Buyer Power and Dependency in a Model of - Semantic Scholar

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Buyer Power and Dependency in a Model of Negotiations Joao Montezy Roman Inderst January 2015 Incomplete as currently being revised Abstract We stu...

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Buyer Power and Dependency in a Model of Negotiations Joao Montezy

Roman Inderst

January 2015 Incomplete as currently being revised

Abstract We study bilateral bargaining between buyers and sellers in a framework that allows both sides ‡exibility to adjust trades during (temporary) disagreement. Our bargaining framework encompasses the outcome of auctions in truthful menus as limiting cases. Looking at the equilibrium per unit transaction prices, we …nd that following an horizontal merger this new larger buyer pays a lower price only when buyers’ bargaining power in bilateral negotiations is su¢ ciently high, and a higher price otherwise— a similar opposite result holds for mergers of sellers. These ambivalent e¤ect is explained by how size a¤ects own dependency of a buyer on each seller and the dependency of each seller on a buyer. This suggests that size is not a substitute (but rather a complement) for bargaining power in bilateral negotiations. When sellers’ bargaining power is lower, their payo¤ is more generally negatively a¤ected when market shares of buyers become more asymmetric. The richer predictions of our model may help to explain the recent ambiguous empirical evidence on buyer size and inform empiricists, business strategists, and antitrust practitioners. Keywords: Buyer power, dependency, bargaining.

University of Frankfurt and Imperial College London. E-mail: [email protected]…nance.uni-frankfurt.de. London Business School, Sussex Place Regent’s Park, London NW1 4SA UK. E-mail: [email protected] y

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Introduction

This paper develops a bargaining model where prices arise endogenously from the ability of buyers to relocate their purchases to alternative sellers and from the ability of sellers to relocate their sales between di¤erent buyers. Prices are determined in bilateral bargaining between buyers and sellers, and disagreement payo¤s are obtained from letting the respective seller and buyer temporarily adjust supplies to, or purchases from, other parties. The model proves tractable enough to accommodate various distributions of bargaining power and, for extreme distributions of bargaining power, nests those situations where buyers or suppliers bid in truthful menus in the respective auctions. The model is applied to a question that has become increasingly important for researchers in Industrial Organization as well as antitrust and business strategy practitioners, namely whether size is of an advantage in vertical relationships. By both allowing for multiple sellers and buyers and interacting size with bilateral bargaining power from other sources, our proposed modelling approach to multilateral negotiations produces a rich set of predictions. In this model, and consistent with previous results, a larger buyer always obtains a lower price if there is a single seller. However this result does not extend to those (often more realistic) situations with multiple sellers of (imperfect) substitute goods. With several buyers and sellers, a large buyer, e.g., that forms after a merger, obtains better terms if and only if the bilateral bargaining power of sellers is su¢ ciently low and, notably, when buyers bid in auctions. Remaining small generates an advantage when buyers have only limited bargaining power. The impact of size on per-unit prices depends further crucially on technology and in particular on whether this allows for an adjustment of bilateral trades when there is (temporary) bilateral disagreement with some buyer or seller. The intuition for these results hinges on our concepts of seller or buyer dependency, as discussed next. Disagreement with a large buyer, who controls a larger fraction of potential demand, leaves a seller with few opportunities to replace his sales to alternative buyers. Instead, a disagreement with a small buyer displaces a smaller fraction of demand, but leaves the seller with many alternatives to turn to. In this sense a seller is more dependent on a larger buyer. However, when a large buyer …nds himself in disagreement, it is equally less pro…table for him to (temporarily) relocate demand to other sellers, as limits to capacity and more

generally increasing marginal costs at higher production volumes render it impossible or relatively more expensive for them to accommodate (o¤-equilibrium) a large required increase in sales. Still we obtain clear-cut predictions. When buyers’bilateral bargaining power is low, e.g., because they are relatively less patient, a newly formed larger buyer obtains worse terms of supply. But when buyers’ bargaining power is high, buyers are able to push sellers close to their inside options, resulting in better terms for the new, larger buyer. In particular, these observations yield unambiguous predictions for auctions, which are nested in our bargaining approach. That relocation of demand can be more costly to a larger buyer has been largely overlooked by the literature. One reason for this is that the e¤ect does not arise when there is a monopolistic buyer, and it is also overlooked when one considers only a single seller or an alternative source of supply that is outside the considered market, all of which are features that are shared by various previous contributions to the literature, as reviewed below. However, as our analysis shows, this countervailing e¤ect of size on buyer power arises naturally from a parsimonious model that admits multiple sellers and buyers. Our results also support the view that relatively concentrated purchases are not per se conclusive of the existence of buyer power (in the sense of better terms of supply). Instead they suggest that practitioners and empiricists may also want to account for particular technological features of the speci…c industry, such as whether sellers in the market are able to accommodate large scale switching by adding capacity or utilizing existing capacity more extensively at a reasonable cost, or they may want to consider the speci…c organization of procurement processes (e.g., whether they are determined in buyer or seller auctions). Overall, our work supports the view that buyer or seller power may be more industry speci…c than previously thought and that there is a richer relationship to size. This seems to accord well with facts. Recent evidence on the U.S. pharmaceutical industry indeed suggests that size alone is no guarantee to obtain discounts (see, for instance, Ellison and Snyder, 2010, Sorensen, 2003, and Grennan, 2013). From the detailed inquiry of the UK’s Competition Commission into the contracting practices in the national grocery industry, we learn that while the buying practices of globally active supermarket chains ensure on average better terms and conditions, there is a wide variation of per unit prices across volumes (Competition Commission, 2008).

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Our work can therefore provide guidance for antitrust and competition policy, for which the exercise of buyer power has become an increasing concern. From this perspective, our model seems to be particularly attractive for two reasons. First, it focuses on the concepts of ease of substitution and dependency and therefore seems to formalize concerns that have previously been informally expressed in the European Commission’s guidelines on horizontal mergers as well as in recent sector inquiries.1 In fact, as a side result we also establish a relationship between the HHI, as a common concentration measure, and dependency. Second, its predictions accord well with the views taken in several important court cases where doubts were cast on the presumption that larger buyers virtually always pay lower prices than smaller buyers.2 The rest of this paper is organized as follows. Section 2 relates our work to the literature. Section 3 introduces the economy. In Sections 4 and 5 we study a model of bargaining with temporary adjustments and also relate the equilibrium outcome to that of …rst-price menu auctions. In Section 6 we analyze conditions under which merging buyers pay either a higher or a lower per unit price. Section 7 extends the analysis, amongst other things to the complementary question of the formation of larger sellers. We conclude in Section 8. All proofs are collected in the Appendix. 1

In the guidelines buyer power is de…ned as “the bargaining strength that the buyer has vis-àvis the seller in commercial negotiations due to its size, its commercial signi…cance to the seller and its ability to switch to alternative suppliers”. This de…nition highlights that, in addition to size, an assessment of buyer power needs to take into account two additional considerations: one are the consequences to the supplier from loosing a particular buyer, another are the consequences to the buyer from loosing a particular supplier. Notably the German antitrust authority (report available at http://www.bundeskartellamt.de/Sektoruntersuchung_LEH.html) in its sector inquiry into supply relationships in the grocery market has expressed concerns about manufacturers’ dependency vis-á-vis retailers that account for a considerable fraction of their overall sales. While the concept of such dependency is not made precise, let alone formal, it has far-reaching implications, as witnessed by its 2014 decision to impose …nes on EDEKA, the largest German retailer, following the demand of better conditions after the take-over of the retailer PLUS in 2008 (document 03_07_2014_edeka.html available at http://www.bundeskartellamt.de/SharedDocs/Meldung/DE/Pressemitteilungen/2014/). 2 In Hutchison/RCPM/ECT (2001) the container terminal operators involved argued that it would be easy for a carrier to switch large volumes to alternative ports and therefore large operators could still negotiate low prices. Yet the European Commission rejected that argument by stating that switching opportunities were limited for the largest operators since “there is currently a limited number of terminal operators able to accommodate the largest vessels being used”and “it becomes economically more di¢ cult for the carrier to switch ports for a signi…cant portion of its cargo”. In yet another case concerning toilet tissue and kitchen towels, SCA/Metsa Tissue (2001), the European Commission observed that “buyer power can only be exercised e¤ectively if the buyer has an adequate choice of alternative suppliers.”

