandebourg 9405 Ivry-sur-Seine, France; Department of Economics, Ecole Polytechnique, route de Saclay 9118 Palaiseau, France, claire.chambolle@ivry.inra.fr. ormandie Université, UCB, CREM-UMR CRS 611, UFR SEGGAT, Esplanade de la Paix, Caen, France, clemence.christin@unicaen.fr 1

2 1 Introduction Slotting fees are upfront payments from the producer to the retailer that are paid to secure a slot for a new product in retailers shelves. 1 Their amount and frequency have rapidly grown since the mid-1980 s. According to the FTC report on slotting allowances on the U.S market, from 50% to 90% of all new grocery product introductions would trigger the payment of such fees in 000. The FTC report further mentions that: [... ] slotting allowances for introducing a new product nationwide could range from a little under 1 million to over million, depending on the product category. 3 Retailers often justify slotting allowances as a risk-sharing mechanism and a means to screen the most profitable innovations. They also argue that slotting allowances are natural cost shifters to pass on the higher retailing costs that result from the increasing flow of new products from suppliers. In contrast, producers often see slotting allowances as rent extracted by increasingly powerful retailers. This paper provides a new rationale for the use of slotting fees. Our starting point is that the demand for a new product depends on the consumers knowledge of its existence. Consumers may be informed through advertising but also more simply by the availability of the new product on retailers shelves. The presence of a new product in a given store is thus a form of informational advertising that may go beyond the store itself. Such an informational spillover may for instance be the result of word of mouth communication among consumers across markets. In other words, by making available the new product, a retailer offers an informational advertising service to the producer. We show that the retailer is able to extract a slotting fee from the manufacturer for this service. Although this slotting fee is only paid once, i.e. at introduction, it may deter the producer s incentive to launch a new product. To do so, we analyze the relationships between an upstream monopolist and several retailers each active on a separate market. We adopt a two-period game in which, in each 1 As in the FTC study (003), we make a clear distinction between slotting fees (for new products) and pay-to-stay fees (for continuing products) as well as advertising and promotional allowances, or introductory allowances and other per unit discounts. FTC staff interviewed six manufacturers and two food brokers, who all gave data for the year 000 (see FTC report, p). 3 This result is obtained assuming that nationwide introduction would require distribution to 85% of the supermarkets in the U.S., and that 85% of these supermarkets would receive a slotting fee, See FTC (003).

3 period, the manufacturer chooses to innovate or not in a first stage and then bargains in a second stage with each retailer to sell its product. We consider secret bargaining among each pair following the multilateral bargaining specification of Stole and Zwiebel (1996). 4 On the demand side, we introduce an informational spillover : When the manufacturer launches a new product in period t, securing one outlet increases demand in all other outlets in which the product is sold in this period. If the new product was launched in period 1, then in period, the market is mature and the informational spillover no longer plays a role. In equilibrium, when the manufacturer launches a new product, he does so in period 1. Comparing the bargaining between the producer and each retailer in the two periods, we show that following the launching of a new product, the retailer is able to extract a slotting allowance from the manufacturer in period 1, i.e. at introduction. We thus derive a new source of buyer power: when selling a new product, the manufacturer must compensate each retailer for the positive informational spillover of a success in their bargaining on all other markets. As a result, informational spillover may deter innovation as the manufacturer may earn a smaller profit, i.e. a smaller slice of a bigger pie, when lauching a new product. We show that innovation deterrence is harmful both for consumer surplus and welfare. We then explore a new product introduction by an entrant when the incumbent manufacturer cannot innovate. In equilibrium, the information spillover enables the incumbent to deter entry by offering pay-to-stay-fees to part of the retailers. Indeed, by locking some of the retailers, the information spillover is limited and therefore the new product cannot reach a mature demand which may be sufficient to discourage entry. We then vary some characteristics of the manufacturer and retailers and analyze their impact on slotting fees and innovation incentives. We show that an advertising campaign when the new product is introduced is likely to lower the amount of slotting fees paid to retailers. Therefore, slotting fees are less likely to deter innovation when the manufacturer is able to heavily advertise its new product at a low cost, as would for instance a well known brand manufacturer. We also show that surprisingly a larger retailer, i.e. a retailer that owns several outlets and is thus present on several markets, may capture less slotting fees per outlet than a smaller retailer. This result contrasts with the usual result that buyer 4 As shown by Stole and Zwiebel (1996), this solution concept gives rise to the Shapley value. 3

4 power comes from buyer size as we exhibit here a positive impact of retail concentration on the manufacturer s innovation incentives. Our work is first related to the industrial organization and marketing literature on slotting fees. A first strand of the literature highlights diverse potential anticompetitive effects of slotting fees without focusing on new products. Shaffer (1991) shows that when differentiated retailers buy from perfectly competing manufacturers who offer an homogenous good, they obtain a contract with slotting fees in exchange for high wholesale prices that enable to relax retail competition. 5 Shaffer (005) considers a framework in which imperfectly competing retailers can either buy from a dominant firm or a competitive fringe. Because of slotting fees, the dominant firm may obtain scarce shelf space even when it is less efficient than rivals, for it is willing to pay a higher price to protect its rent. Conversely Marx and Shaffer (007) highlight that slotting fees may facilitate retail foreclosure: a powerful retailer can use slotting fees to exclude its weaker rival. However, Miklos-Thal et al (011) and Rey and Whinston (013) show that this result may be reversed allowing for contingent contract or menu of tariffs. Marx and Shaffer (010) highlight that capturing the rent of manufacturers through slotting fees may also push retailers to restrict their shelf space. Slotting fees then reduce the variety of products offered to consumers. Though they relate the existence of such fees to retail buyer power, these articles do not take into account the peculiarities of new product introduction in their analysis. A second strand of literature partly fills this void and mainly emphasizes efficiency effects of slotting fees. As shown by Chu (199)or Larivière and Padmanabhan (1997), slotting fees can be an efficient way for privately informed manufacturers to convey information about the likelihood of success of their new product. The retailer simply uses slotting fees as a screening device. Sullivan (1997) and Larivière and Padmanabhan (1997) show that slotting fees may be used to compensate the retailer for extra retail costs inherent to the launching of a new product. Foros et al (009) show that, when the retailer is powerful, slotting fees make up for a high wholesale price that raises incentives for the manufacturer to promote its new product through demand-enhancing investments. Slotting fees therefore enable a better coordination within the vertical chain. 5 See also Foros and Kind (008) for an extension of Shaffer (1991) taking into account procurement alliances. 4

