Shopping costs and the welfare effects of countervailing power

Abstract

We show that the countervailing power possessed by a large retailer can lead to an increase in retail prices for consumers and a loss in social welfare. We consider a set-up with vertical contracting between a supplier and a retail industry where a large retailer competes with smaller retailers that carry a narrower range of products. We use the retail competition model developed by Chen and Rey (AER, 2012): consumers are heterogeneous in their shopping cost and the large retailer exerts seller power by screening consumers according to their shopping cost. Thus, consumers will either be multi-stop shoppers or one-stop shoppers depending on their shopping cost. Countervailing power of the large retailer is modeled as the threat of demand-side substitution. The supplier faces a trade-off between maximizing joint-profits and extracting surplus. We show that, in this setting joint-profits maximization calls for marginal wholesale prices equal to marginal cost. While the presence of small retailers generates a competitive pressure, it allows the large retailer to discriminate consumers according to their shopping costs, and this is best achieved through marginal wholesale prices which are at the marginal cost. By contrast, surplus extraction will be effective when the supplier instead charges high marginal wholesale prices. By inducing less intra-brand competition through higher marginal wholesale prices, the supplier makes it less attractive for the large retailer to switch to alternative sources of supply. The reason is that by increasing marginal wholesale prices the screening strategy of the large retailer with respect to consumers is less effective; less intra-brand competition can thus be optimal for the supplier to disadvantage the large retailer. High marginal wholesale prices thus appear as an extracting device of the surplus rather a joint-profits maximization. Industry surplus falls and the retail prices are higher when the large retailer possesses countervailing power. The polarization of the retail industry and the existence of shopping costs are crucial for our analysis.