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Related Literature

At the core of our approach to bilateral negotiations is the possibility of (temporary) adjustments to bilateral contracts, as these shape the alternative options of both buyers and sellers, i.e., their respective disagreement points. In Section 5 we motivate in detail our choices in terms of "inside options", i.e., of temporary adjustments. There, we also stress that the adjustments still honour the respective bilateral contracts that have (already) been concluded, while adjusting the level of trade, and that future agreement is still expected whenever this generates positive surplus. We o¤er also a non-cooperative foundation of the applied bargaining solution, where in case of delay in bilateral negotiations, the two a¤ected parties can temporarily adjust their transactions with all other parties. Di¤erent assumptions on the outcome in case of disagreement underpin several other prominent solutions. In this section, we organize the discussion of the related literature around this theme. A common approach is to assume that in case of a bilateral disagreement all other agreed terms (of linear supply contracts) remain unchanged. This approach was pioneered in Horn and Wollinsky (1988) and has been subsequently adopted in both theoretical and empirical work (e.g., Chipty and Snyder, 1999, Björnerstedt and Stennek, 2007, Crawford and Yurukoglu, 2012, Grennan, 2013). While the approach certainly o¤ers the attraction of simplicity, it still has important limitations. For example, in situations like the one we consider here with decreasing returns to production, if one buyer fails to agree with one seller and that buyer can increase its order from the alternative sellers at the same unit price, then all those alternative sellers may realize a strictly negative payo¤ o¤ equilibrium— to avoid this it is often assumed that marginal costs are constant, which as our work shows is not without signi…cant loss of generality. Moreover, as we discuss in Section 6 in more detail, under this assumption mergers or the formation of buyer groups that do not generate horizontal concerns should have no impact on upstream (wholesale) contracts, which is however not the view of various antitrust authorities and also seems not to accord well with facts. As we discuss further in Section 6, our modelling approach also suggests to incorporate more information both about suppliers’ full cost function and their alternative options, notably as often also suppliers may be able to instigate (temporary) adjustments to de-

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liveries. With respect to costs and technology, Section 7 analyses cases where a buyer’s or sellers’adjustment options are restricted, e.g., as sellers have limited capacity, showing that then the impact of size may become unambiguous. This is notably di¤erent from the unambiguous e¤ect of size that arises when a large buyer’s advantage stems from the (more) credible threat to access an option that is outside the market (such as backward integration; cf. Katz, 1987). Then, …xed costs from accessing the alternative option generate increasing returns to scale from switching. Our setting seems more applicable when negotiations are shaped by the, often more credible, option to (temporarily) relocate demand across sellers in the same market (and with which a buyer has a relationship). In the extant theoretical literature, a more elaborate approach assumes that each bilateral disagreement restarts all previously successful negotiations for all parties. It does however rule out the future formation of a “grand coalition” that would include the link on which agreement has not been reached— as in Stole and Zwiebel (1996) and deFontenay and Gans (2014). Also the assumption of ultimately non-binding contracts, from which parties can walk away whenever there is disagreement with other trading partners, may not be equally suitable across all applications. With such renegotiations the solution coincides with random order values, with the Shapley value being obtained when symmetry on bilateral bargaining power is imposed. This ties up with a small literature in cooperative game theory that has analyzed the possibility that owners of substitutable resources may lose from forming a monopoly in market games, which has been on identi…ed in Postlewaite and Rosenthal (1974) for the Core, later studied by Gardner (1977), Guesnerie (1977) and Segal (2003) for the Shapley value and by Legros (1987) for the Nucleolus. Speci…cally, Segal (2003) shows that for random order values a pairwise merger may or may not be pro…table depending on a complex chain of how each of the remaining players increases or decreases the substitutability of the two merging parties in each possible market con…guration. In Section 6 we discuss in more detail how predictions di¤er, how we add to that debate and why our model may be better suited than alternative concepts to many of the applications of supplier-buyer relationships in industrial organization.

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3

Buyers, Sellers, and Trades

There is a set of goods G, with jGj denoting the number of goods. The cost of producing x

units of each good i 2 G is c(x), where c is a continuously di¤erentiable, strictly increasing,

and strictly convex function with c(0) = 0. Each seller is the only producer of a subset of goods. S is the partition of G, with jSj elements, such that each element I 2 S contains exactly the jIj goods produced by each seller I.

There are jN j symmetric consumers in a set N . The utility of a consumer j 2 N is jGj

u(aj ) + t, where t is money and aj is a generic vector in R+ denoting the quantity of each of the jGj goods consumed by j. The utility function u is symmetric, twice continuously di¤erentiable, and strictly concave, with strictly positive …rst-order derivatives and strictly negative cross-partial derivatives, so that goods are substitutes and there are strictly decreasing bene…ts of consumption. Each buyer is a group of consumers that will bargain jointly with each seller. Formally, B denotes the partition of the set of consumers N , such that each of its jBj elements contains exactly the jJj consumers represented by each buyer J 2 B. Throughout the paper we will generically refer to I as a seller and J as a buyer. Trade in the economy is summarized by a trade matrix A with dimension jN j

jGj

where each element aij is the quantity of good i 2 G delivered to consumer j 2 N . The

column vector aj therefore represents the quantity of each good that is delivered and consumed by consumer j. The gross bene…t of each buyer J 2 B at A is vJ (A) =

P

u(aj ),

j2J

and the total production cost to seller I 2 S at A is CI (A) =

X X c( aij ). i2I

j2N

Total surplus is concave and is given by (A) =

P

vJ (A)

J2B

P

CI (A).

I2S

The marginal cost c0 (0) is assumed to be su¢ ciently low and c0 (x) su¢ ciently large for large x such that the unique level of trade that maximizes the economy surplus is strictly positive and …nite. Let A be the trade matrix that maximizes the economy surplus. Given symmetry and assumed convexity of costs and concavity of utility, for each good i 2 G 7

and consumer j 2 N we have aij = a with c0 (jN j a ) = ui (aj ), where aj is a column vector with each element equal to a and ui is the partial derivative with respect to good

i 2 G. (Hence, jN j a is the production and consumption quantity for each good.) By

imposing symmetry on consumers and goods we ensure that di¤erences between buyers and sellers are accounted for only by di¤erences in size. The characterization of our bargaining solution does, however, not rely on symmetry. We study those situations where each seller and buyer pair fI; Jg, with I 2 S and

J 2 B, try to reach an agreement specifying a jIj

jJj trade matrix AIJ , with each

element aij representing the quantities of each good i 2 I delivered to each consumer

j 2 J, and tIJ a transfer received by seller I from buyer J.3 The set of agreements

between all buyers and sellers is summarized by the pair (A; T ) where A is a trade matrix and T a jBj

jSj matrix of transfers. In the following sections we study how buyers and

sellers come to these agreements. As a …rst step, and before introducing bargaining, it

will be helpful to discuss the polar cases where either sellers or buyers are auctioneers in …rst-price menu auctions.

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Auctions with Truthful Menus

In the …rst stage of an auction, bidders simultaneously submit a menu to each auctioneer. A menu speci…es contingent payments for each possible bilateral trade. In the second stage, each auctioneer selects whether to accept each menu, picks a level of bilateral trade from each accepted menu, and the respective payments are made. We consider both auctions organized by sellers and those organized by buyers. These will also represent the polar cases of our subsequently analyzed bargaining game. Truthfulness. Suppose …rst that all buyers conduct auctions simultaneously. In that case sellers compete with each other by bidding supply contracts. Rather than stipulating only a single transfer, the strategy of each seller I 2 S is to o¤er a menu t(AIJ ) to each

buyer J 2 B. These menus stipulate a transfer for each possible trade matrix AIJ .4 A

strategy for each buyer J is then to choose a trade matrix AIJ and to pay the respective 3

We could likewise stipulate that a contract prescribes for each good an aggregate volume delivered to the respective buyer, which would then distribute it (e¢ ciently) across the consumers that it represents. 4 Note here that we abbreviate the notation somewhat as we write t(AIJ ) rather than also indexing the function accordingly, i.e., by writing instead tIJ (AIJ ).

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transfer, or alternatively to reject a menu. To abbreviate the following expressions, we capture the non-trade or rejection option by specifying t(0) = 0. For a particular strategy pro…le, seller I’s payo¤ when buyers choose to trade A is then given by I (A)

=

P

t(AIJ )

CI (A);

J2B

and buyer J’s payo¤ is J (A)

= vJ (A)

P

t(AIJ ).

I2S

It is well known that even with a single auctioneer and complete information such auctions have in general a continuum of Nash equilibria, many of which are implausible. Bernheim and Whinston (1986) proposed the concept of truthful Nash equilibria, i.e., equilibria in which bidders use truthful strategies, as an attractive re…nement of the equilibrium set. We now adopt this concept to our case with multiple auctioneers and bidders. Following Bernheim and Whinston (1986), seller I’s menu o¤er t(AIJ ) is said to be truthful, now relative to a trade matrix A, if and only if for every other A0IJ 6= AIJ and A0IJ 6= 0 we have that

t(A0IJ )

CI (A0 ) = t(AIJ )

CI (A),

(1)

where A0 satis…es a0kl = akl if k 2 = I or l 2 = J. This means that, having A as a reference,

each menu t(AIJ ) allows buyer J to change trade with seller I at conditions such that the

respective transfer is adjusted to exactly re‡ect the respective change in I’s costs. It is in this sense that the seller’s supply contract truthfully re‡ects his marginal costs. Suppose now, instead, that sellers conduct auctions simultaneously. The strategy spaces are then swapped between buyers and sellers: buyers submit demand menus and sellers accept or reject and choose a level of trade from each menu. A buyer J 0 s menu t(AIJ ) is now said to be truthful relative to a trade matrix A if and only if for every other A0IJ 6= AIJ and A0IJ 6= 0 we have that vJ (A0 )

t(A0IJ ) = vJ (A)

t(AIJ );

(2)

where A0 satis…es a0kl = akl if k 2 = I or l 2 = J. Having A as a reference, t(AIJ ) allows seller

I to change his trade with buyer J provided the transfer is adjusted to exactly re‡ect the respective change in the surplus of J. That is, when buyers bid, the transfer t(AIJ ) truthfully re‡ects the respective buyer’s marginal valuation (which in turn re‡ects the aggregated marginal utilities of the respective consumers). 9

De…nition 1. Let

denote the set of all bidders’ menus and A a trade matrix that

summarizes the trades chosen by the auctioneers. Then a strategy pro…le (A; ) is said to be a Truthful Nash Equilibrium of a …rst-price menu auction if and only if it is a Nash Equilibrium and bidders’strategies are truthful relative to A.

Equilibrium Construction. Consider the following trade matrix for a given buyer and seller pair:5 AIJ = arg max (A) s.t.

aij = 0 if i 2 I and j 2 J : aij = a if i 2 = I and j 2 =J

That is, to obtain from the matrix of e¢ cient trades A the trade matrix AIJ the following steps are undertaken. First, all bilateral trades between these two parties are set equal to zero, aIJ ij = 0 if i 2 I and j 2 J. Second, we leave all trades between any other buyers and sellers unchanged, so that aIJ = I and j 2 = J. The …nal step is to adjust the ij = a , if both i 2 trades between seller I and all buyers other than J and between buyer J and all sellers

other than I. These trades are adjusted so that total surplus is maximized, which by strict concavity of

(A) yields a unique solution.