5 To the best of our knowledge, Yehezkel (014) is the only article that both takes into account new product peculiarities and exhibits harmful welfare effect of slotting fees. In a context in which a manufacturer itself does not know either the quality of its product, the optimal contract that gives incentives to the manufacturer to develop costly tests of its product quality comprises a slotting fee. Slotting fees may have harmful welfare effects toward financially constrained manufacturer. In the same vein, our article exhibits slotting fees for the introduction of a new product and emphasizes that, by deterring efficient innovations, slotting fees harm consumers and welfare. In contrast with the existing literature, information about the quality of the new product is perfect within the vertical chain. Consumers are however imperfectly informed about this new product. By offering the new product on its shelves, a retailer contributes to vehicle information about this product to consumers which has a positive spillover effect on the new product s demand. A retailer is therefore able to make the producer pay for this service through slotting fees. Our work also builds on the literature on bargaining and buyer size, e.g Inderst and Wey (003,007), Montez (007), Smith and Thanassoulis (01). More specifically the seminal paper by Chipty and Snyder (1999) show that when an upstream manufacturer negotiates simultaneously with separate retailers, a large buyer obtains a larger (respectively smaller) discount whenever the suppliers gross revenue function is concave (resp. convex). In our set-up, the informational spillover shifts the industry revenue function in the innovation period and in turn affects the bargining between the manufacturer and the retailers in a similar fashion. This paper also relates to the industrial organization literature on buyer power and upstream innovation. Inderst and Wey (007), analyze the upstream incentives to innovate in a similar framework when production cost is convex and show how the presence of large buyer may strengthen the supplier s incentive to innovate. In contrast Batigalli, Fumagalli and Polo (007) show that a larger buyer power may, by increasing hold-up, reduce the upstream incentives to invest in quality. Chen (014) considers, as we do, a framework in which one of the retailers serves several markets whereas other retailers serve only one. He shows that a large buyer has a larger status-quo profit because it can benefit more from backward integration if the negotiation fails, which hinders the manufacturer s incentive to innovate. In contrast, in our framework, buyer size may lower buyer power and therefore 5

6 facilitate upstream innovation. Finally, our paper also indirectly relates to the literature on network effects. In our model, informational spillovers create complementarity between retail markets such as in networks. The potential deterrence effect of the innovation may be, at first sight, related to usual result of under-adoption of a single network (see Farrell and Klemperer (006)). However, such result clearly relies on the simultaneity of consumer s adoption decision. In our model, we have adopted a sequential bargaining approach which prevents such effect from happening. Another striking difference with this literature is that we have strategic buyers who have bargaining power instead of a mass of final consumers. In our model, absent downstream bargaining power, an efficient innovation would always be launched. Each buyer is big enough to make the supplier pay for the spillover exerted on other markets and this is the reason why an efficient innovation may be deterred. When considering competition between an entrant who launches a new product and the incumbent firm who offers an old product, only the entrant can benefit from the informational externality effect. In contrast, one key element in network competition is that adopting one network from a consumers means not adopting another and therefore the externalities goes both ways. Section derives the model. Section 3 highlights that slotting allowances are paid for a new product, at introduction, and derives their consequences on innovation, consumers surplus and welfare. Section 4 explores the case of new product introduction by an entrant. Section 5 analyzes the effect of advertising campaign or buyer size on slotting fees and innovation. Section 6 concludes. The Model We consider a framework with independent and symmetric markets. An upstream firm U may sell a good of quality q through i = {1,..., } symmetric monopolistic retailers. Production and retailing costs are normalized to 0. We first assume that each retailer is the owner of a single outlet. 6 We assume that there is a mass of potential consumers on each market, which we normalize to 1. A representative consumer earns utility u(q, x) from consuming a quantity 6 We will allow further a retailer to exploit several outlets. 6

