Alternative forms of buyer power in a vertical duopoly: implications for profits, welfare, and cost pass-through

We examine the implications of different ways in which downstream firms can exercise buyer power over their upstream suppliers. We derive several variations of a model in which two upstream firms supply a differentiated product under exclusive contracts to two downstream firms which compete in prices in the retail market. We begin with a benchmark model (upstream first-mover pricing), and then compare its outcomes with those of models that feature different modes of exercising buyer power: downstream first-mover pricing; Nash Bargaining with linear and two-part tariffs; and vertical integration. We rank these five regimes in terms of wholesale and retail prices, social welfare, the pass-through rates of changes in upstream costs, and downstream firms’ profits. We show under what conditions more powerful downstream firms benefit consumers by exercising ‘countervailing power’ against upstream suppliers. We also show that the lump-sum component of the two-part tariff can go in either direction (a slotting allowance or a franchise fee), depending in a very precise way only on parameters representing bargaining power and the degree of product differentiation. Exactly the same configuration of these parameters is shown to determine the ranking of wholesale and retail prices, pass-through rates, and downstream profits, as between the Nash Bargaining regimes with linear and two-part tariffs. Finally, we show that downstream firms which possess buyer power always prefer vertical arrangements that are socially sub-optimal.