Upstream conduct and price authority with competing organizations

Economists Enrique Andreu, Damien Neven, Salvatore Piccolo and Roberto Venturini recently authored an article for the Journal of Economics and Management Strategy. The article examines the degree of price authority that competing upstream principals award their downstream agents in a setting where these agents own private information about demand and incur nonverifiable distribution costs.

The objective is to understand the forces shaping delegation and the constraints imposed on equilibrium prices. When principals behave noncooperatively, agents are biased toward excessively high prices because they pass on distribution costs to consumers.

Abstract

We characterize the degree of price authority that competing upstream principals award their downstream agents in a setting where these agents own private information about demand and incur non-verifiable distribution costs. Principals cannot internalize these costs through monetary incentives and design `permission sets' from which agents choose prices. The objective is to understand the forces shaping delegation and the constraints imposed on equilibrium prices. When principals behave non-cooperatively, agents are biased towards excessively high prices because they pass on distribution costs to consumers. Hence, the permission set only features a price cap that is more likely to bind as products become closer substitutes, in sectors where distribution is sufficiently costly, and when demand is not too volatile. By contrast, when principals behave cooperatively, the optimal delegation scheme is richer and more complex. Because principals want to charge the monopoly price, the optimal permission set features a price floor when the distribution cost is sufficiently low, it features instead full discretion for moderate values of this cost, and only when it is high enough, a price cap is optimal. Surprisingly, while competition (as captured by stronger product substitutability) hinders delegation in the non-cooperative regime, the opposite occurs when principals maximize industry profit.

Introduction

Upstream principals (manufacturers or upstream suppliers) often delegate authority to their downstream agents (retailers or local distributors), who possess market knowledge critical for local pricing decisions (Joseph, 2001; Lai, 1986). Yet, the preferences of these agents do not always align with the objectives of their principals. As a result, they may exploit their informational advantage to abuse discretion and make choices suboptimal from the principals' standpoint. This misalignment of preferences gives rise to the so-called “delegation dilemma”: giving up authority to gain flexibility or retain price control and implement rigid rules unresponsive to local market conditions?

The positive relationship between price delegation and firm performance has been documented in several prominent industries, with this link becoming stronger as market uncertainty and information asymmetry increase (see, e.g., Frenzen et al., 2010; Homburg et al., 2012; and Phillips et al., 2015, among others). Yet, the evidence on the relationship between competition and delegation is far from conclusive. While Acemoglu et al. (2007) and Bloom et al. (2009) document a positive correlation between competition and delegation, Marin and Verdier (2008) report evidence from Germany and Austria that firms tend to centralize decisions when competition intensifies.

What are the determinants of price delegation in competitive environments? How does this form of delegation depend on the principals' conduct in the upstream market? What types of constraints does it require? What managerial and policy lessons can be learned from the endogenous link between product market competition, upstream conduct, and price delegation?

To answer these questions, we follow Melumad and Shibano (1991) and apply the idea of constrained delegation to a framework where the principals of two competing vertical organizations (supply chains) grant price discretion to their exclusive agents, who are privately informed about an aggregate demand shock. To introduce a simple wedge between upstream and downstream objectives, we assume that agents incur a nonverifiable distribution cost to finalize a sale. These nonverifiable costs, together with agents' private information, create a natural misalignment of preferences. That is, agents are incentivized to pass on these costs to consumers and, therefore, charge excessive prices compared to what upstream competition mandates (a logic reminiscent of the double marginalization phenomenon).

This scenario is common in several prominent industries where multinational corporations centralize production and sell their products in many parts of the world (e.g., automotive, trucks, aerospace, digital devices, etc.). In these sectors, consumer prices in each location may have country-specific components (common to all distributors competing in a specific market) and product-specific distribution costs that may be difficult to estimate at the upstream level (see, e.g., Goldberg & Verboven, for evidence of local marginal cost components for car prices).