7 x of a good of quality q. We make the standard assumptions on the utility function, that is u(q, x) 0, u x > 0, u < 0 and u x q > 0. Among the pool of consumers, some may be informed of the existence of a new good, whereas others are not. The representative consumer has a probability ξ(n) of being aware of the existence of the new product, with n {1,, } the total number of markets on which the product is actually sold. The probability ξ(n) is increasing with respect to n, with ξ(0) 0 and ξ() = 1. This reflects the presence of an informational spillover: as more markets sell the new good, there are more informational channels for a given consumer to discover its existence. This informational spillover creates a complementarity link between markets despite the fact that each market is a monopoly. 7 In contrast, we assume that ξ(n) is independent of x i (i {1,, }), that is the strength of the informational spillover is not affected by the quantity sold on each market. Although a correlation between the quantity sold and the strength of the informational spillover would make sense, it creates additional interactions between markets which we want to rule out in our analysis. On a given market i, the representative consumer maximizes its expected indirect utility ξ(n)u(q, x i ) P x i. 8 This generates the inverse demand function P (q, n, x i ). Our assumptions on the consumer s expected utility translate into the following assumptions on demand for a new product: Assumption 1 P (q, n, x i ) P (q, n 1, x i ) > 0 for all n {1,, }. Assumption P (q,n,x i) x j = 0 for all n {1,..., } and all j i. Therefore, demand on a given market for a new product is at most the demand when all markets are active, that is P (q,, x i ). If instead a product is old, consumers on all markets i {1,...} are already aware of its existence and therefore the demand for an old good on every market i is P (q,, x i ) even if the product is not sold on markets i {n + 1,..., }. The informational spillover 7 Two consumers do not need to visit the same store to talk with eachother about a new product. 8 This is one among several possible micro-foundations for our demand function. Another story could be that ξ(n) represents a level of trust of consumers regarding the quality of the new product. As more retailers offer the product, consumers are more inclined to purchase it. ote that in this case, the utility function could instead be written in an addititive way: u(ξ(n)q, x i) P x i. 7

8 has no role to play as an old product is well known by consumers. 9 We denote by υ n the optimal revenue earned in each outlet i {1,...n} when U sells a new product of quality q through n markets. Conditions on the demand function ensure that the output that maximizes revenue on a given market i is unique. We therefore have: υ n (q) max x i P (q, n, x i )x i. (1) Assumption 1 implies that υ n+1 (q) > υ n (q) (see Appendix A.1): an increase in the number of outlets that actually sell the new good increases the individual profit on each active market. Total industry revenue for a new product with n outlets is defined as follows: Υ n (q) n υ n (q) = nυ n (q). () In contrast, the optimal revenue earned in outlet i {1,...n} when U sells an old product of quality q through any number n {0,..., } of markets is υ (q) and total industry revenue is simply nυ (q). We consider a two-period game in which periods are indexed by t {1, } and we neglect the discount factor (δ = 1). In each period, we assume that the manufacturer can produce an old product of quality q at no cost and can innovate at cost F hence launching a new product of quality q + q. The innovation cost is paid only once for all periods and the quality q + is known by the manufacturer and the retailers. We also assume that if the new product was sold in all markets in period 1, then it becomes an old product in period, i.e. its demand in period is P (q +,, x i ) even if n <. 10 In each period, we consider the following three-stage game. In stage 1, the manufacturer chooses whether or not to innovate; in case it innovates it pays F. In stage, the upstream firm bargains simultaneously with each retailer i on a two-part tariff (w it, T it ) where w it is the unit wholesale price and T it a fixed fee for the new (in case of innovation) or the old product (otherwise). 11 In stage 3, each retailer i maximizes its profit by setting quantities on its single outlet. 1 9 ote that we assume that only one type of product is sold at a time in a given outlet. One can see this as a capacity constraint on the retailers shelves. For this reason, the quality q has no subscript i. 10 We prove further that in equilibrium, the new product is sold either on or 0 markets in period In order to reflect actual practices, we assume that long term negotiations over tariffs are not possible. 1 Because we consider local monopolies, we would obtain the same results if retailers set prices. 8

9 We consider a sequential bargaining à la Stole and Zwiebel (1996). In the sequence of negotiations, the success or failure of any given negotiation is common knowledge. Therefore, each retailer knows how many outlets are open when bargaining with the manufacturer U. Besides, in case of failure of the negotiation between one retailer and U, the failing pair can never negotiate again, and all other pairs renegotiate their contracts from scratch. 13 In this framework, in each period t {1, }, each pair U i uses w it to maximize their joint profit and T it to share it. Assumption ensures that the bilaterally efficient wholesale price is w it = 0 for all i {1,..., }. Indeed, there is no incentive for a pair to distort the wholesale price, because for a given market structure, the output decision of one retailer does not affect the output decision of the other retailers. 14 The value of T it depends on the firms respective bargaining weights and outside options. Without loss of generality we set the bargaining weights to ( 1, 1 ).15 If the disagreement payoff of i (resp. U) is d i (resp. d U ), when U bargains with i among n retailers, the optimal fixed fee, T it is given by: n υ n (q) T it d i = T it + T jt d U. (3) j=1,j i 3 Slotting allowance for a new product As the cost of innovation is only paid once whereas the revenue it generates can be at most cumulated over the two periods, it is immediate that, if ever, the manufacturer launches a new product in t = 1. Indeed, it can only be less profitable to launch the new product in t =. Without loss generality we thus restrict our analysis to the case in which the manufacturer makes its innovation decision in t = 1. In section 3.1 we determine the the subgame equilibrium in which the manufacturer has chosen not to innovate in t = 1 and thus sells an old product during the two-periods. In section 3. we consider the other subgame equilibrium in which the manufacturer has chosen to innovate in t = 1 and 13 ote that this bargaining framework is equivalent with simultaneous bargaining in which the parties sign contracts which are contingent to the equilibrium market structure, that is, here, the number of active links in equilibrium. 14 For instance, with P (q,n,x i) x j > 0, the producer of the new product would have an incentive to sell its product at a wholesale price lower than the marginal cost in order to increase the quantity bought by each retailer and therefore increase its profits on all other markets. 15 ote that the outcome of the negotiation coincides with the Shapley value. 9

