Margaret E. Slade
In most Western economies, a very large fraction of retail sales are subject to some form of exclusive-dealing clauses. 1 Within this class, new-automobile sales dominate. Other products and services, however, such as gasoline, fast food, and business services, are also important. Most of these exclusive-retailing arrangements can be grouped under the umbrella of franchising.
Within the realm of franchising, there are two commonly used modes. Traditional franchising, which involves an upstream producer and a downstream seller (e.g., gasoline), is more important from a sales-revenue point of view. Business-format franchising, however, is growing faster. 2 With business-format franchising, production takes place at the retail outlet (e.g., fast-food). In this chapter, I consider the traditional manufacturer-retailer relationship.
The products that are sold through exclusive-retailing arrangements are most often branded and are thus not homogeneous from the consumer’s point of view. It is well known in the economics literature that differentiation, whether it results from the brand name, the spatial location of the retail outlet, or any other source, endows a seller with some degree of pricing power. 3 Furthermore, manufacturers of consumer products are apt to operate in markets that can be classified as oligopolistic rather than perfectly competitive. At the upstream or manufacturing level, pricing power can be due to economies of scale that limit entry, exclusive trademarks, or unique product features.
When both upstream and downstream firms possess some degree of pricing power, the monopoly market failure is compounded. Indeed, since each firm extracts a profit, there are successive output restrictions that result in retail prices that are higher than those that would be chosen by a single vertically integrated producer/retailer pair. This phenomenon is usually referred to as double marginalization. 4 Furthermore, the manufacturer’s profit is lower, and the sum of manufacturer and retailer profits can be lower under double marginalization than under integration. 5 One might therefore expect manufacturers to sell their products themselves or through vertically integrated subsidiaries. However, although such arrangements exist, they do not dominate retail markets. Indeed, retail markets tend to be organized according to one of several standard forms.