You are on page 1of 51

Wholesale Bargaining: Models

and Antitrust Implications
Joshua Gans
Melbourne Business School
University of Melbourne
Background Papers

Joint work with Catherine de Fontenay

RAND Journal of Economics, 2005

Review of Network Economics, 2005

IJIO, 2004

“Bilateral Bargaining with Externalities”

Applications

“Concentration Measures and Vertical Market Structure”
(JL&E forthcoming)

“Markets for Competitive Advantage” (w/ Michael Ryall)

“Network Bargaining” (Martin Byford)
Wholesale Markets

Posted prices

Spengler (JPE): double
marginalisation

Salinger (QJE): successive
Cournot oligopoly

Take it or leave it offers

Hart and Tirole (1990)

O’Brien and Shaffer (1992)

McAfee and Schwartz (1994)

Segal (1999)

Marx and Shaffer (2004)

Bargaining

Inderst and Wey (2003)

O’Brien and Shaffer (2004)

Segal and Whinston (2001)

Stole and Zwiebel (1996)

Grossman-Hart-Moore

MacDonald and Ryall (2004)

Brandenberger and Stuart
(2006)
Antitrust Issues: Traditional Views
How do we analyse
competition between
sellers into a wholesale
market?

Same as any horizontal
market

Versus countervailing
power from buyers
How do we analyse vertical
restrictions?

Perfect efficient contracting:
vertical practices only
chosen for efficiency
reasons

Versus firms with market
power who can use practices
to extract rents
New Results

Changes in competition (e.g., concentration) in
upstream markets have a different impact on
final consumers than changes in downstream
markets

Vertical practices can have anti-competitive
effects and result in a redistribution of rents

Can use quantitative bargaining models to
analyse trade-offs
Outline
1. Our Bargaining Model and Result
2. Treatment of Upstream Competition
3. Analysis of Vertical Integration
4. Future Directions
The Research Goal for Strategy
Environmental
Characteristics:

Consumer demand

Resource availability
• Production technology
• Bargaining power
Surplus
Generated
Surplus
Division
Payoffs to
owners of
factors of
production
Given environmental characteristics, what
are the expected payoffs to factor owners?
That is, what determines appropriability.
Cooperative Bargaining Theory
The Benefits

Relates environmental
characteristics to surplus
division

Easy to compute

E.g., Myerson-Shapley
value is weighted sum of
coalitional values
The Problems

Presumption that
coalitions operate to
maximise surplus

Requires observable and
verifiable actions

Coalitional externalities
are usually assumed
away

If considered, impact on
division only (Myerson)
Non-Cooperative Bargaining Theory

Benefit: Robust
predictions in the
bilateral case

Nash bargaining

Rubinstein and Binmore-
Rubinstein-Wolinsky

Problem: Bilateral case
in isolation cannot deal
with

externalities

coalitional formation
D1
U1
We need a theory that can deal with
this …

Competitive Externalities

Ds and Us may be competing
firms

Can’t negotiate

Bilateral Contracts:

Ds and Us cannot necessarily
observe supply terms of
others

Connectedness does not
necessarily imply surplus
maximisation
D1
UA
D2
UB
… while being tractable and intuitive.
Our Approach

Bilaterality

Assumes that there are no actions that can be
observed beyond a negotiating pair

Potential for inefficient outcomes

Non-cooperative bargaining

Does not presume surplus maximisation

Looks for an equilibrium set of agreements
Our Results
In a non-cooperative model of a sequence of bilateral
negotiations …

There exists a Perfect Bayesian Equilibrium whereby

Coalitional surplus is generated by a Nash equilibrium
outcome in pairwise surplus maximisation

Division is based on the weighted sum of coalitional
surpluses

We produce a cooperative division of a non-
cooperative surplus

Strict generalisation of cooperative bargaining solutions

Collapses to known values as externalities are removed

Non-cooperative justification for cooperative outcomes
Some Notation

Actions
– q
ij
is the input quantity
purchased by Di from Uj
– t
ij
is the transfer from Di to Uj

(A1) Can only observe
actions and transfers you are a
party to (e.g., UB and D2
cannot observe q
11
or

t
11
)

Primitive Payoffs
– Di: π (q
iA
+q
iB,
q
-iA
+q
-iB
)–t
i1
–t
i2
– Uj: t
1j
+ t
2j
– c(q
1j
+q
2j
)

Usual concavity assumptions
on π (.) and c(.)
D1
UA
D2
UB
Network State

Network

Bilateral links form a graph of
relationships denoted by K

Initial state: K =
(1A,1B,2A,2B)