Take now …rst the case where sellers are the auctioneers. When seller I rejects the bid of buyer J, the optimal reallocation of trades is represented by the respective row vectors aIJ (of AIJ ) for goods i 2 I. Note that when making these adjustments, from i

the truthfulness of all buyers’ bids seller I can extract the full incremental valuation, which for a given buyer J 0 6= J equals vJ 0 (AIJ )

vJ 0 (A ), while the di¤erence between the

seller’s on equilibrium costs and his respective o¤ equilibrium costs after this adjustment is CI (A )

CI (AIJ ). As he is just kept indi¤erent between acceptance and rejection, the

di¤erence between these two terms yields the transfer t(AIJ ) = 'IJ , as reported in (3) of Proposition 1.6 Uniqueness follows from the strict concavity of the total surplus function (A) and as from (1) each seller chooses, holding all other trades constant, each respective trade aij so as to maximize total surplus. The case when sellers bid is analogous, as now the reservation value of buyer J with respect to the o¤er of seller I is obtained from acceptance and optimal adjustment of the o¤ers made by all other sellers I 0 6= I. The respective transfers {IJ are reported in (4). 5

That is, superscripts denote that these trades are obtained from adjustments. Note also that a seller can also not pro…tably deviate by rejecting the o¤ers of more than one buyer, instead, and adjust trades to all other buyers. This observation follows immediately from our speci…cation of decreasing returns. 6

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Proposition 1 A menu auction where either buyers bid or sellers bid has an unique Truthful Nash Equilibrium, and trade is given by the e¢ cient trade matrix A , while equilibrium transfers between each seller I 2 S and each buyer J 2 B are characterized as follows in the two cases:

i) Seller auction (buyers bid): tIJ = 'IJ

P

J 0 2BnJ

(vJ 0 (AIJ )

vJ 0 (A ))

(CI (AIJ )

CI (A )).

(3)

CI 0 (AIJ )).

(4)

ii) Buyer auction (sellers bid): tIJ = {IJ

(vJ (A )

vJ (AIJ ))

P

I 0 2SnI

(CI 0 (A )

Discussion. It can be easily checked that all bilateral transfers are strictly higher when sellers bid instead of when buyers bid, i.e., 'IJ < {IJ . How the transfers compare across buyers and sellers as a function of size will be analyzed later. Before moving on, note that both the di¤erence between 'IJ and {IJ and variations across seller-buyer pairs are due to the fact that each buyer and seller enjoys some "market power" in the following sense. Denote

= c0 (jN j a ) = ui (aj ) and recall that jN j a is the total production volume of

each product and aj the consumption vector of each consumer. We can show that both transfers, 'IJ and {IJ , converge to the limit jIj jJj a , where jIj denotes the number of goods produced by seller I and jJj the number of consumers represented by buyer J,

when we replicate our economy more and more often. This competitive benchmark is intuitive as then, in the limit, at disagreement the responding side could fully replace the respective trades by turning to (in…nitely many) other producers or consumers of this good. By truthfulness a disagreeing buyer would then have to pay, in the limit, to each of the remaining producers only the marginal costs c0 (jN j a ) and a disagreeing seller could extract from each of the respective alternative consumers the marginal utility ui (aj ).7

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Bargaining

We now take a bargaining approach. The previously characterized auctions in truthful menus will represent the limiting cases when all bargaining power lies with sellers or with buyers. We provide a formulation of the bargaining problem both in terms of applying the 7

A proof is contained in the online appendix.

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asymmetric Nash bargaining solution to all bilateral negotiations and as an equilibrium of a non-cooperative bargaining game. After deriving our key comparative results, in relation to buyer power, we will discuss how the characterized bargaining solution di¤ers from other solutions proposed in the literature, both in the underlying assumptions and implications. Bilateral (Axiomatic) Nash Bargaining. For the bilateral bargaining problem between each seller and buyer pair fI; Jg, with I 2 S and J 2 B, the generic payo¤ for each

side is

I (A)

and

J (A).

Denote further the net disagreement payo¤s by dIJ and dJI for I

and J respectively. Below we will discuss in detail the choice of disagreement payo¤s. Given that utility is transferable, each trade AIJ that is consistent with bilateral Nash bargaining, i.e., that maximizes the Nash product, will maximize the bilateral gains from agreement between I and J, which are given by gIJ (A) =

I (A)

+

J (A)

dIJ

dJI :

The asymmetric Nash solution captures di¤erences in bilateral bargaining power through the respective choice of the sharing rule. The outcome of Nash bargaining with seller power awards seller I a share

of the gains from bilateral agreement plus his disagreement

payo¤ dIJ and buyer J the remainder of those gains plus his disagreement payo¤ dJI . This yields8 I (A)

= dIJ + gIJ (A) and

J (A)

= dJI + (1

)gIJ (A):

(5)

It is noteworthy that this approach would allow also to apply a di¤erent sharing rule to each bilateral negotiation.9 Truthful Disagreement Points. An important modelling choice concerns the selection of the disagreement payo¤s. The non-cooperative bargaining literature has typically invoked two main motives that induce players to reach an agreement. A …rst motive to come to an agreement is the fear that prolonged negotiations may eventually lead negotiations to break down, as one party may randomly withdraw permanently from the bilateral bargaining process. In this case the disagreement payo¤ of a player is a so called 8

Generally, a larger exponent of a player in the Nash product is interpreted as representing a higher bargaining power of that player in bilateral negotiations. The corresponding sharing rule is obtained as utilities are linear in payments. 9 In the interest of clarity this generalization is made only in the online appendix.

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“outside option”: his payo¤ in the event of a permanent breakdown of that particular bargaining process. Bargaining may however take place in a more deterministic manner, rather than being subject to the risk of breakdown. In that case players’main motivation to reach an agreement is to avoid losses associated with delays, as the process of preparing and exchanging o¤ers is time consuming and they forego a mutually bene…cial trading opportunity during delay (cf. our strategic model of negotiations below). In this case, the disagreement payo¤ of a player is a so called “inside option”: the net bene…t accruing to that player in the course of the dispute while an agreement is delayed. Our choice of disagreement payo¤s rests on the concept of such “inside options”.10 We are now more speci…c about this. Take a disagreement between seller I and buyer J. Re‡ecting the temporary nature of disagreement— as also captured in our strategic game below— we stipulate that only those players that failed to reach an agreement are presently aware of it and will therefore want to make temporary adjustments in their transactions with all other players. We propose a variant of the truthfulness criterion, as introduced in our discussion of buyer or seller auctions, as a parsimonious way to capture such “local” o¤-equilibrium adjustments. While the respective adjustments will not be used on-equilibrium, their use o¤-equilibrium pins down the exact distribution of total surplus— just as in the auction case. This approach thus o¤ers a solution that is tailored to modelling bargaining situations where disagreements are expected to be only temporary. Precisely, we stipulate that contracts allow each side to require an adjustment of trade that makes the other side just indi¤erent between accepting the adjustment or trading according to the (equilibrium) contract point. This is the case if and only if the respective adjustment of the transfer truthfully re‡ects the incremental valuation or incremental cost of the counterpart.11 We note, however, that all results hold as well when the side that proposes the adjustments can only extract a strictly positive share

> 0 of the resulting incremental bilateral surplus.

De…nition 2. Take the model of simultaneous bilateral Nash bargaining. The disagreement points dIJ and dJI for seller I and buyer J respectively are said to be truthful relative to 10

The preceding discussion thus re‡ects some of the fundamental ideas in Binmore et al. (1986). On a broader discussion, notably of such “outside options” and “inside options”, see also Muthoo (1999). 11 This does not entail that agreements can be re-opened unilaterally. The case where both sides to an agreement would want to adjust the contract in this way will not be relevant for the construction of the equilibrium (cf. also the discussion in the subsequent game of strategic negotiations). For completeness we may stipulate, however, that then the original trades persist.

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a trade matrix A if and only if they represent the option for each side to adjust their trade with all their other trading partners on a truthfulness basis: Seller I can request from some buyer J 0 6= J an adjustment of trade from the contractually agreed trade AIJ to another A0IJ 0 at an incremental transfer vJ 0 (A0IJ 0 )

vJ 0 (AIJ 0 ) and buyer J can request from some

seller I 0 6= I an adjustment from the contractually agreed trade AI 0 J to another A0I 0 J at an incremental transfer CI 0 (A0I 0 J )

CI 0 (AI 0 J ).