10 therefore sells the new good over the two periods. Finally, we compare both equilibria and derive the main results of the paper in section The manufacturer does not innovate When the manufacturer does not innovate, the two periods are exactly identical. t {1, }, the manufacturer bargains with manufacturers to sell the old product of quality q. In this case, the profit in each outlet is υ (q) = Υ (q). All negotiations are thus independent of one another, and since the manufacturer and each retailer have no outside option in their bargaining (d U = d i = 0), the manufacturer gets half of the profit on each market. As the manufacturer s profit strictly increases with the number of markets served, U bargains in equilibrium with retailers and therefore in equilibrium obtains a profit Υ (q)/. When the manufacturer sells an old product, its profit is Υ (q)/, and the profit of each retailer i is Υ (q)/(). We denote Π n t (q) the equilibrium profit of the manufacturer in period t when dealing with n firms and selling an old product of quality q. We obtain the following lemma: For Lemma 1 When the manufacturer offers an old product over the two periods, its equilibrium profit is Π t (q) = Υ (q) for t {1, }. Proof. Straightforward. 3. The manufacturer innovates If now the manufacturer has innovated at cost F, it bargains to sell the new product in t {1, }. However the two periods now differ and we thus solve the game backward. Assume that the new product was effectively sold in markets in t = 1 16, then, in t =, the new product generates a profit υ (q + ) on each market i since the informational spillover has already played its role in period 1. Again all negotiations are independent of one another. Still, an important difference remains as compared to the previous case of an old product. In case of a breakdown in one pair s negotiation, the producer is still able to bargain over the old product with the retailer and therefore each of them (U and i) obtains the same disagreement payoff d i = d U = Υ (q). As by assumption q+ q, Υ (q + ) Υ (q), and therefore any negotiation between the manufacturer and a retailer 16 We prove further that if the new product is sold in the period 1, it is always sold by all retailers. 10

11 over the new product succeeds, and υ (q + ) is shared according to equation (3). The optimal fixed fee is thus given by: Υ (q + ) T i Υ (q) = T i Υ (q) As the term Υ (q) is on both sides, it cancels out. In the period equilibrium, retailers sell the new product and pay the same tariff denoted ˆT = Υ (q + ). Denoting the equilibrium profit of the manufacturer in period by ˆΠ (q+ ), we obtain: ˆΠ (q + ) = Υ (q + )/. We now solve backward the negotiation in period 1. In this period, due to the informational spillover, negotiations are no longer independent of one another. When U bargains with n {1,..., } retailers, the outside option of U with retailer i amounts to the profit it would earn if it were negotiating with all n 1 retailers except for i plus the profit obtained from bargaining over the old product on market i. The same reasoning can be applied when U bargains with n 1 retailers, etc. ote that in equilibrium, each retailer considers itself as marginal in its bargaining with the manufacturer, and therefore all n retailers pay the same tariff to U, which we denote ˆT n 1 if n markets are open. We define the upstream equilibrium profit in period 1 as: ˆΠ n 1 (q + ) n ˆT n 1. (4) We first consider the case in which U bargains with only one retailer. In this case, both disagreement payoffs are d i = d U = Υ (q) : U can still bargain with the retailer to sell the old product. Equation (3) can be rewritten as follows: Υ 1 (q + ) ˆT 1 1 Υ (q) = ˆT 1 1 Υ (q) (5) There are now two cases to consider. Case (1) If Υ 1 (q + ) > Υ (q) : the first negotiation succeeds as it is possible to find a mutually profitable agreement and the equilibrium tariff is thus given by: ˆT 1 1 = Υ1 (q + ). (6) U obtains a profit ˆΠ 1 1 (q+ ) = ˆT

12 Case () If Υ 1 (q + ) Υ (q) : the first negotiation breaks down and the manufacturer and the retailer negotiate for the sale of the old product. U obtains a profit ˆΠ 1 1 (q+ ) = Υ (q). Let us now proceed with the complete bargaining in cases (1) and (). In case (1), Υ (q) Υ 1 (q + ) > Υ (q) and thus it is immediate that i 1, we have Υi (q + ) i > and therefore all the negotiations from the first will succeed in equilibrium. If U now bargains with two symmetric retailers, the outside option of U with i = 1, is given by d U = ˆT Υ (q), whereas the outside option of each retailer is d i = Υ (q). From equation (3), and since retailers are symmetric, we obtain: Υ (q + ) ˆT 1 Υ (q) = ˆT 1 ˆT 1 1 Υ (q) 3 ˆT 1 = Υ (q + ) In period 1, the total profit of U when facing two retailers is: + ˆT 1 1 ˆT 1 = Υ (q + ) + Υ 1 (q + ). 6 ˆΠ 1(q + ) = ˆT 1 = 1 3 ( Υ (q + ) + Υ 1 (q + ) ). From this point on, we determine a recurrence relation to obtain ˆΠ n 1 (q+ ) for any n 1. When Υ 1 (q + ) > Υ (q), the manufacturer always bargains in equilibrium with retailers and realizes a profit: ˆΠ 1 (q + ) = The details of the recurrence are provided in Appendix A.. Υ i (q + ). (7) In case (), Υ 1 (q + ) Υ (q), i.e. the first negotiation fails. To determine the equilibrium profit in that case, first assume that negotiations succeed if and only if the producer bargains at least with ˆn retailers. Therefore the cut-off level ˆn is such that the following condition is satisfied: Υˆn 1 (q + ) ˆn 1 Υ (q) Υˆn < (q + ) ˆn ote that there always exists a cut-off level ˆn [1, ] since Υ (q + ) > Υ (q) and Υ 0 (q + ) = 0. Solving the negotiations for all n ˆn, we determine by recurrence the equilibrium profit depending on the value of ˆn [0, ]. (8) When Υ 1 (q + ) Π (q), the 1

