Limit Pricing under a Vertical Structure

Abstract

A small food manufacturer is trying to convince two retailers, a chain and an independent grocery store, to carry its product in a given neighbourhood. The manufacturer and the chain store's manager are uncertain on how well the product will sell in this location. An independent store is usually locally owned and operated. Thus, the independent grocer is more likely to know the demand for the product and thereby, is more willing to carry the product. However, this results in a dilemma for the independent grocer. If he sells a lot of the product initially, the manufacturer will observe this and will convince the chain store's manager to carry the product. This results in lowering the independent grocer's future sales of the product. He can prevent this by selling less of the product than he could have otherwise. However, this lowers his initial profit. In their seminal paper, Milgrom and Roberts (1982) analyze how entrants can perceive current pricing as indicators of an industry's characteristics. For example, an incumbent firm can use low prices to signal that it has a low cost of production. This may deter entry. However, a firm with a high cost of production may also lower prices to pretend that it is a low cost firm. The idea of limit pricing is then based on how observed prices can affect entry decisions. A variant of this model can posit the uncertainty in demand as a condition of the industry rather than of the cost structure of the incumbent firm. The point of departure for this paper is to introduce a vertical structure where the manufacturer of a good differs from the seller of the good. Note that limit pricing is still a credible policy of an incumbent seller. In the observation described above, the manufacturer also faces a dilemma in deciding the wholesale price of its good. If it sets a high wholesale price, this may make the product harder to sell and discourage other retailers from carrying its product. Conversely, if it sets a low wholesale price, it may encourage the independent grocer to practice limit