Bargaining Solution. We now consider bargaining outcomes that have the following properties: De…nition 3. A bargaining outcome with “two-sided truthfulness” and seller power

is a

pair (A; T ) of a trade and a transfer matrix that gives raise to payo¤s that are consistent with bilateral Nash bargaining where i) for each pair of buyer J 2 B and seller I 2 S the sharing rule is such that the seller obtains the share

of the net gains from trade and ii)

disagreement points dIJ and dJI are truthful relative to A (according to De…nition 2). We now apply the sharing rule (with weights

and 1

, as in expression (5)) and

De…nition 2 for the disagreement points to a generic pair I and J. For given (A; T ) this uniquely ties down the transfer. As A = A follows as the bilateral surplus is maximized in each transaction and as industry pro…ts are strictly concave, we have: Proposition 2 The pair (A ; T ), with tIJ = (1

)'IJ + {IJ ;

(6)

forms the unique bargaining outcome with “two-sided truthfulness” and seller power , where 'IJ and {IJ are the equilibrium payments of the Truthful Nash Equilibrium of menu auctions, where respectively buyers or sellers bid (cf. Lemma 1). An important implication of Proposition 2 is that by studying the outcome of truthful auctions in Proposition 1, we also learn the most and the least that buyers may pay to sellers when they bargain bilaterally and both sides are allowed to make truthful adjustments. The measure of seller power in bilateral negotiations in that interval. 14

pins down where the payment lies

Strategic Negotiations. We conclude this section by proposing a strategic bargaining game that supports as an equilibrium the allocation in Proposition 2. For brevity’s sake we relegate much of the formal exposition to the Appendix. We consider an alternating o¤er bargaining game in the spirit of Rubinstein (1982) and Binmore et al. (1986). Bargaining takes place in periods

= 0; ::; 1. The time between each period is z > 0. We stipulate

that bargaining proceeds simultaneously in pairwise negotiations between agents of each buyer and seller pair fI; Jg, with seller agents making the …rst o¤ers in

= 0 and buyers’

agents making o¤ers in all odd periods. Buyers have a discount rate rb > 0 and sellers rs > 0. In each negotiation, the respective agents form rational expectations about the outcomes in all other (still proceeding) negotiations and seek to maximize the payo¤ of the respective buyer or seller they represent. Once an agreement is reached, negotiations in the respective pair stop. The chosen game form where agents of each buyer and seller negotiate bilaterally is shared with much of the literature.12 As we show in the online Appendix, however, we can also support the characterized outcome as a sequential equilibrium of a game where …rst players make simultaneous o¤ers. Then, in case the o¤ers do not match, sellers and buyers take turns with each side making simultaneous o¤ers to all counterparties without matching o¤ers, which these also either accept or reject simultaneously each received o¤ers. If they reject, then they may ask for adjustments from those counterparties with whom they already have an agreement with. (Add the detailed description of procedure, and propose to only keep this one. Add Appendix.) In line with the preceding speci…cations, a bilateral agreement consists of a contract (AIJ ; tIJ ) that still gives parties the option to adjust purchases and sales as long as this makes the other side not worse o¤ (De…nition 2). Each period, after these potential adjustments have been made, sellers produce and buyers make consumption decisions.13 Hence, when there is delay in any bilateral relationship, this does not forestall production and the respective trades and consumption under existing agreements. To model this, we let the respective payo¤s and transfers, arising from costs and consumption, represent ‡ows. We relegate a full derivation of payo¤s and the equilibrium to the proof of the 12

This holds in particular for the (structural) empirical literature that is referenced in the Introduction as well as further below. 13 As previously, we need not be speci…c about what happens when both sides to an agreement request an adjustment at the same time. For completeness only we may stipulate that if, for a given contract, a request is simultaneously made by the respective seller and buyer, then no adjustment is made.

15

subsequent result:14 Proposition 3 Consider the strategic game with alternating o¤ers in each bilateral negotiation. Contracts specify the respective trades and transfers (AIJ ; tIJ ) together with the option for each party to temporarily adjust purchases or sales as long as the other side is not worse o¤ ("two-sided truthfulness"). Then we obtain for each length of time between two consecutive o¤ers z a sequential equilibrium that leads to immediate and e¢ cient trade such that, along the respective sequence of equilibria, for z ! 0 transfers converge to those of the Nash bargaining outcome ((6) in Proposition 2), where

= rB =(rB + rS ) and where

we interpret costs and utilities as ‡ows.

6

Buyer Power

6.1

Dependencies

Take now a merger of any two buyers J1 and J2 to form a larger buyer of size jJ3 j =

jJ1 j + jJ2 j. Observe …rst that this will not a¤ect the traded quantities, which are still given by A . An immediate consequence of this is that the transfers paid by any other buyers

J 2 = fJ1 ; J2 g are still the same. For the newly formed larger buyer J3 , the respective per unit prices are lower than the average prices paid by J1 and J3 before if and only if (1

)'IJ3 + {IJ3 < (1

)('IJ1 + 'IJ2 ) + ({IJ1 + {IJ2 ).

(7)

To determine when (7) holds, it is instructive to …rst consider separately the two benchmark cases with

= 0 and

= 1. In either case transfers are such that the payo¤s

of one side of the market are reduced to the value of the respective alternatives, as expressed by the adjusted trade matrix AIJ . We thus need to ask how the larger purchasing volume of J3 a¤ects the value of these alternatives for both sides. We frame this in terms of the two sides’relative dependency. Seller Dependency. The e¤ect on seller dependency can be summarized as follows: Lemma 1 Suppose buyers J1 and J2 form a buyer J3 with size jJ3 j = jJ1 j + jJ2 j. Then 'IJ3 < 'IJ1 + 'IJ2 14

With transferable utility, the proof follows the very transparent exposition in Sutton (1986).

16

(8)

holds, implying that when buyers hold all the bilateral bargaining power ( = 0), the unit price paid by J3 is always strictly lower than the average per unit price paid jointly by J1 and J2 . O¤ equilibrium any seller I has the opportunity to (temporarily) increase the sales to all remaining buyers. A disagreement with the larger buyer leaves the seller with less alternative consumers to sell to. As consumers have decreasing marginal utility for the seller’s products, the alternative to adjust sales therefore becomes less valuable after disagreement with the larger buyer. In this sense a seller becomes more dependent on the newly formed larger buyer J3 than he was on either J1 or J2 before. It is worthwhile noting that this is however no longer the case when costs are linear, simply as in this case there are no pro…table adjustments to be made by the respective seller when there is disagreement with either a smaller or a larger buyer. Trades with other buyers are already such that the respective marginal utilities equal marginal costs. Lemma 1 derives also from a second e¤ect, which - as further discussed below - would also be present when adjustments of trades were not possible. This is the “incremental cost” e¤ect that has already been isolated in the literature:15 To put it succinctly, J3 negotiates for the larger trading volume less “at the margin”and more “inframarginally” and as marginal costs are increasing, the per-unit incremental cost that J3 generates at any seller I and for which the buyer must compensate I is strictly lower than for either J1 or J2 . Buyer Dependency. The e¤ect of the merger on buyer dependency can be summarized as follows: Lemma 2 Suppose buyers J1 and J2 form a buyer J3 with size jJ3 j = jJ1 j + jJ2 j. If jIj = 6 jGj, so that there is more than one seller,

{IJ3 > {IJ1 + {IJ2

(9)

holds, implying that when sellers hold all the bilateral bargaining power ( = 1) the unit price paid by J3 is always higher than the average per unit price paid jointly by J1 and J2 . If jIj = jGj ; then {IJ3 = {IJ1 + {IJ2 , so that for 15

= 1 the merger has no e¤ect.

Cf. the survey in Snyder (2012). With large …xed costs, the opposite result has been shown to hold (Raskovich, 2003).

17

Recall that by purchasing more from other sellers o¤ equilibrium, a buyer can reduce the loss associated with the failure to reach an agreement with any particular seller. As marginal costs are increasing, however, the per-unit incremental costs of temporarily increasing the trade level with other sellers is higher for larger quantities, as demanded by J3 . In this sense a larger buyer becomes more dependent on each seller. This negative e¤ect of size, as it increases the per-unit price, relies crucially on the possibility to adjust trades and is thus not present when there is only one seller (as frequently assumed in the theoretical literature). It is also not present when contracts or technology rule out such adjustments (cf. the further analysis in Section 7.2). In sum, in our model the formation of a larger buyer can thus be said to increase both the dependency of any seller on the newly formed buyer (Lemma 1) and the dependency of the large buyer on all sellers (Lemma 2).

6.2

Large Buyer Advantage or Disadvantage?

Recall that the unit price paid by the large buyer J3 is strictly lower than the average price paid by J1 and J2 before if and only if (7) holds. Rearranging terms, this condition becomes [{IJ3 'IJ3

({IJ1 + {IJ2 )] 1 > 'IJ1 + 'IJ2

(10)

Lemmas 1 and 2 allow us to sign the left-hand side, which is always strictly positive and invariant in , unless there is a single seller in which case is exactly zero. The right-hand side is monotonically decreasing in , from 1 when

= 0 to 0 when

= 1. We obtain the

following result:

Proposition 4 Suppose buyers J1 and J2 form a buyer J3 with size jJ3 j = jJ1 j + jJ2 j. The larger buyer pays a strictly lower per unit price if and only if either i) there is only a single seller, i.e., jIj = jGj for some I 2 S and

< 1 (as for

= 1 the

single seller always extracts all surplus);

ii) or there are multiple sellers, i.e., jIj 6= jGj for every I 2 S, and

is lower than some

critical level that lies in (0; 1).