13 manufacturer bargains with retailers in equilibrium and obtain a profit: ˆΠ 1 (q +, q, ˆn) = Υ i (q + ) + i=ˆn ˆn(ˆn 1) Υ (q) + 1 (9) Details of the recurrence are provided in Appendix??. It is interesting to note that the profit of the manufacturer in case (1) is the limit of the profit of the manufacturer in case () for ˆn = 1. Thefore, we can summarize the equilibrium profit of the manufacturer on the two period-game in the following lemma: Lemma In case the manufacturer innovates in t = 1, the manufacturer bargains with all retailers in each period t {1, }, and its profit is: ˆΠ 1 (q+, q, ˆn) = 1 +1 i=ˆn Υi (q + ) + ˆn(ˆn 1) Υ (q) +1 where ˆn [1, [ is defined by (8) and ˆΠ (q+ ) = Υ (q + ). Proof. See Appendix A. ote that ˆΠ 1 (q+, q, ˆn) is decreasing with respect to ˆn (See Appendix A.) 3.3 Slotting fees at introduction Comparing the manufacturer s profit in the two cases, we now obtain the following proposition: Proposition 1 When selling an old product, the manufacturer obtains the same profit from the retailer in each period t = 1,. When launching a new product, the manufacturer obtains a smaller profit in the first period (at introduction) than in the second ( ˆΠ (q + ) ˆΠ 1 (q+, q, ˆn) > 0) because each retailer is able to extract a slotting fee for the informational spillover it creates on all other markets. Proof. From Appendix A.1 we know that Assumption 1 implies that Υi (q + ) i < Υ (q + ), i. Therefore: i=ˆn Υ i (q + ) < Υ (q + ) i=ˆn i = (( + 1) ˆn(ˆn 1))Υ (q + ) 13

14 Besides, we know that Υ (q) < Υ (q + ), and therefore we obtain: ˆΠ 1 (q, q +, ˆn) = Υ i (q + ) + i=ˆn ˆn(ˆn 1) Υ (q) + 1 < (( + 1) ˆn(ˆn 1))Υ (q + ) ( + 1) = Υ (q + ) = ˆΠ (q + ). + ˆn(ˆn 1) Υ (q + ) + 1 The rent the retailer is able to capture in the first period from the manufacturer who launches the new product results from a renegotiation effect. ote first that since in equilibrium, retailers sell the new product in period 1, the joint industry profit is the same in both periods, and equal to Υ (q + ). The sharing of this profit, however, is affected in period 1 by the information spillover. In period 1, for any number of open markets n, negotiations are symmetric as each retailer considers itself as marginal in its negotiation with the manufacturer. For all n, in case of a breakdown in the negotiation with one retailer, the profit realized on each remaining market is strictly lower than in case of success, as there is less spillover, i.e. the demand is lower with n 1 markets open than with n. Because of our renegotiation setting, this is common knowledge to all players, therefore each retailer is able to extract some rent from its marginal extra-contribution (the spillover) to total industry profit. For instance, assume = and the negotiation with retailer 1 already took place and succeeded. When bargaining in period 1, in case of a breakdown outside options are d U = υ1 (q + )+υ (q), as retailer sells the old product and retailer 1 sells the new, and d = υ (q). In contrast, in period, outside options are d U = υ (q + )+υ (q) and d = υ (q). As the outside option of the manufacturer is strictly lower in period and the outside option of the retailer is unchanged, the share of the joint profit that the manufacturer is able to extract is lower in period 1. Assume now that = 3. The equilibrium profit of the manufacturer obtained when = is nothing else than its outside option in the negotiation with the marginal retailer when = 3. Therefore, applying the same reasoning as above, the equilibrium profit of the manufacturer is strictly lower than Υ3 (q + ), i.e. the profit it would earn with an old product. This cumulative lag in the status-quo profit of the manufacturer remains and 14

15 keeps degrading the equilibrium manufacturer s profit for all 3 < n. ote that in a simultaneous bargaining setting à la Chipty and Snyder (1999), as a breakdown would not change the equilibrium tariffs paid by all remaining retailers to the manufacturer, the marginal retailer would not be able to extract a rent from the spillover. 17 As a consequence of the spillover and renegotiation effects, each retailer pays a lower fixed fee to the manufacturer in period 1 than in period. Conversely, the manufacturer has to pay slotting fees to each retailer to introduce a new product. ote here that, in contrast to Shaffer (1991), slotting fees do not materialize through negative fixed fees in equilibrium. In our approach slotting fees and standard franchise fees are mixed, and result in equilibrium in a lower payment from the retailer to the manufacturer. 18 However, slotting fees are only paid upfront, that is in period 1. Let us now partly relax Assumption 1 by assuming that the informational spillover entirely disappears once the manufacturer has reached 1 markets in period 1. Indeed, it seems reasonable to assume that a new product only needs to be present in a large enough share (lower than 100%) of the market to reach all its potential consumers. Though there is no extra-contribution of the marginal retailer when bargaining for a new product (as the spillover effects disappears), retailers still obtain slotting fees from the manufacturer. Indeed, the status-quo profit of the manufacturer that results from negotiations with 1 retailers is still lower in period 1 than in period. Therefore in its negotiation, the manufacturer still obtains a profit lower than Υ (q + ). 19 Our result is thus robust to such a variation in the spillover effect (the same reasoning applies whenever the spillover stops after the opening of n markets). 3.4 Innovation deterrence Consider now the decision of the manufacturer to innovate at the first stage in period 1. The manufacturer chooses to innovate if and only if the net benefit it yields (as compared 17 In eq. (3), if the bargaining is simultaneous, d i = Υ (q) and du = j i Tj + Υ (q), and therefore T i = υn (q + ). 18 In contrast with Marx and Shaffer (007) and Miklos-Thal et al (011), we do not distinguish formally the franchise fee as paid when a positive quantity of good is ordered from a slotting fee paid also if the quantity ordered is zero. 19 From eq (3), in period 1, given symmetry among retailers and that d i = υ (q) and d U = υ (q) ˆΠ 1 ˆΠ (q + ), we have ( + 1) ˆT 1 = υ (q + ) + 1 (q + ). Taking into account that υ (q + ) = υ 1 (q + ), as 1 long as ˆΠ 1 (q + ) < Υ 1 (q + ), that is as long as some spillover exists, we have ˆT 1 < υ (q + ). 15

