Vertical Contracts in the Video Rental Industry

Abstract

A large body of theoretical work has explored the channels through which vertical contracts can induce efficiency improvements. However, it is also important to study vertical contracts empirically in order to gain insight into the relative size of different types of efficiency gains. In this paper, I empirically analyse a contractual innovation in the vertically separated video rental industry. Prior to 1998, video stores obtained inventory from movie distributors using simple linear-pricing contracts. In 1998, revenue-sharing contracts were widely adopted. I investigate the effect of the introduction of revenue-sharing contracts on firms' profits and consumer welfare. I analyse a new panel data set of home video retailers that includes information on individual retailers' contract and inventory choices, as well as rentals and contract terms for 246 movie titles and 6137 retailers in the U.S. during each week of 1998 and 1999 and the first half of 2000. A structural econometric model of firms' behaviour is developed that describes the nature of firms' contract choices. Estimates from this model indicate that both upstream and downstream profits increase by 10% under the revenue-sharing contract for popular titles. For less popular titles, the effects can be even larger. I also estimate that consumers benefit when revenue-sharing contracts are adopted.