Sticks and Carrots: Is Resale Price Maintenance Necessary?

Abstract

While the existing literature on vertical contractual relations has established that resale price maintenance is sufficient to coordinate the retail network of a manufacturer, this paper asks whether such vertical restraints are necessary. Specifically, this article studies the vertical contracting problem between an upstream manufacturer and his downstream retailers in a setting where spot market contracts fail, but resale price maintenance cannot be appealed to due to legal prohibition, to examine whether other forms of contracting can achieve the outcome of vertical integration. I show that a bonus scheme based on retail revenues is sufficient to provide incentives to decentralized retailers to elicit the correct levels of both price and service. Interestingly, an incentive scheme based on retail sales is unable to do so. Intuitively, an incentive scheme based on quantity alone will fail because it does not alter the source of incentive incompatibility between manufacturer and retailer, namely retail price competition. On the other hand, an incentive scheme based on retail revenue is able to coordinate the distribution channel because higher bonus levels are attainable not only by increasing sales, but also by increasing price; higher service levels then follow, as there is a large enough retail margin to underwrite them.