16 to selling an old product over the two periods) exceeds the cost of innovation, that is: [ˆΠ 1 (q +, q, ˆn) + ˆΠ (q + )] [Π 1 (q) + Π (q)] F, We thus obtain the following proposition Proposition In equilibrium if innovation takes place, it arises in period 1. Due to slotting fees, efficient innovations are deterred for any fixed cost of innovation F such that: F [ ˆΠ 1 (q +, q, ˆn) + ˆΠ (q + ) Υ (q), Υ (q + ) Υ (q)]. Innovation deterrence always damages consumer surplus and welfare. Proof. The lower bound is obtained by comparing the manufacturers profit with innovation ˆΠ 1 (q+, q, ˆn) + ˆΠ (q+ ) F and without Υ (q) over the two periods. The upper bound derives from the comparison of the profit the manufacturer would obtain by selling a new product (absent the spillover effect, i.e. Υ (q + ) F and without innovation Υ (q) over the two periods. For more details, see Appenddix A.3. We can show that regardless of the value of ˆn, when dealing with retailers, we always have ˆΠ (q+ ) > ˆΠ 1 (q+, q, ˆn) > Υ (q). Therefore, absent innovation costs, it is always profitable for the producer to introduce the new product when it can use the old product as a threat point in its bargaining with the retailers: without innovation cost, an efficient innovation is always launched in equilibrium. The insight is that, by using the old product as a threat point, the manufacturer is by definition able to extract at least the profit it would get by selling the old product. ote that, the larger the quality gap between old and new products, the less restrictive this condition. hold-up effect arises. Moreover, for F [ Υ (q + ) Υ (q), (Υ (q + ) Υ (q)) ], a standard Indeed, since the manufacturer has to leave half of the rent of innovation to retailers while incurring all the cost, it naturally under-invests. Besides this effect, slotting fees reinforce the innovation deterrence. Proposition shows that the need for the manufacturer to compensate each buyer for the informational externality deters the introduction of some efficient innovations on the market. This damages consumer surplus, because efficient innovation would increase the quality of the product offered to consumers. It also damages the industry profit, as higher quality leads to larger industry profit: although the manufacturer prefers selling 16

17 the old product, the loss inflicted to the retailers is clearly larger than the gain for the manufacturer. Such deterrence effect of slotting fees paid for the introduction of new products was pointed out by the FTC in its 003 report on Slotting allowances: roughly 10 percent of ice cream products fail to earn enough revenue in their first year to cover their slotting fees. Let us now consider a variation in spillover intensity. In our framework, this corresponds to a change in the function ξ(.). If the spillover decreases, that is the spillover is now ξ(n) ξ(n) for all n {1,..., } and there exists n such that ξ(n) > ξ(n), information across markets through the sales in retailers outlets has a smaller role to play to boost demand. Among all potential consumers on a given market, fewer can be captured through word of mouth and/or more consumers are prompt to purchase a new product as soon as it appears in their store. As a result, the gap between the profit without spillover (υ (q + )) and the profit on each market when n < markets are open (υ n (q + )) weakly decreases. 0 We obtain the following corollary: Corollary 3 A decrease (resp. increase) in the informational spillover weakly reduces (resp. reinforces) the amount of slotting fees paid by the manufacturer for the new product introduction. It weakly softens (resp. reinforces) the innovation deterrence effect. Proof. When the information spillover decreases, from eq (), Υ n (q + ) weakly increases for all n [1, 1] and n 1 such that Υ n (q + ) strictly increases. Recall that the profit of the manufacturer is: ˆΠ 1 (q +, q, ˆn) = Υ i (q + ) + i=ˆn ˆn(ˆn 1) Υ (q) + 1 Then, there are three cases: First, if the change in spillover only affects v n (q + ) for n < ˆn and ˆn is unchanged, there is no effect of this change on the manufacturer s profit. Indeed, the term 0 ote that we restrict our attention to monotonic variations in the spillover intensity in the sense that the difference υ (q + ) υ n (q + ) weakly decreases when the spillover decreases for all n [1, 1] and strictly decreases for at least one n [1, 1]. 17