This result con…rms and extends the current understanding of buyer power in the literature. It con…rms because when there is a single seller, a larger buyer will indeed pay a lower per unit price for any bargaining power in bilateral negotiations. However that 18

simple result no longer holds when there are multiple sellers of substitute products and sellers have decreasing returns. Then a larger buyer can still obtain lower per unit prices, but only if buyers have a su¢ cient advantage in bilateral bargaining, i.e.,

is su¢ ciently

low. In that case buyers are able to push sellers close to their alternative option, which as we saw becomes relatively less favorable as the larger buyer controls more of all purchases. However, when sellers have the advantage in bilateral bargaining a larger buyer pays a higher per unit price. In that case sellers are able to push buyers close to their alternative option, which we saw is relatively less favorable for a larger buyer because it becomes more costly to shift a larger volume to alternative sellers. Buyers’incentives to merge are thus in general higher when bargaining power arising from other channels is already high. In other words, bargaining power as represented by the sharing rule

and size have a mutually reinforcing role in bringing down the per

unit price. This also implies that size is not a good substitute for the lack of bilateral bargaining power, as expressed by the sharing rule. In what follows we derive from these results further implications that may, in particular, inform future empirical work. In the subsequent section we then provide additional formal results. Discussion of Implications. As noted in the introduction, our approach allows to encompass both …ndings where larger buyers enjoy a discount as well as contrasting …ndings in the empirical literature where larger buyers seem to pay a premium, o¤ering for this an explanation that is based on the ability buyers and sellers have of adjusting trade in case of temporary disagreement (which is in turn based on the fundamentals, preferences and technology) rather than heterogeneity in …rm-speci…c bargaining abilities— as the latter could also be perceived as a circular argument. It also yields predictions on when we should observe mergers, as well as the formation of buyer groups, that are motivated by their e¤ect on buyer power. Relying …rst on the interpretation in terms of seller and buyer auctions, the implications depend on the procurement format that prevails in the industry.16 When buyers run procurement auctions, size could be a disadvantage as it increases dependency on any individual seller. Next, whether size bestows an advantage depends, more generally, on the sharing rule .17 The 16

We are aware that this may itself be an endogenous variable, unless the particular format was determined by technological requirements or e¢ ciency considerations. 17 As noted above, our approach as well as the comparative results, can be extended to the case where

19

literature has identi…ed, both empirically and theoretically, various determinants of such a bilateral sharing rule. Notably, this may re‡ect both sides’relative impatience to come to an agreement, which may in turn depend on their …nancial ‡exibility and the importance of the respective pro…ts for their overall revenues. Empirically, the former may relate to …rms’ leverage while conglomerates or notably multi-product retailers may depend less on the respective revenues than more focused …rms.18 Ceteris paribus, for buyers with more …nancial ‡exibility, when this translates into a larger sharing rule, size should be of (additional) advantage. We also noted above that technology should determine which of our isolated e¤ects is stronger. Here, our analysis suggests the importance of incremental costs at “inframarginal”units of production versus incremental costs at “supramarginal”units of production (that is, above the equilibrium production levels). These may again be features of the industry that are either observable to empiricists or known by practitioners. Furthermore, buyer size a¤ects buyer dependency only when there is indeed scope (o¤-equilibrium) to temporarily adjust purchases from other sellers, which should again depend on technology. We continue to analyze the role of technology more formally in Section 7.2. We conclude our brief discussion of implications with a closer comparison to the recent empirical literature that has shown increasing interest in markets where prices are determined through bilateral negotiations and, more speci…cally, in the determinants of buyer power. Several structural empirical papers adopt a pairwise negotiations framework, as we do in this model, albeit they restrict consideration to linear costs (possibly, with additional …xed costs).19 When remedies imposed by antitrust authorities on a buyer merger or the particular structure of a buyer group ensure that downstream competition was not a¤ected, then in these models the terms of trade would not depend either on a buyer’s absolute size or on its importance for a particular seller. As we discussed in the introducthe sharing rule di¤ers between negotiations ( IJ with I 2 S and J 2 B). A formal extension is contained in the online appendix. 18 The role of …nancial assets and thus …nancial ‡exibility has been analyzed theoretically and empirically in the labour literature on union-…rm bargaining (cf. Cramton and Tracy 2002 for a survey), though the respective theory models are typically based on a screening motive or involve particular assumptions on how outside options develop over time (e.g., Hart 1989). This literature also includes an analysis of negotiations with (deeper-pocket) conglomerates. The relationship between leverage and a …rm’s trade-o¤ between pro…ts today and tomorrow has been analyzed in the …nancing literature (e.g., in Chevalier and Scharfstein 1996). 19 E.g., Grennan (2013) or Govrisankara et al. (2014) on health markets and Crawford and Yurukoglu (2012) on cable television.

20

tion, these possible determinants of buyer power are however of key concern to antitrust authorities.20 Our model shows how nonlinear costs at suppliers and decreasing returns at buyers can generate size e¤ects and how other determinants of bargaining power, as expressed by , interact to then account for better or worse terms of supply. A few exceptions in the empirical literature analyze also non-linear supply contracts. As researchers typically do not observe wholesale contracts, the assumption of a particular form of wholesale contracts is part of the identifying restrictions and di¤erent models are then compared in terms of their overall …t with the data.21 Our approach suggests broadly to extend these models to allow also suppliers more ‡exibility in reacting to (temporary) disagreements. Here, the imposition of bilateral truthfulness may both account for the relatively ‡uid form of agreements in some markets and allow to incorporate more information, in particular about manufacturers’alternative sales options at other retailers.22 6.2.1

Relation to other Solution Concepts (to add discussion)

Introduce parts of letter and prepare the remainder, with solutions, as online appendix Our approach is clearly geared towards the considered application in Industrial Organization, notably to vertical negotiations. There, disagreement in bilateral negotiations should often not render void any other agreements or exclude any of the …rms from other agreements (such as by partitioning the set of all buyers and sellers accordingly). Further, individual contracts may allow for the ‡exible adjustments of quantities and may thereby still react to disagreements with other …rms. While we certainly do not claim that our approach provides a full description of any particular real-world negotiation,23 incorporating these features may still add realism in many circumstances and, what seems more important, it provides additional structure to generate novel implications. We explore in 20

An example in a merger context is the take-over of the large grocery retailer PLUS by Germany’s largest grocery retailer EDEKA in 2008. As is common, this was only cleared after the divestiture of outlets in regional markets where concentration would otherwise have increased. Still, this merger has observably put large downward pressure on supply contracts, which were objected by a later decision in 2014 (cf. the reference in footnote 1). 21 For the grocery market see, e.g., Draganska et al. (2010) and Bonnet et al. (2013). Again under the assumption of linear costs, a prominent such restriction is to impose marginal cost pricing for suppliers (in exchange for the payment of a …xed fee). 22 In practice, applied to the grocery market, this may be achieved through manufacturer instigated promotions. 23 In the language of one of our referees, our model thus provides a particular "parable" of such negotiations.

21

Section 7.2 how the scope for adjustments, which should depend on technology, generates disadvantages of size that would otherwise be absent. In Section 6.2 we showed also how the interaction between the sharing rule and buyer size generates novel predictions, which are further extended to seller size in Section 7.1. As we discussed in Section 6.2, our approach thus di¤ers notably from other contributions that apply the Nash bargaining solution to bilateral negotiations. As noted in the Introduction, we share however our interest in the implications of mergers with another strand of the literature, which applies cooperative solution concepts to general (N -person) bargaining problems. We argue next that also in light of this literature our approach provides novel insights. Our characterized equilibrium is also not generally contained in the Core. As noted in the Introduction, various other approaches have lead to the Shapley value, which essentially includes or excludes players to calculate their respective incremental contribution to various coalitions. Applying this to our setting, where in each coalition production and consumption is chosen so as to maximize joint surplus, we …rst note that the results do not coincide. Precisely, there exists no value

for which our approach yields

the Shapley value. It is also noteworthy that under the Shapley value convex costs together with submodularity of consumption are not su¢ cient to unambiguously sign the impact of a merger. This holds as well when we apply generalized random-order bargaining values, as in Segal (2003).24 Besides these evident di¤erences, as our discussion of implications shows, the close-knit relationship to the Industrial Organization application ensures that we can isolate various e¤ects, notably relating to buyer and seller dependency, and relate them to potentially testable implications.

7 7.1

Extensions of the Analysis The Case of Seller Power

We now turn our attention to the mirror case of how seller size a¤ects the average unit price paid by each buyer. In analogy to how we proceeded in the case of buyer power, let there thus be two sellers I1 and I2 and consider the e¤ect of a merger so that we have a seller I3 with size jI3 j = jI1 j + jI2 j. In equilibrium each individual consumer still receives 24

Even there it can be shown that, for any given random-order bargaining value, we can not …nd a value so that the outcomes coincide.

22

the same quantity of each good, before and after the merger. The large seller I3 receives a strictly higher per unit price from some buyer J if and only if (1

)'I3 J + {I3 J > (1

)('I1 J + 'I2 J ) + ({I1 J + {I2 J ).

Like above, we focus in turn on the e¤ect of the merger on seller and buyer dependency. Lemma 3 Suppose sellers I1 and I2 form a buyer I3 with size jI3 j = jI1 j+jI2 j. If jJj = 6 jN j, so that there is more than one buyer, then

'I3 J < 'I1 J + 'I2 J

(11)

holds, implying that when buyers hold all the bilateral bargaining power ( = 0) the unit price received by I3 is always strictly lower than the average per unit price received jointly by I1 and I2 . If jJj = jN j ; then 'I3 J = 'I1 J + 'I2 J , so that for

= 0 the merger has no

e¤ect.

