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Coke, Pepsi, Product Promotion and the Efficiencies of Vertical Integration

The soda industry is trending toward vertical integration, which Coke and Pepsi acquiring their largest bottlers.  From the WSJ:

Coke and PepsiCo sell concentrate to bottlers, which then bottle and distribute the soft drinks in their territories. Many of these smaller bottlers are small businesses that have been run by family members for decades and have perpetual contracts to distribute the sodas.   One concern for some smaller bottlers is that the big cola makers might now push for more price promotions in the regions they control, a move that could also drive down prices and profit margins at smaller bottlers. There are also questions about how both companies will handle distribution of any new drinks they launch.

For Coke and PepsiCo, managing the often delicate relations with their remaining independent bottlers will be key to driving sales and efficiency in their distribution systems.  PepsiCo said it is committed to nurturing “constructive” and “mutually profitable” relationships with its independent bottlers. PepsiCo says it has no plans to acquire the remaining portion of its bottling system, but instead it intends to focus on teaming up with its bottlers.  Coke declined to comment.

Most industry watchers say that independent bottlers will continue to have a strong presence and that both companies will likely strive to keep relations cordial with these distributors. Small bottlers will also benefit as the overall beverage system gets more efficient. Nonetheless, the big bottler deals are set to bring major changes to the industry, which is fighting a slump in sales of traditional sodas….

The recent deals will allow Coke and PepsiCo to cut costs sharply and allow them to be more flexible on pricing and in offering retailers better deals, moves that could indirectly push smaller bottlers to do the same.  “The pressure would be that they might lower prices to major customers on some products, where the independent bottlers may not have thought it necessary in the past,” Mr. Glover said.

This trend back toward vertical integration is pretty interesting.  The article suggests that integration will result in greater pricing flexibility and lower overall prices, suggesting that perhaps integration is solving a double marginalization problem.  But has bottler market power increased in the last decade or so?  Why now?

A second possible explanation is that the costs of ameliorating promotional incentive conflicts by contract has increased over the relevant time frame. Like most vertical contracts, the key here is to understand how the incentives of the prospective transacting parties do not coincide and therefore must be controlled contractually rather than left to unrestrained competition and self-interest.  A common incentive incompatibility, identified by Klein & Murphy (1988) and later analyzed by Klein (1995), occurs when: (1) manufacturers sell a product at a significant markup over marginal cost, (2) the retailer provides some input like marketing activity or promotion that has a significant impact on demand for the product, and (3) consumers have heterogeneous demand for these promotional services, i.e. different value placed on placement of the product on eye-level shelf space, product demonstrations, etc.    The basic economic forces under these conditions suggest that the downstream “promotional service provider” such as a franchisee or retailer does not have adequate incentives to promote the product or supply the efficient level of marketing activity. This is because the franchisee does not take into account the franchisor’s (large) profit margin on additional sales induced by provision of promotional services. This is most likely to be the case when products are differentiated, e.g. soda!

Under these conditions, transacting parties will find contractual solutions to these problems (including vertical integration) to induce the supply of the efficient level of promotional services. My analysis with Ben Klein on slotting contracts and solo authored work on category management contracts are examples of the types of contracts one sees put to use in the retail industry to control the transacting parties incentives in favor of non-performance and faciliate self-enforcement of the contract.  But the real question here is whether the incentive conflict has changed in the soda market in recent years such that vertical integration has become a more efficient solution for assuring supply of the desired distribution services than contracting.   I’m not sure what the change could be.  Contractual relationships with bottlers can be governed by franchise termination laws, which render if incredibly difficult and nearly impossible to terminate a bottler for non-performance.  The article notes that many of the bottler contracts are “perpetual.”

Relatedly, Muris, Scheffman & Spiller (1992) provide a similar analysis of the previous shift to vertical integration in the soft drink distribution market following a dramatic increase in the importance of marketing activity in the industry, e.g. supplying retailers with product display, “pushing” product by encouraging retailers to give premium shelf space with “slotting contracts,” and executing local promotions. It is true that one could call this change in optimal contractual form as a response to increasing transactions costs, but that is probably a bit misleading and certainly too vague to really get at the underlying economics.  Most folks assume that this means a response to an increased incentive to engage in hold up over specialized assets. But this incentive to vertically integrate has nothing to do with specialized assets in the conventional Klein, Crawford, and Alchian (1978) or Williamsonian sense.

Filed under: antitrust, business, economics