Within this setting, we characterize the equilibrium permission set from which agents are entitled to choose prices, determine what constraints (if any) principals impose on their pricing choices, and examine how these constraints respond to industry characteristics such as product substitutability and demand uncertainty. We consider two alternative decision-making regimes. In the first regime, principals choose the permission set granted to their agents noncooperatively—that is, each principal maximizes her profit for given expectations about the rival's behavior. In the second regime, principals maximize industry profit—for example, because they agree on a code of conduct constraining pricing discretion on an industry-wide basis, merge into a single multiproduct monopolist delegating every product line to an agent, or form a cartel with the deliberate scope of harmonizing pricing decisions.

In the noncooperative regime, we show that agents are biased toward excessively high prices compared to the price their principals would choose in a noncooperative equilibrium of the hypothetical scenario where they can observe demand. The reason is that the pricing choices of these agents reflect their distribution cost, thereby creating a pass-through that lowers sales and hurts principals (as well as consumers). Hence, in the noncooperative regime, the equilibrium permission set only requires a price cap (or, equivalently, a list price) that limits from above the set of prices that agents can charge to final consumers to avoid that they appropriate excessive margins when demand conditions are favorable. Moreover, we show that the equilibrium price cap is more likely to bind when products are relatively closer substitutes and in sectors where distribution costs are sufficiently high. Instead, the price cap is less likely to bind in industries featuring higher demand volatility.

These findings are broadly consistent with customized pricing with discretion (see, e.g., Phillips, 2021), a practice that appears to be widespread in several markets where prices are inherently customized due to the additional costs needed to satisfy buyers (e.g., quality customization, delivery requirements, service provision such as loan and insurance application, etc.). However, downstream agents are allowed further discretion to negotiate rebates with customers off the list price set in advance upstream.

In the cooperative regime, which is the most interesting and novel aspect of our analysis, the optimal permission set features a richer and more complex structure than in the noncooperative regime: a counterbalancing force shapes the conflict of interest between principals and agents. The reason is that industry profit maximization (or firms' attempts to coordinate prices) requires prices to increase to the monopoly level. As a result, a moderate distribution cost may, ceteris paribus, align incentives within the competing organizations. The optimal permission set features a price floor rather than a list price when the distribution cost is sufficiently low. It features complete discretion for moderate values of this cost. Only when it is large enough it features a price cap. Furthermore, the region of parameters in which agents are granted full pricing discretion expands when demand is more uncertain and when the market becomes more competitive, as implied by greater product substitutability. Interestingly, these findings question the traditional view that upstream coordination is associated with tighter vertical price control and suggest that principals' cooperative conduct may partly explain observed patterns of price delegation rather than individual decision-making behavior.

Summing up, in addition to showing that collusion in the upstream market does not necessarily require price caps and may well be consistent with full delegation, another key message of our analysis is that the impact of competition on delegation depends, among other things, on the conduct of principals in the upstream market. The evidence of a negative relationship between competition and delegation offered by Marin and Verdier (2008) aligns with the noncooperative conduct of principals in the upstream market. Yet, the evidence of a positive relationship between competition and delegation offered by Acemoglu et al. (2007) and Bloom et al. (2009) is consistent with the results obtained in the cooperative regime. Therefore, controlling for principals' conduct in the upstream market when investigating the link between competition and delegation empirically might be essential in obtaining estimates more aligned to economic theory.

The rest of the paper is organized as follows. Section 2 lays down the model. In Section 3, we characterize the benchmark with informed principals. Section 4 characterizes the equilibrium permission set under each decision-making regime. In Section 5, we highlight the robustness and limitations of the baseline model. In Section 6, we summarize the connections between our model and the existing literature. Section 7 concludes. Proofs are in the appendix. Further material is available in the online appendix.

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This paper was originally published for the Journal of Economics & Management strategy here. The views expressed are those of the authors only and do not necessarily represent the views of Compass Lexecon, its management, its subsidiaries, its affiliates, its employees, or clients.

Enrique Andreu, Damien Neven, Salvatore Piccolo and Roberto Venturini , Upstream conduct and price authority with competing organizations, Journal of Economics & Management Strategy (2023), https://onlinelibrary.wiley.com/doi/10.1111/jems.12546