18 1 +1 i=ˆn Υi (q + ) is not affected as it only depends on v n (q + ) for n ˆn. The second term is by definition independent of the spillover. Second, if the change in spillover only affects v n (q + ) for n < ˆn and ˆn decreases as a result of the decrease in spillover, the profit of the manufacturer increases. Indeed, assume that only Υˆn 1 changes and is now equal to Υˆn 1, so that the new threshold is ˆn 1. Then, the new profit of the manufacturer is: i=ˆn Υ i (q + ) + Υˆn 1 (q + ) + 1 We compare this to its former profit, that is: i=ˆn + (ˆn 1)(ˆn )Υ (q). ( + 1) Υ i (q + ) + ˆn(ˆn 1)Υ (q). ( + 1) The difference between these two profits is given by: ( 1 Υˆn 1 (q + ) ˆn 1 ) + 1 Υ (q). Because we now have Υˆn 1 (q + ) ˆn 1 > Υ (q), this term is positive. Finally, if there exists n ˆn such that the decrease in spillover affects v n (q + ), it is immediate that the profit of the manufacturer increases, as 1 +1 i=ˆn Υi (q + ) increases. 4 A new product is launched by an entrant Assume now that the new product of quality q + is launched by a potential entrant, denoted E, while the incumbent manufacturer, denoted I, cannot innovate and therefore at best sells the old product that yields total profit Υ (q). ote that here the innovation stage in each period boils down to an entry decision stage by E. Again, it is always strictly more profitable for E if he enters to do it in period t = 1 as he then gets a profit over the two periods. We thus restrict ou attention to the case where he chooses to enter in t = 1. When threatened by the entry of a rival, the incumbent may now wish to offer exclusive 18

19 dealing agreements to (part of) the retailers to deter entry. Such pay-to-stay fees are however perceived as an exclusionary conduct and may be prohibited in the US by Section 1- of the Sherman Act. In what follows, we first analyze in section 4.1 the decision to enter when pay-to-stay fees are not allowed, and compare innovation deterrence in the two cases in which innovation is made by I and E. In section 4., we then allow I to offer pay-to-stay fees to (part of) the retailers and analyze how such possibility affects innovation deterrence. 4.1 o pay-to-stay fee Assume first that pay-to-stay fees are forbidden. We solve the game backward. Consider the period t =. If E has entered in t = 1, then we prove further that the product is sold in markets in t = 1. Therefore, as by assumption q + q, Υ (q + ) Υ (q), and any negotiation between the manufacturer and a retailer over the new product succeeds, and negotiations are independent of one another. Then, the equilibrium tariff T n t by the following equation (3) : Υ (q + ) is determined T n Υ (q) = T n T n = 1 ( ) Υ n (q + ) Υ (q). (10) n We denote Π n t = n T t n the profit of the entrant who bargains with n retailers at period t. Therefore, we obtain Π ( ) (q+, q) = 1 Υ (q + ) Υ (q). In case of entry, the incumbent obtains 0 whereas absent entry, it obtains Π Υ(q) (q) =. We now solve period t = 1. Consider first that all negotiations but one have failed with E. The disagreement payoff of E is 0, whereas the disagreement payoff of the retailer is Υ (q). From equation (3), the optimal fixed fee denoted T 1 1 is thus given by: Υ 1 (q + ) T 1 1 Υ (q) = T 1 1 T 1 1 = 1 ( ) Υ 1 (q + ) Υ (q). (11) It is immediate that T 1 1 is smaller than the tariff ˆT 1 1 earned by an incumbent firm selling a new product, since the entrant has no status-quo in its bargaining with each retailer. This negotiation does not occur if Υ 1 (q + ) Υ (q). Therefore, as in the previous case, there exists a cut-off value ñ that represents a minimum number of negotiations that must 19

20 take place in order to succeed. Here, the cut-off value is defined by: Υñ 1 (q + ) ñ 1 Υ (q) < Υñ(q + ) ñ It is lower than ñ < ˆn: the entrant needs access to less retailers than the incumbent to successfully launch the new product. By recurrence, we determine the profit made by E in period 1 with n > ñ retailers : ( n Π n 1 (q +, q, ñ) = 1 Υ i (q + ) n + 1 i=ñ n(n + 1) ñ(ñ 1) ) Υ (q) (1) As firms bargain with E in equilibrium, E obtains Π 1 (q+, q, ñ). Without innovation cost, the entrant would always find it profitable to enter and launch the new product, as in the previous case. We summarize our results in the following lemma: Proposition 3 If pay-to-stay fees are forbidden, due to slotting fees efficient innovations by the entrant are deterred for any innovation cost such that: [ ] F Π 1 (q +, q, ñ) + Π (q + ), Υ (q + ) Υ (q) Due to the Arrow replacement effect, a new entrant always has higher incentives to launch a new product than an incumbent manufacturer. Proof. See Appendix A.4. Two forces are in balance to explain that it is easier for the entrant than for an incumbent to launch a new product. On the one hand, the lower bound Π 1 (q+, q, ñ) is always lower to ˆΠ 1 (q+, q, ˆn). Indeed, despite the fact that ñ < ˆn, the entrant has a lower status-quo than the incumbent in its first negotiation (0 v. Υ (q)/). Therefore, it gets a lower share of the joint profit in this first negotiation. This affects all subsequent negotiations and tends to reduce the profit of the entrant as compared to the profit of the incumbent: the hold-up effect is stronger for the entrant than for the incumbent. On the other hand, while the entrant launches the new product as soon as it yields a positive profit, the incumbent must ensure that it yields a larger profit than Υ (q)/, the profit it would earn with the old product. This corresponds to the Arrow replacement effect 0

