Contractual form, retail price, and asset characteristics

Abstract

Vertical restraints have a long and controversial literature in the economics of antitrust policy.They have a shorter but less controversial literature in positive economic theory 1 .In this latter literature, vertical agreements are analyzed as a response to principal-agent problems.The upstream firm sells its output to self-interested downstream agents for transformation and resale.In the absence of contractual restraints, the agents' choices of price and/or quality often will not be in the best interest of the upstream principal.The purpose of the contract is to align the interests of the agent with the interests of the principal.There is a modest empirical literature addressing this view of vertical contracts 2 .Brickley and Dark (1984) investigate the effect of monitoring costs and reputation investment on the upstream firm's decision to operate downstream units as franchises rather than companyowned outlets.They find patterns consistent with franchising to economize on monitoring costs by establishing the franchisee as a residual claimant at remote outlets and with company ownership when the downstream firm has an incentive to free-ride on the reputation of the upstream firm.Lafontaine (1988) and Norton (1988) also report results suggesting that monitoring costs and moral hazard affect the choice between franchising and company ownership.Ornstein and Hanssens (1987) find evidence that industry-wide resale price maintenance agreements increase the retail price of distilled spirits.Although previous empirical studies have addressed the choice of price or contractual form made for each outlet, they have in general been hampered by a paucity of outlet-level data.As a result, they have relied on variation in industry or market averages to estimate a relationship between characteristics and contractual form.In general, the studies test for a relationship between the industry proportion of outiets operated under some contractual form and some set of industry characteristics.The theory invoked by these studies, however, makes no 1The positive theory of vertical restraints is summarized in Tirole (1988) and Katz (1989).For a more institutional application of principal agent theory to franchising see Rubin (1978).2 There is a related empirical literature on the effect of asset specificity, or the potential for ex post rent extraction by some party to the agreement, on contract choices.See, for example, Joskow (1987).The contracting problem addressed in this paper does not involve relationship specific assets.prediction about proportions.Indeed, in the absence of important (and unobserved) heterogeneity across outlets, no mix of contractual form should be observed 3 .This study is an empirical test of the implications of principal-agent theory in which outlet-specific data appropriate to the theoretical predictions are used.Data on an outlet's characteristics, its retail prices and the contract under which it is managed are used to examine the relationships among the outlet characteristics, the upstream firm's choice of contracts, and the agent's choice of retail price.One focus of the study is the upstream firm's choice of the allocation of control rights (contractual form) as a function of the characteristics of the downstream asset.Thus, the observed mix in contractual form is tied to observed heterogeneity in outlet characteristics.A second focus is the effect of contractual form on the agent's choice of retail price conditional on asset characteristics.Differences in retail prices are tied to differences in characteristics and the incentives embodied in the contractual form.The application addressed here is gasoline retailing, and the study exploits the facts that principals (refiners) sell gasoline through variously configured stations and use several contractual forms.Variation in station characteristics lead to variation in the importance of agent effort and the extent to which the relevant effort is observable to the principal.Because an unconstrained agent generally will not choose the level of effort preferred by the principal, contractual forms with strong performance incentives will be used at stations where effort is important and unobservable.At stations where effort is observable, the refiner may choose a contractual form that allows more direct control over observable effort but offers weaker performance incentives.Legal constraints on contracting on price make the price and effort problems asymmetric.Price is always observable, but can be directly chosen by the upstream firm only at a companyowned outlet where providing incentives for unobservable effort may be more difficult.Holding constant the quality of the product, retail prices will be affected by whether they are chosen by the upstream or downstream firm.Because agents will generally not chose the price that 3 Gallini and Lutz (1990) develop a signaling model in which a choice variable for the upstream firm is the proportion of company-owned stores in the distribution network, and Lafontaine (1990) presents some related empirical results.The standard principal-agent theory invoked in this paper and in the bulk of the empirical work, however, requires outlet-level heterogeneity to support a mix of contractual forms.