Vertical Restraints with Incomplete Information

Abstract

When a firm contracts with a privately informed retailer, vertical restraints may be insufficient to eliminate distortions arising from having to induce truthful reporting. With franchise fee contracts (which are equivalent to any other quantity forcing contract), two distortions arise. The is the need to transfer surplus to the retailer and the second is a reduction in the marginal return to production. With RPM contracts, the first best outcome of vertical integration is obtainable if the retailer observes private information only about the state of demand. If the retailer observes also private information about retailing costs, both distortions persist. IN AN earlier paper, Rey and Tirole [1986] (R&T) compare various forms of vertical restraints in a stochastic environment, where retailers have superior private information than the firm about the uncertain state of the world. They demonstrate that with asymmetric information, vertical restraints may be insufficient in order to reproduce the first best outcome of vertical integration. In R&T, contingencies are not feasible in the contracts since there are multiple retailers who can arbitrage. In particular, the wholesale price and the franchise fee under Franchise Fee contracting (FF), or the retail price imposed upon the retailer under Retail Price Maintenance (RPM), cannot be selected contingent upon any future communication with the retailers. In contrast in the present paper, we assume that the firm is served by a single retailer which then facilitates consideration of contingent contracts. The reason we make this different assumption is in order to investigate whether more sophisticated contracts can resolve the agency problem. We still obtain similar negative results to the ones obtained by R&T. Specifically, vertical integration cannot generally be reproduced by appropriate contracting, if retailers can observe private information about demand or retailing costs. There is another characteristic of the class of contracts considered in R&T that we modify in the present analysis. While in R&T the agent agrees to serve the firm as long as its ex-ante expected payoff is nonnegative, in the present paper we require that the ex-post profits of the agent are nonnegative, irrespective of how unfavorable is the realization of the state of nature. This