If a pair suffer a breakdown
(e.g., D1 and UA), the new
network is created

New state: K = (1B,2A,2B)

(A2) The network state (K) is
publicly observed
D1
UA
D2
UB
D1
UA
D2
UB
Possible Contracts

Bilaterality

As terms of other pairs are unobserved by at least
one member of a pair, supply terms cannot be
made contingent upon other supply contract terms

Network Observability

As the network state is publicly observed supply
terms can be made contingent on the network state

Example:
• q
11
(1A,1B,2A,2B) = 3 and t
11
(1A,1B,2A,2B) = 2 and
q
11
(1A, 2A,2B) = 4 and t
11
(1A, 2A,2B) = 5 and so on.
Extensive Form

Fix an order of pairs (in this case 4)

Precise order will not matter for equilibrium we focus on

Each pair negotiates in turn

Randomly select Di or Uj
– That agent, say Di, makes an offer {q
ij
(K), t
ij
(K)} for all possible K
including Di and Uj.
• If Uj accepts, the offer is fixed and move to next pair
• If Uj rejects,
– With probability, 1-σ , negotiations end and bargaining recommences over the
new network K –ij.
– Otherwise negotiations continue with Uj making an offer to Di.

Binmore-Rubinstein-Wolinsky bilateral game embedded in a
sequence of interrelated negotiations

Examine outcomes as σ goes to 1.
Beliefs
• Game of incomplete information
– Need to impose some structure on out of equilibrium beliefs
– Issue in vertical contracting (McAfee and Schwartz; Segal) in that
one party knows what contracts have been signed with others and
offer/acceptance choices may signal those outcomes
• Simple approach: impose passive beliefs
– Let be the set of equilibrium agreements
– When i receives an offer from j of or
– i does not revise its beliefs about any other outcome of the game
,
ˆ
ˆ { ( ), ( )}
ij ij ij K
q K t K

ˆ ( ) ( )
ij ij
q K q K ≠ ˆ
( ) ( )
ij ij
t K t K ≠
Equilibrium Outcomes: Actions

Bilateral Efficiency

A set of actions satisfied bilateral efficiency if for all ij in
K,

Suppose that all agents hold passive beliefs. Then, as
σ approaches 1, in any Perfect Bayesian
equilibrium, each q
ij
(K) is bilaterally efficient (given
K).
1 2
ˆ ˆ ˆ ˆ ( ) argmax ( , ( ) ( )) ( ( ))
ij
ij x iA iB iA iB j j
q K q q q K q K c q q K π
− −
∈ + + − +
Equilibrium Outcomes: Actions
• Suppose that all agents hold passive beliefs. Then, as σ approaches 1, in any Perfect
Bayesian equilibrium, each q
ij
(K) is bilaterally efficient (given K).
• Intuition
– Negotiation order: 1A,1B,2A,2B and suppose that 1A and 1B have agreed to the equilibrium
actions
– If 2A agree to the equilibrium action, 2B negotiate and as this is the last negotiation, it is
equivalent to a BRW case – so they choose the bilaterally efficient outcome
– If 2A agree to something else, D2 will know this but UB wont
• UB will base offers and acceptances on assumption that 2A have agreed to the equilibrium outcome
(given passive beliefs)
• D2 will base offers and acceptances on the actual 2A agreement. Indeed, D2 will be able to offer (and
have accepted) something different to the equilibrium outcome
– Given this, will 2A agree to something else?
• D2 will anticipate the changed outcome in negotiations with UB
• Under passive beliefs, UA will not anticipate this changed outcome (so its offers don’t change)
• D2 will make an offer based on:
• By the envelope theorem on q
2B
, this involves a bilaterally efficient choice of q
2A
.
2
2 2 2 2 1 1 1 2 1 2 2
ˆ ˆ ˆ ˆ argmax ( ( ), ) ( ) ( ( ))
A
A q A B A A B A A B B A
q q q q q q c q q c q q x π ∈ + + − + − +
Equilibrium Outcomes: Payoffs

Result: As σ approaches 1, there exists a perfect
Bayesian outcome where agents receive:

This is each agent’s Myerson-Shapley value over
the bilaterally efficient surplus in each network.
( ) ( )
1
6
ˆ ˆ ˆ ˆ ˆ ˆ 3 (1 ,1 , 2 , 2 ) (1 ,1 , 2 , 2 ) 2 (1 , 2 ) (1 , 2 ) ( , ) 2 ( , )
UA
v A B A B c A B A B j j c j j iA iB c iA iB π π π · − − + + −
( ) ( )
1
1 6
ˆ ˆ ˆ ˆ ˆ ˆ 3 (1 ,1 , 2 , 2 ) (1 ,1 , 2 , 2 ) 2 (1 , 2 ) (1 , 2 ) ( , ) 2 ( , )
D
v A B A B c A B A B j j c j j iA iB c iA iB π π π · − + − − +
Remarks

Stole and Zwiebel adopt a similar approach in proving their
non-cooperative game yields a Shapley value

Make mistake: do not specify belief structure

Our most general statement shows that the solution concept is
a graph-restricted Myerson value in partition function space.