21 (Arrow, 196), which reduces the net gain of launching a new product for the incumbent. This second effect always dominates. ote that the upper bound Υ (q + ) Υ (q) is larger than the upper bound in the incumbent case Υ (q + ) Υ (q). Again, this is because the replacement effect overwhelms the hold-up effect. 4. Pay-to-stay fees We now assume that the incumbent may offer pay-to-stay fees to the retailers. We now assume that in period t = 1, in a preliminary stage the incumbent may offer an exclusive dealing agreement to each retailer in exchange for a lump-sum payment ( i.e. offer a payto-stay fee). Without loss of generality, we assume that the exclusivity agreement prevails over t = {1, }. These agreements may be discriminatory. After this preliminary stage, a new entrant selling a new product of quality q + > q chooses to enter or not at cost F. Assume first that f > ñ retailers are free, i.e. they have refused the incumbent contract in the preliminary stage. ext, assume that E entered. Then, the f free retailers may bargain with Ein periods t = 1,. In this bargaining, each of the free retailers has a status-quo profit equal to Υ (q). According to the previous section, we know that E thus succeeds in its bargaining with all f retailers in equilibrium in t = 1. As n retailers where selling the product of the incumbent, the spillover has not entirely played its role. In the second period, though, there is no more spillover among the n free retailers: the joint profit on each of the f free outlets is υ f (q + ). In period, I obtains a profit ( f) Υ (q) (minus the pay-to-stay fees), each tied retailer earns Υ the profits of the entrant Π f (q+, q, ñ). We denote π n t (plus the pay-to-stay fee), and the profit of a single retailer which deals with the entrant when n retailers sell the new product in period t. Here, each retailer obtains π f (q+, q) = 1 f (Υf (q + ) + Υ (q) ). We now solve period t = 1. Again, E succeeds in its bargaining with all f retailers in equilibrium in t = 1. As among the f retailers, the spillover effect arises, the profit of the entrant in the first period is Π f 1 (q+, q, ñ) defined by equation (1). In equilibrium, the profit of a free retailer is π f 1 (q+, q, ñ) = Υf (q + ) Π f 1 (q+,q,ñ) f. The profit of I and the tied retailers are the same as in t =. At the entry stage, E enters if and only if it expects a positive profit, i.e. when F < Π f 1 (q+, q, ñ) + Π f (q+, q). In that case the profit of I over the two periods is ( f) Υ (q). 1

22 At the preliminary stage, the incumbent chooses between two types of strategies: either to accomodate or to blockade entry. Assume first that I offers a pay-to-stay fee to ñ or less retailers. In that case, regardless of the number of tied retailers, E enters and sells to all f ñ free retailers. In each period t = 1,, the profit of each retailer that buys from E is necessarily larger than its status-quo profit, Υ (q). Then, each pay-to-stay fee would have to be larger than Υ (q) for any exclusivity contract for t = 1, to be accepted by a retailer. However, I earns at most ( f) Υ (q). I therefore cannot profitably lock-in less that ñ retailers. Second, assume that I offers a pay-to-stay fee to strictly more than ñ retailers. In that case, if all retailers accept, entry is blockaded and I earns Υ (q). It is then optimal for I to offer pay-to-stay fees to exactly ñ + 1 retailers. Each retailer is ready to accept a pay-to-stay fee, denoted φ, if its profit with I is then at least equal to the profit he would obtain in refusing the exclusive dealing agreement and successfully negotiating with E after entry. This condition can be written as follows: Υ (q) + φ π 1 (q +, q, ñ) + π (q +, q, ñ). (13) The incumbent chooses φ in order to bind the above constraint. As in case of entry, the incumbent has no profit, it is ready to pay such a fee to each of the ( ñ + 1) retailers whenever it obtains a larger profit in blockading entry, that is if: Υ (q) ( ñ + 1)φ. (14) This condition can then be written as follows: Υ (q) > ñ + 1 ( π ñ (q +, q, ñ) + π (q +, q) ). (15) We obtain the following proposition: Proposition 4 With pay-to-stay fees, entry can be blockaded by the incumbent even without innovation cost. It is all the easier to blockade entry that the threshold ñ is larger. In particular, it is impossible for the incumbent to blockade the entrant if ñ = 1 as long as q + > q. Entry is more likely to be blockaded as the difference in quality between the old and new products decreases.

23 Proof. See Appendix A.5 Compared to the previous cases, pay-to-stay fees facilitate innovation deterrence. Entry is blockaded without innovation cost, but only because, due to pay-to-stay fees, less than m retailers remain free to bargain with the entrant. The condition for entry to be blockaded when m = M is very likely to hold, as Assumption 1 implies that ΠM 1 (q + ) M 1 < Υ (q + ) M. Entry could only occur if the informational spillover was extremely strong and concentrated on the last retailer. In particular, if we consider that the informational spillover is constant or decreasing, the incumbent always blockades entry when m = M. The strategy of the incumbent in this framework corresponds to the divide-andconquer strategy highlighted in the literature on naked exclusion. In particular, Segal and Whinston (000) focus on a framework in which an incumbent producer sells its good to several buyers. Because of cost economies of scale, a potential rival can only enter if it can deal with a sufficiently large number of buyers (say m). Then, when buyers can coordinate and the joint profit is large enough, the incumbent may profitably deter entry by offering exclusive dealing agreements to a large enough subset of buyers. Our condition (14) precisely corresponds to this argument. 1 In our framework, however, the advantage of the incumbent results from the informational externality, which similarly ensures that the optimal profit is convex with the number of firms. ote also that, in contrast with the literature, it is essential that retailers have a positive bargaining power. Indeed, the need to secure at least m retailers to launch its product would not exist absent any retailer s bargaining power. Besides, in our framework, it is possible to exclude the potential entrant even if it bears no cost to launch the new product. 5 Who Pays more Slotting fees? 5.1 Advertising strategies and slotting fees Consider now that the manufacturer can affect the informational spillover intensity. He could do so for instance by launching an advertising campaign to inform consumers about 1 ote also that the result of Rasmusen et al. (1991) holds in our framework. That is, if retailers cannot coordinate over accepting or refusing the incumbent s offer, there exists an equilibrium in which the incumbent can profitably deter entry by offering any pay-to-stay fee between 0 and Π /M to each retailer. 3