All proofs for the results in this section are relegated to the online appendix as they proceed largely analoguously to those with a buyer merger. Since buyers have decreasing returns, in case of disagreement with any buyer the larger seller I3 will …nd it harder to sell his relatively larger number of goods to the same set of alternative buyers without depressing prices too much.25 Thus, as a seller’s size increases, so does his dependency on any particular buyer. Note that this is analogous to the interaction of buyer dependency and buyers’size. There, we observed that as a larger buyer …nds it relatively more costly to reallocate purchases, given sellers’convex costs, a buyer merger increases dependency on any individual seller. In the case where = 1 suppose …rst that goods are perfect substitutes so that we can P 26 write u(aj ) = u Then, concavity of u( ) mirrors convexity of c( ) and it is i2G aij .

intuitive that again the result mirrors that of a buyer merger. When goods are however not perfect substitutes, then we need an additional assumption for this to hold, namely that when a consumer loses access to some good, then this reduces his utility by more when he is already more constrained in that he has access to fewer good. Writing this in a continuous fashion, take thus some consumption vector aj and consider the derivative 25

Note that this presumes strictly convex costs so as to make such adjustments optimal. As then the e¢ cient allocation does not prescribe how all bilateral trades are allocated across sellerbuyer pairs, we consider here the symmetric equilibrium outcome. 26

23

with respect to some element aij , ui (aj ), representing (in absolute terms) the marginal loss when consumption of good i must be reduced. Consider then any other two goods z and y and suppose that we further tilt consumption towards, say, good z, as already azj > ayi and as we consider a further shift dazj = ui (aj ) satis…es27

dayi =

d ui (aj ) dazj

> 0. We suppose that the impact on

d ui (aj ): dayj

(12)

Lemma 4 Suppose sellers I1 and I2 form a seller I3 with size jI3 j = jI1 j + jI2 j. Then with condition (12)

(13)

{I3 J > {I1 J + {I2 J

holds, implying that when sellers hold all the bilateral bargaining power ( = 1), the unit price received by I3 is always strictly higher than the average per unit price received jointly by I1 and I2 . Finally, taking together the results from Lemmas 3 and 4, we immediately obtain the following result that is analoguous to that for the formation of a larger buyer in Proposition 5. Proposition 5 Suppose sellers I1 and I2 form a seller I3 with size jI3 j = jI1 j + jI2 j and (12) holds. The larger seller receives a strictly higher per unit price if and only if either i) there is only a single buyer, i.e., jJj = jN j for some J 2 B and

> 0 (as for

= 0 the

single buyer always extracts all surplus);

ii) or there are multiple buyers, i.e., jJj = 6 jN j for every J 2 B, and

is higher than some

critical threshold that lies in (0; 1).

7.2

Technology

Our bargaining approach presumes that bilateral (temporary) adjustments of trades are feasible. A particular case where these adjustments may however not be feasible could be that were the technology is such that adjustments would involve additional and su¢ ciently large lump-sum costs, which we did not consider in our model (or assumed to be su¢ ciently small).28 Formally, we could capture this by so-called “quantity-forcing”contracts that do d d Then the total change to ui (aj ) equals dazj ui (aj ) dayj ui (aj ) > 0: 28 When incorporating such …xed adjustment costs in future work, it is notable that if these are not prohibitively high, then this would generate economies of scale "o¤ equilibrium". 27

24

not allow for adjustments. For analyzing both the case of auctions and that of bargaining, we focus on the equilibrium that supports the e¢ cient trade matrix A .29 Therefore, at IJ disagreement trades are now given by AIJ with aIJ ij = 0 if i 2 I and j 2 J and aij = a

otherwise. For the two auction games we can adopt Proposition 1 and obtain, when buyers bid ( = 0), the transfers 'IJ = jIj [c ((jN j a )

c ((jN j

jJj)a )]

(14)

and, when sellers bid ( = 1), the transfers {IJ = jJj u(aj )

u(aIJ IJ ) .

(15)

Also Proposition 3 extends with quantity-forcing contracts, so that the outcome of bilateral negotiations is again a convex combination of 'IJ and {IJ . With respect to buyer size, we now no longer have two con‡icting sources (dependencies). When adjustments are not possible, only the well-known “incremental cost”e¤ect remains, which - as discussed after Lemma 1 - still ensures that condition (8) holds, now with the respective transfers from (15), while with the transfers from (14) condition (9) no longer holds. Likewise, condition (13) holds, but without adjustments there is again no negative countervailing e¤ect of seller size. A formal statement of this is part of Proposition 6 below. Adjustments may also be made infeasible or unpro…table by the shape of the cost function. In the remainder of this section we explore the role of capacity constraints. We suppose …rst that capacity is limited in that c(x) is well-behaved until some K, while c(x) = 1 when x > K. The capacity constraint is binding with a = K= jN j, which now deprives buyers of their option to adjust trades in case of disagreement, so that {IJ is still

given by (15). The adjustment option however now still persists for sellers, as re‡ected in the originally derived transfer 'IJ in (3), so that only for 'IJ the previously derived negative impact of own size holds.30 With limited capacity but otherwise convex costs, size is then an unambiguous advantage only for buyers. In a mature industry, …rms may have adjusted to a predictable production level, e.g., by employing su¢ cient sta¤, so that marginal costs may increase only above x = jN j a , 29

As noted already in Section 4, equilibria with only quantity-forcing contracts can support a multiplicity of ine¢ cient outcomes. 30 Strictly speaking, we would need to slightly modify the proof to take into account the corner solutions for aIJ IJ .

25

e.g., by only then requiring more expensive overtime. For this case, we may thus suppose that c(x) = c holds up to x = jN j a , while c00 (x) > 0 for x > jN j a . As marginal

costs are thus constant at “inframarginal” production levels, as already noted, optimally sellers will not use their adjustment option, so that with c(x) = c expression (14) further simpli…es to 'IJ = c jIj jJj a . Then, through this channel (“seller dependency”) a seller’s

size can not be a disadvantage. On the other hand, as costs are still strictly convex for adjustments above the equilibrium production level, though not prohibitively high to rule out any adjustments, the “buyer dependency”e¤ect is now still present. For the following summarizing statement we simplify the exposition and restrict consideration to the case with more than one seller and more than one buyer. The results follow immediately from the discussed comparative analysis of 'IJ and {IJ . Proposition 6 We compare the terms of a large buyer J3 with size jJ3 j = jJ1 j + jJ2 j to

the average terms of the smaller buyers J1 and J2 and the terms of a large seller I3 with size jI3 j = jI1 j + jI2 j to the average terms of the smaller buyers I1 and I2 . In contrast to

the preceding main analysis, consider the following change in adjustment possibilities:

i) ("Quantity-forcing" contracts): Suppose no adjustments are feasible. Then the larger buyer always pays a lower unit price (and strictly so when always receives a higher unit price (and strictly so when

< 1) and the larger seller

> 0).

ii) (Binding capacity constraints): Suppose c(x) = 1 when x > K, with a = K= jN j. Then the larger buyer always pays a lower unit price (and strictly so when the larger seller receives a higher unit price when

< 1), while

is higher than some critical threshold

that lies in (0; 1) and a lower unit price otherwise. iii) (Adjusted capacity): Suppose c(x) = c for x

jN j a and c00 (x) > 0 for x > jN j a .

Then the larger buyer always pays a larger unit price (and strictly so when larger seller always receives a higher unit price (and strictly so when

7.3

> 0) and the

< 1).

Asymmetries and Concentration

So far our attention was focused on a comparison of the terms of trade of larger and smaller sellers or buyers, notably through considering the implications of a merger. As discussed in the Introduction, this was motivated also by recent antitrust interest in supply markets and the exertion of buyer power. In the more standard analysis of mergers and

26

market power vis-a-vis consumers,31 however, what matters for authorities as well is the asymmetry in market shares. Most prominently, this is captured by the HHI, which is the sum of the square roots of individual market shares and which is probably the most important …rst-phase screening criterion for mergers, as used in, for instance, the EU’s 2004 horizontal guidelines and the respective US guidelines (revised 2010). Interestingly, the latter acknowledge that, just as in the present paper, buyer power may be exerted in bilateral negotiations rather than through withholding demand (monopsony), but still note the following: “To evaluate whether a merger is likely to enhance market power on the buying side of the market, the Agencies employ essentially the framework described above for evaluating whether a merger is likely to enhance market power on the selling side of the market.”Our subsequent results provide a foundation for this approach. In light of our present interest in market concentration, we now take the (limit) case P where products are perfect substitutes, so that u(aj ) = u ( aij ). We compare market

structures that di¤er in the respective sizes of two buyers: While the joint size of J1

and J2 remains unchanged at jJ1 j + jJ2 j = M , starting from a situation where already jJ1 j jJ2 j, we let them trade assets (i.e., consumers) so that subsequently Jb1 = jJ1 j + m and Jb2 = jJ2 j m with m > 0.32 Bilateral relationships are left unchanged as we consider the outcome with aij = a . This reorganization of sellers’market increases the respective HHI, that is33

HHIB =

X

J2B

jJj jN j

2

:

We show in the proof of Proposition 7 that the considered increase in asymmetry reduces each seller’s pro…ts when

= 0.34 As HHIB also increases after a buyer merger, together

with Lemma 1 we have the following result: Proposition 7 Consider either a merger of two buyers or a trade of assets (consumers) between them so that concentration increases (higher HHIB ). Then this increases seller 31 More precisely, the de…ning characteristics are typically non-negotiated and thus also nondi¤erentiated terms that are accessible to all consumers (“uniform pricing”). 32 The case where m = jJ2 j is covered, as a limit, by the subsequent analysis, though given the subsequent restrictions on substitutability, the preceding analysis is not made redundant. 2

2

2

2

jJ1 j jJ2 j m j+m 2j In fact, the respective increase equals the di¤erence of jJ1jN and jJ , j jN j jN j jN j which is strictly positive as jJ1 j jJ2 j and m > 0. 34 In light of our subsequent discussion we show this both for our baseline case and when there is a binding capacity constraint (case ii) in Proposition 6). 33

27

dependency: For each I,

P

J2B

'IJ strictly decreases.

Proposition 7 already informs us about the total impact on sellers’pro…ts for di¤erent scenarios, notably when capacity is constrained (cf. the discussion preceding Proposition 6), when contracts are determined through auctions where buyers bid (cf. Proposition 1), or in negotiations when buyers can extract a su¢ ciently large share of the bilateral surplus (low ). De…ning next from buyers’perspective HHIS =

X I2S

jIj jGj

2

;

we have the following mirror image to Proposition 7. Proposition 8 Consider either a merger of two sellers or a trade of assets (production facilities) between them so that concentration increases (higher HHIS ). Then this increases P buyer dependency: For each J, I2S {IJ strictly increases.