The symmetry in the buyer-seller network case masks some additional
difficulties in the general case

There is some indeterminacy in the complete graph case

The cooperative game solution concept has never been stated before

Nor has it been related to component balance and fair allocation

So our proof does cooperative game theory before getting to the steps
before
Ultimate Solution
1
1 1
ˆ ( , ) ( 1) ( 1)! ( , )
( 1)( ) N
p P
i
T P i T P
P P
T T
N L p v T L
N p N T

′ ∈ ∉ ∈

′≠
]
]
ϒ · − − −
]

− −
]
]
∑ ∑ ∑
where:
• N is the set of agents
• P is a partition over the set of agents with cardinality p
• P
N
is the set of all partitions of N
• L is the initial network (i.e., initial set of bilateral links)
• L
P
is the initial network with links severed between partitions defined
by P.
Additional Results

(No component externalities) Suppose that primitive
payoffs are independent of actions taken by agents
not linked the agent

Obtain the Myerson value over a bilaterally efficient
surplus.

(No non-pecuniary externalities) Suppose that the
primitive payoffs are independent of the actions the
agent cannot observe

Obtain the Myerson value.

If agreements are non-binding and subject to
renegotiation, the results hold.
Computability
m buyers
S1 S2
( )
1
0 0
1
0 0 0
( 1)
ˆ( , 2)
2
( 2)
( 1)
ˆ |
2 1
s i
m x
S
s i
m x h i
m s h m m s m s h
s h i
s
m i
v v m s
s m i
m s h
m m s i
v s h
s h m i m h

· ·
− − − +
− − − − −
· · ·
| `
| `



| `
. ,

· −


− +
. ,

. ,
| − − `
| `




| `| ` −
. ,

+ +


− + − +
. ,. ,

. ,
∑ ∑
∑∑ ∑
ˆ
( , 2) v m s −
( )
ˆ
| v s h
Bilaterally efficient surplus
with m-s buyers supplied by
both suppliers
Bilaterally efficient surplus if s
buyers are supplied only by S1
and h are supplied only by S2
Upstream Competition
Why upstream competition should be
treated differently when there is
wholesale bargaining?
2 x 2 Structure (NI)

U
A
U
B

D
1
D
2
Model Structure & Notation

2 upstream & 2 downstream assets each with an associated
manager (necessary for the asset to be productive); integration
changes ownership but not need to use manager
• U
j
can produce input quantities, q
1j
& q
2j
to D
1
and D
2
at cost,
c
j
(q
1j
, q
2j
); quasi-convex
• D
1
earns (gross) profits of π
1
(q
1A
,q
1B
;q
2A
,q
2B
); concave in (q
1A
,q
1B
)
and non-increasing in (q
2A
,q
2B
).

Industry profit outcomes:
1 1
2 2
1 2 , 1 1 1 2 2 2 2 2 1 1 1 2 1 2
,
( ) max ( , , , ) ( , , , ) ( , ) ( , )
A B
A B
A B q q A B A B A B A B A A A B B B
q q
D D U U q q q q q q q q c q q c q q π π Π ≡ + − −
1 1
1 , 1 1 1 1 1
( ) max ( , , 0, 0) ( , 0) ( , 0)
A B
A B q q A B A A B B
DU U q q c q c q π Π ≡ − −
1
1 1 1 1
( ) max ( , 0, 0, 0) ( , 0)
A
A q A A A
DU q c q π Π ≡ −
1
1 2 1 1 2 1
( , ) max ( , 0, 0, ) ( , 0)
A
A B q A B A A
DU DU q q c q π Π ≡ −
Upstream Merger
U
A
U
B
D
1
D
2

D
2
U
A
U
B

D
1
Incentives to Merge

Upstream firms jointly gain:
– One third of the profits from a U
B
Monopoly

Intuition: the possibility that a breakdown could
generate this was used by downstream firms as
leverage on the other upstream firm

Downstream firms jointly lose this

Face higher transfers
Impact on Efficiency

Bilateral negotiations for upstream supply under
upstream competition

Bilateral negotiations for upstream supply under
upstream monopoly
No difference in outcomes so no impact on efficiency
1
1 1 1 2 2 1 2
max ( , ; , ) ( , )
A
q A B A B A A A
q q q q c q q π −
1
1 1 1 2 2 1 2 1 2
max ( , ; , ) ( , ) ( , )
A
q A B A B A A A B B B
q q q q c q q c q q π − −
Upstream Competition

Changes to upstream competition have a different
impact to changes in downstream competition

Fragmentation amongst downstream firms drives
impact on consumers, input and output choices. It
constrains upstream market power.