Propositions 7 and 8 are silent about the impact of increased concentration on the

dependency of the respective side of the market, e.g., the dependency of two buyers J1 and J2 that trade assets. As is intuitive from our preceding analysis, unless adjustment options are restricted (e.g., by capacity constraints, cf. Proposition 6), the “joint”dependency of the involved parties, here the two buyers, indeed increases, as captured by an increase in P 35 While the impact of greater asymmetry on payo¤s is thus generally I2S ({IJ1 + {IJ2 ). ambiguous, it is precisely for an asymmetric distribution of bargaining power, i.e., relatively low or high values of , that we obtain clear-cut predictions, which should be indeed the cases of greatest interest to antitrust authorities.

8

Conclusion

In this paper we proposed a framework to model bargaining in a bilateral oligopoly where adjustments are possible but are not expected to be permanent. Our approach nests as special cases auctions in truthful menus, both among sellers and among buyers. In fact, the outcomes from these two more standard mechanisms are obtained at the extremes where either sellers or buyers have all bargaining power. Even if one side has all bargaining power, 35

A proof is contained in the online appendix.

28

our approach ensures that the other side’s payo¤ does not go to zero, as long as there are alternative buyers or sellers that stand ready to buy more or sell more of (imperfect) substitute goods. In case of delay in bilateral bargaining, when a strategic approach is taken, it allows the two a¤ected parties to temporarily adjust their transactions with all other parties, without presuming that all parties must adjust and change the terms of trade with one another— i.e., adjustments are “local”rather than “global”. We then used our approach to study the determinants of buyer power. A key result of this paper is that buyer size can be both an advantage or a disadvantage when trying to secure a low price. We expressed this result in terms of buyer and seller dependency. Size a¤ects either buyer or seller dependency di¤erently. Which e¤ect becomes stronger and then determines the overall e¤ect of a merger depends on the distribution of bargaining power, i.e., how net surplus is shared in bilateral transactions. Seller dependency on a particular buyer captures the ease with which a seller can pro…tably adjust sales to other buyers when there is (temporarily) no agreement with the buyer. Buyer dependency captures likewise the pro…tability of a buyer’s adjustment of his purchases from all other sellers. The size of a given player can increase the dependency of his counterparties but it can also increase his own dependency, as switching becomes a less attractive alternative for both sides. By considering di¤erent technologies and contracts, varying in the degree to which adjustments are feasible or optimal, we make transparent the di¤erent channels through which size advantages or disadvantages arise. Also, when a buyer’s bargaining power from other sources is weak, the negative e¤ect of size dominates, given that then the option to substitute a seller becomes more important for the overall outcome of negotiations. Technology as well as the distribution of bargaining power, as also expressed in the procurement format, thus determine whether the overall e¤ect of size, but also that of asymmetry in market concentration, are driven by the e¤ect on seller or buyer dependency. We assumed that a change in buyer size does not change the nature of the procurement process. In that respect we have taken the prevalent view that otherwise “it would be too easy to obtain a theory of the costs and bene…ts of integration if it were supposed that the bargaining process changes under integration”(Hart, 1995). If however, in addition to the e¤ects discussed here, size also shifts bilateral bargaining power in more subtle ways (for example a larger buyer may …nd it pro…table to hire a more skilled procurement team),

29

this may also change the way buyer power would go. A further avenue for future work that we brie‡y discussed is the analysis of the equilibrium market structure, rather than considering an exogenously chosen merger or trade of assets between seller or buyers. Hart and Kurtz (1983, 1984) introduced several concepts of stability for this type of analysis, which has been pursued by many others in particular in environments with externalities (see, for instance, the survey by Bloch, 2002). Assume in our setting that only players of the same type, buyers or sellers, can form groups that will bargain jointly but are otherwise unconstrained in what groups they can form (this is unlikely to be the case in most applications). It follows from our results that for extreme values of bilateral bargaining power, i.e., for

close to 0 or 1, the players on the strong

side bene…t from forming a monopoly. Then the players of the other type, anticipating that they will face a monopoly, also bene…t from forming themselves a monopoly. Thus in those cases a bilateral monopoly should emerge in equilibrium. The problem becomes signi…cantly more complex for balanced distributions of the bilateral bargaining power, and in particular and it becomes dependent on the way the concept of stability speci…es how the members of a group will organize if one if its subgroups deviates.

9

Appendix

Proof of Proposition 3. To support an equilibrium, suppose that the e¢ cient trade matrix was implemented and that bilateral transfers are given by tSIJ , where the superscript shall denote that the respective o¤ers were made by sellers (e.g., in

= 0). Still stipulating

symmetric discount rates for all buyers, rb > 0, and symmetric discount rates for all sellers, rs > 0, we then have the following discounted payo¤s: 1 rS 1 = rB

WI = VJ

P

tSIJ

CI (A ) ;

J2B

vJ (A )

P

tSIJ

:

I2S

Now suppose instead that one agreement, namely that between I and J, has not yet been concluded. In the present period, their adjustments to all other trades are given by

30

AIJ , so that over the period of length z their discounted payo¤s are respectively # " P 1 e zrS CI (AIJ ) ; DIJ = tSIJ 0 + vJ 0 (AIJ ) vJ 0 (A ) rS 0 J 2BnJ " # P 1 e zrB DJI = vJ (AIJ ) (tSI0 J + CI 0 (A0IJ ) CI 0 (A )) : rB 0 I 2SnI Suppose next that I and J reach an agreement in the following period, leading to the e¢ cient trade matrix and with respective transfers (from the buyer’s o¤er) tB IJ , so that from then onwards their continuation payo¤s are WIB

1 = rS

VJB

1 = rB

To now make buyer J in

tB IJ +

P

J 0 2BnJ

tSIJ 0

CI (A ) ; P

tB IJ

vJ (A )

!

I 0 2SnI

tSI0 J

!

:

= 0 just indi¤erent between acceptance and rejection, it must

hold that VJ = DJI + e

zrB

VJB :

(16)

Likewise, provided that there was disagreement between I and J and

= 1 is reached, for

the respective o¤er of the buyer to now make seller I just indi¤erent, it must hold that WIB = DIJ + e

zrS

(17)

WI :

We show next that the respective equations (16) and (17) yield a unique solution for (tSIJ ; tB IJ ), which also does not depend on all other transfers. After substitution, these two equations transform to tSIJ

e

rB B tIJ

= (1 = (1

e e

rB

rB

"

) vJ (A )

vJ (AIJ )

P

I 0 2SnI

){IJ

(CI 0 (A )

#

CI 0 (AIJ ))

and tB IJ

e

rS S tIJ

= (1 = (1

e e

rS

rS

)

"

P

J 0 2BnJ

vJ 0 (AIJ )

)'IJ ;

31

vJ 0 (A ) + CI (A )

#

CI (AIJ )

respectively. Substituting out for tB IJ , this yields tSIJ = As

(1

e

rB

){IJ + e 1 e

rB

(1

e

rS

)'IJ

(rB +rS )

:

! 0 this converges to tSIJ =

rB {IJ + rS 'IJ = {IJ + (1 rB + rS

)'IJ :

Finally, to fully characterize the equilibrium, we make the following speci…cations. We specify that in

= 0 all agents of sellers make the respective o¤ers (AIJ ; tIJ ), which buyers’

agents accept. Further, if there was so far no agreement in one particular relationship (I; J), then it is expected that there will be immediate agreement in the next period, namely to the respective contract o¤ered by the buyer’s agent (AIJ ; tB IJ ) in odd periods and to the respective contract (AIJ ; tSIJ ) in even periods. By construction of transfers, given these expectations, as well as by construction of the e¢ cient trade matrix, the respective strategies indeed constitute an equilibrium. Q.E.D. Proof of Lemma 1. Given that in equilibrium the total quantity purchased by J1 and J2 will be equal to the quantity purchased by J3 alone, we only have to compare the respective transfers: 'IJ =

P

J 0 2BnJ

(vJ 0 (AIJ )

vJ 0 (A ))

(CI (AIJ )

CI (A )).

In what follows, we will …rst transform this expression. For this note that CI (A ) = P jIj c(jN j a ) and that J 0 2BnJ vJ 0 (A ) = (jN j jJj)u(aj ); where aj is a column vector with each element equal to a . Recall as well that ui (aj ) denotes the partial derivative of

u with respect to the consumption of good i 2 G. Recall that aIJ j denotes the adjusted

consumption vector for j. It is convenient to write all elements i 2 = I as aIJ ij =

jN j a jN j

jJj zIJ ; jJj

where we still need to determine the (symmetric) adjustments z IJ . From the …rst-order condition we have c0 (jN j a

jJj z IJ ) = ui (aIJ j );

(18)

so that with strict convexity we have immediately z IJ 2 (0; a ) (while, for future reference, note that z IJ = 0 when costs are linear). With this notation, using also that CI (AIJ ) = 32

jIj c((jN j a

jJj z IJ ) and that

'IJ , notably also 'IJ3 = (jN j

jJ1 j

P

J 0 2BnJ

3 jJ2 j)(u(aIJ j )

vJ 0 (AIJ ) = (jN j

jJj)u(aIJ j ), we can rewrite all

jIj (c(jN j a

u(aj ))

jJ3 j z IJ3 )

c(jN j a )): (19)

We proceed as follows. To establish the assertion, we derive boundaries for the leftIJy

hand and right-hand side of expression (8). For this let next b aj

be the column vector

with each element equal to a for i 2 = I and IJ

b aij y =

jN j a jJy j z IJ3 jN j jJy j

(20)

IJ

3 for i 2 I, where in the latter case we have b aij y < aIJ ij for y = 1; 2. (Formally, di¤erentiating

expression (20) with respect to jJy j the respective sign is determined by a

z IJ3 > 0,

which we established to hold strictly with strictly convex costs.) We then have for y = 1; 2 that 'IJy > (jN j

IJ

jJy j)(u(b aj y )

jJy j z IJ3 )

jIj (c(jN j a

u(aj ))

c(jN j a )),

(21)

since we did not use the optimal adjustment jJy j zIJy but instead jJy j zIJ3 . For condition (8) to hold, using (19) and (21) it is su¢ cient that the following two conditions hold: jJ3 j z IJ3 )

(c(jN j a c(jN j a ))

c(jN j a ))

(c(jN j a

jJ2 j z IJ3 )

(c(jN j a

jJ1 j z IJ3 )

(22)

c(jN j a ))

> 0, and (jN j (jN j

jJ1 j

jJ2 j)(u(ajIJ3 )

2 jJ2 j)(u(b aIJ j )

u(aj ))

(jN j

1 jJ1 j)(u(b aIJ j )

u(aj ))

(23)

u(aj ))

0. We con…rm (22) and (23) separately. Take thus …rst condition (22), which transforms to c(jN j a )

c(jN j a

jJ1 j z IJ3 ) > c(jN j a

jJ2 j z IJ3 )

c((jN j a

(jJ1 j + jJ2 j)z IJ3 );

so that this is indeed strictly satis…ed when c is strictly convex. Next, for condition (23) observe that the left-hand side is zero when z IJ3 = a (which it is not). Note as well that for y = 1; 2 and z IJ3 2 (0; a ), we have that

jN j a jJ3 j z IJ3 jN j a jJy j z IJ3 < . jN j jJy j jN j jJ3 j 33

Di¤erentiate now the left hand side of (23) with respect to z IJ3 , which by symmetry can be simpli…ed to 1 2 jIj jJ1 j ui (b aIJ aIJ j ) + jJ2 j ui (b j )

3 (jJ1 j + jJ2 j)ui (aIJ j )

(24)

IJ

3 for any i 2 I. Recall now that b aij y < aIJ = I. As the second-order ij for y = 1; 2 and i 2

IJ

3 derivatives are strictly negative for each i; j 2 G, we then have that ui (aIJ aj y ), so j ) < ui (b

that the derivative (24) is positive. Finally, when z IJ3 2 (0; a ) holds strictly, as we just veri…ed for strictly convex costs, the left hand side of (23) is increasing in that interval

and equal to zero when z IJ3 = a , so that (23) holds (strictly) when costs are (strictly) convex. This completes the proof. Q.E.D. Proof of Lemma 2. Again, as the total quantity purchased by J1 and J2 will be equal to the quantity purchased by J3 alone, we only have to compare the respective transfers P

vJ (AIJ ))

{IJ = (vJ (A )

I 0 2SnI

(CI 0 (A )

CI 0 (AIJ )),

as used in condition (9). As vJ (A ) = jJj u(aj ), these elements cancel in (9), which we can

therefore rewrite as

P

vJ (AIJ3 )

I 0 6=I

P

vJ (AIJ1 )

I 0 6=I

CI 0 (AIJ3 ) +

P

I 0 6=I

(25)

CI 0 (A )

CI 0 (AIJ1 ) + vJ (AIJ2 )

P

I 0 6=I

CI 0 (AIJ2 ) + 2

P

I 0 6=I

CI 0 (A ):

We proceed as in the proof of Lemma 1 by …rst deriving properties of the optimal reallocation of purchases. Let

IJ

denote the (symmetric) increase in the purchases from

i 2 GnI, so that for these elements aIJ ij = a + ui (aIJ j ). Note that

IJ

IJ

= jJj, and note that c0 (jN j a +

IJ

)=

> 0 as the cross partial derivatives of u( ) are strictly negative.

Using that vJ (AIJ ) and

P

I 0 6=I

P

I 0 6=I

CI 0 (A ) = (jGj

CI 0 (AIJ ) = jJj u(aIJ j )

(jGj

jIj)c(jN j a +

IJ

).

(26)

jIj)c(jN j a ), we can further rewrite condition (25) as follows:

3 jJ3 j u(aIJ j )

(jGj

jIj)c(jN j a +

IJ3

)

2 jJ2 j u(aIJ j )

(jGj

jIj)c(jN j a +

IJ2

1 ) + jJ1 j u(aIJ j )

34

(jGj

jIj)c(jN j a ) (jGj

(27) jIj)c(jN j a +

IJ1

).

If there is a single seller, i.e., jIj = jGj, then

IJ

is zero and therefore both sides of (27) are

equal. Suppose for the remainder that jIj = 6 jGj. We proceed as in the proof of Lemma 1

by deriving boundaries. Inequality (27) will then be satis…ed if a more stringent inequality is satis…ed, which is obtained by replacing in the inequality above the optimizers IJ1

IJ3 jJ2 j jJ3 j

respectively by

and

IJ3 jJ1 j . jJ3 j

IJ2

and

But then the respective column vectors used as

3 arguments in u( ) in (27) are all the same, namely equal to aIJ (that is, each element equal j

IJ3

to a +

= jJ3 j for each good that is not produced by I and 0 for each good produced

by I). The respective utilities in (27) then cancel out and after dividing by (jGj are left with the condition c jN j a +

IJ3

c jN j a +

This is …nally equivalent to c(x + y) where x = jN j a ,

=

jJ1 j jJ3 j

Z

c jN j a +

jJ3 j

c(x + y)

and y = (1

IJ3 jJ1 j

IJ3

c(x + (1

IJ3 jJ2 j

+ c (jN j a )

jJ3 j

)y) + c(x)

jIj) we 0:

0,

. We can then further rewrite this as

)y

[c0 (x + y + s)

c0 (x + s)] ds

0;

0

which holds strictly by strict convexity of c( ). Q.E.D. Proof of Proposition 7. We consider …rst the baseline case with strictly convex costs and no capacity constraints. As goods are now perfect substitutes, we can simplify expressions as follows. Considering a disagreement between I and J, we generically denote by a the choice of (adjusted) trade of seller I with all other buyers J 6= I, so that 'IJ = max [(jN j a

jJj) u ((jGj

jIj) a + jIj a)

jIj c ((jN j

jJj) a)] [(jN j

jJj) u (jGj a ) (28)

Denote the respective expressions for the two buyers by 'IJ1 and 'IJ2 . As described in the main text, we consider an increase in jJ1 j and a corresponding decrease in jJ2 j. Though jJj takes on only integer values, note that expression (28) is de…ned also generally for

real-valued jJj. To make this transparent, denote the respective expression by a function ' e I (x = jJj). Letting x2 = M

x1 , we thus have from application of the envelope theorem

that

d(e 'I (x1 ) + ' e I (x2 )) = [u ((jGj jIj) a + jIj b a2 ) dx1 jIj [b a2 c0 ((jN j x2 ) b a2 ) 35

u ((jGj b a1 c0 ((jN j

jIj) a + jIj b a1 )] (29) x1 ) b a1 )] ;

jIj c (jN j a )]

where b ay (for y = 1; 2) solves (after dividing by (jN j u0 ((jGj

xy ) jIj)

c0 ((jN j

jIj) a + jIj b ay )

xy ) b ay ) = 0;

(30)

so that from strict convexity of c( ) and strict concavity of u( ) we have b a1 > b a2 as long as x1 > x2 . Substituting (30) into (29), this expression is strictly negative if u ((jGj

jIj) a + jIj b a1 )

> jIj b a1 u0 ((jGj

jIj) a + jIj b a2 )

u ((jGj

jIj b a2 u0 ((jGj

jIj) a + jIj b a1 )

(31)

jIj) a + jIj b a2 ) :

Using strict concavity of u( ) and b a1 > b a2 , (31) surely holds if, on the right-hand side, we replace u0 ((jGj

jIj) a + jIj b a2 ) by u0 ((jGj

su¢ cient requirement: u ((jGj

jIj) a + jIj b a1 ) u ((jGj jIj (b a1 b a2 )

jIj) a + jIj b a1 ), which yields the following

jIj) a + jIj b a2 )

> u0 ((jGj

jIj) a + jIj b a1 ) :

This holds from strict concavity of u( ). The assertion in the proposition then follows as, …rst, by leaving jJ1 j + jJ2 j = M constant, all other 'IJ for J 2 = fJ1 ; J2 g are not a¤ected, and, second, we can express ('I Jb1 + 'I Jb2 )

('IJ1 + 'IJ2 ) =

Z

jJ1 j+m

jJ1 j

d(e 'I (x1 ) + ' e I (M dx1

x1 ))

dx1 < 0:

It remains to prove the assertion for the case where adjustments are not given by the …rst-order condition (30) but are (optimally) equal to a binding capacity constraint, given that c(x) = 1 when x > K, while a = K= jN j. For this case, we have, using that goods are perfect substitutes, 'IJ = (jN j Then, with x2 = M

jJj) u (jGj

jIj) a + jIj

K jN j

jJj

u (jGj a ) :

x1 , we have in this case

d(e 'I (x1 ) + ' e I (x2 )) = dx1

u (jGj jIj

jIj) a + jIj

K u0 (jGj jN j x2

K jN j x2

jIj) a + jIj

To show that this is strictly negative, using now

K jN j x1

>

K jN j x2 K , jN j x2

complete analogy to the previous (interior adjustment) case. Q.E.D. 36

jIj) a + jIj

u (jGj

K jN j x1

K u0 (jGj jN j x1

we can proceed in

jIj) a + jIj

10

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39