Extreme: permit upstream mergers when there is no
vertical integration

Leads to additional upstream investment (maybe over-
investment)

May lead to reduced downstream entry
Vertical Integration
What is the competitive impact of
vertical integration?
Effect of Integration
U
A
U
B
D
1
D
2
U
A
U
B
D
1
D
2
U
A
U
B
D
1
D
2
FI
BI
Will D
1
and U
A
profit from VI?
( )
1
1 2 2
1
1 2 6
1
1 2 2 6
ˆ
( )
ˆ
( )
ˆ
( ) ( )
UC A B
UC A
B B
D DU U
D DU
D DU DU
∆ Π
+ ∆ Π
+ Π −Π
FI
BI
UC UM
( )
1
1 2 2
1
1 2 6
1
1 2 6
ˆ
( )
ˆ
( )
( ) ( )
UC A B
UC A
A B B
D DU U
D DU
DU U DU
∆ Π
+ ∆ Π
+ Π −Π
1
1 2 2
1
1 2 6
ˆ
( )
ˆ
( )
UM A B
UM A
D DU U
D DU
∆ Π
+ ∆ Π
( )
1
1 2 2
1
1 2 6
1
2 1 2 6
ˆ
( )
ˆ
( )
ˆ
( ) ( )
UM A B
UM A
A B B
D DU U
D DU
DU U D DU
∆ Π
+ ∆ Π
+ Π −Π
Comparisons

FI versus BI

UC versus UM
As downstream products become more differentiated, strategic VI is
more likely under upstream competition than upstream monopoly
1 2 2
ˆ
( ) ( )
B A B
D D U D U U Π ≥ Π
( )
1
1 2 2 3
1 2 1 2
ˆ
( ) ( )
ˆ ˆ
ˆ ˆ
( ) ( )
B B
UM A B UC A B
D D U D U
D D U U D D U U
Π − Π
≥ Π − Π
Impact on Efficiency

Bilateral negotiations for upstream supply under NI

Bilateral negotiations for upstream supply under VI
Incentive to ‘raise rivals’ costs’
1
1 1 1 2 2 1 2
max ( , ; , ) ( , )
A
q A B A B A A A
q q q q c q q π −
1
1 1 1 2 2 1 2
max ( , ; , ) ( , )
A
q A B A B A A A
q q q q c q q π −
2
1 1 1 2 2 2 2 2 1 1 1 2
max ( , ; , ) ( , ; , ) ( , )
A
q A B A B A B A B A A A
q q q q q q q q c q q π π + −
2
2 2 2 1 1 1 2
max ( , ; , ) ( , )
A
q A B A B A A A
q q q q c q q π −
VI and Foreclosure
• Upstream competition
– With homogenous inputs (and some symmetry), VI does not change
efficiency
• Upstream monopoly
– VI leads to industry profit maximisation (with symmetry and
substitutability); D
2
is not supplied any inputs

Under FI, D
2
still receives a payoff of:
Technical foreclosure but downstream firm still valuable in
disciplining internal negotiations
( )
2
1
1 2 12
( ) ( ) ( )
D A B i j
v FI D DU U DU · Π −Π
An Outsourcing Issue

Outsourcing (make vs buy) decision

Typically assumes ‘new’ function or no sunk assets in the
industry

Major outsourcing decisions: typically involve existing
assets that must be divested or scrapped

Dilemma

If outsource to existing firm, vulnerable to lack of upstream
competition in the future (lack of long-term contracts).

If create new independent supplier, assets divested may not
be worth as much.

Examples: GE to Matsushita vs Samsung; Motorola to
BenQ.
Outsourcing Dilemma
U
A
D
1
U
B
D
2
U
A
-U
B
D
1
D
2
or ?
Create U
A
or sell assets to U
B
?
Integration implies common ownership of assets
Assume that D
1
and D
2
do not compete and fixed gain from outsourcing, ∆
Results

D
1
chooses to outsource to U
B
over an independent firm if

Established outsourcing reduces D
1
’s profits by

But increases total upstream profits (U
A
and U
B
) by
• Always occurs

Choose the option that harms D
2
the most; that is where the rents
are coming from
( )
1
1 2 1 2 12
2 ( ) ( )
j A B
D DU D DU U Π −Π
( )
1
1 2 1 2 6
2 ( ) ( )
j A B
D D U D D U U Π − Π
1 2 1 2
2 ( ) ( )
j A B
D DU D DU U Π ≥ Π
Summary

Outsourcing and upstream competition

Standard view: more likely to outsource when upstream
markets are competitive

Here: outsourcing incentives stronger if can preserve or
establish upstream market power

Outsourcing and competitive advantage

Standard view: outsourcing gives comp adv

Here: outsourcing more desirable if harms other
downstream firms but no comp adv as supply on equal
terms
Quantitative Evaluation
How can mergers impacting on
vertical market structure be
evaluated?
Wholesale Bargaining

N firms indexed by i

Each may operate in an upstream and/or
downstream segment
– s
i
: downstream share
σ
i
: upstream share

Perfect substitutes (downstream)

Market demand: P(Q)
– Costs: upstream (C
i
(.)), downstream (c
i
(.))
Lerner Index for Vertical Chain

Negotiations between i and j:
( )
max ( ) ( ,.) (.) ( ) (.) ( ,.)
ij
q ij ik i ij i jk j j ij
k j k
P Q q q c q C P Q q c C q

+ − − + − −
∑ ∑
( )
( ) ( ) ( ) 0
( ) ( )
1
j
i
ij ij
j
i
ij ij
C
c
ik jk q q
k
C
c
q q
ik jk
k
i j
P Q P Q q q
P
P Q q q
s s
P P ε


∂ ∂


∂ ∂

+ + − − ·
− − ′
+
⇒ · − · +


Vertical HHI

The average Lerner index is:

If there is a preference for internal supply,
2
1
N
i
i
HHI s
·


1 1 1
1 1
( / ) ( / )
N N
i i i ii i i ii
i i
s s q Q HHI s q Q
ε ε ε
σ σ
· ·
+ − · + −
∑ ∑
1
1
max{ , }
N
i i i
i
VHHI s s
ε
σ
·
·

Properties

Ranges between 0 (perfect competition) and 10,000
(downstream monopoly)

Collapses to HHI (Downstream) when all downstream
firms are net buyers of inputs or non-integrated

If there is integration then VHHI > HHI

Upstream concentration not relevant

Non-integrated upstream mergers do not change VHHI

Only look upstream if merger involves a net supplier
Some Examples

Example 1:

4 equal sized upstream firms and 10 equal sized
downstream ones

Up HHI = 2500; Down-HHI = 1000 = VHHI

Vertical merger leaves HHI’s unchanged (no concern) but
raises VHHI to 1150 (potential concern)

Example 2:

8 downstream firms with 10% share and a 9
th
with 20%
share

If vertical merger involves large firm then HHI does not
change but VHHI goes from 1300 to 1400 (no concern)
despite higher concentration.
Approach #2: Successive Oligopoly

Firm’s post unit prices in wholesale market

With linear demand and costs (and homogenous
inputs):

Like bilateral bargaining but with additional
distortions (that can be removed by vertical
integration)
( )
2
( min[ , ])( min[ , ])
1 1
1 min[ , ]
1 1 1 1
max[ , ] ( )
i i i j j j
i i
i
N N N N
s s s
j j j j j j
s
j j j i
VHHI s s s
σ σ σ
ε ε
σ
σ σ σ
− −

· · · ·
· + − +

∑ ∑ ∑∑
Application: Exxon-Mobil in California
Company Upstream (Refining) Market Share
(%)
Downstream (Retailing) Market Share (%)
Chevron 26.4 19.2
Tosco 21.5 17.8
Equilon 16.6 16
Arco 13.8 20.4
Mobil 7 9.7
Exxon 7 8.9
Ultramar 5.4 6.8
Paramount 2.3 0
Kern 0 0.3
Koch 0 0.2
Vitol 0 0.2
Tasoro 0 0.2
PetroDiamond 0 0.1
Time 0 0.1
Glencoe 0 0.1
Concentration Measures
Concentration
Measure
Pre-Merger Post-Merger Post-Merger
with Exxon
Refinery
Divestiture
Post-Merger
with Exxon
Retail
Divestiture
Upstream HHI 1800 1900 1800 1900
Downstream HHI 1600 1800 1800 1600
VHHI Contracting 2100 2400 2400 2100
VHHI Cournot 2200 2500 2700 2100
Future Directions

Other Vertical Practices

Exclusive dealing

Negotiations over linear prices

Quantitative Analysis

Construct simulation model of bargaining

Empirical tests of vertical market structure
concentration measures and pricing