Buyer Power and Vertically Differentiated Retailers

Abstract

We consider a model of vertical competition where retailers purchase an upstream input from a monopolist and are able to differentiate from each other in terms of quality. Our primary focus is to study the effects of introducing a large retailer, such as a Wal-Mart Supercenter, that is able to lower wholesale prices (i.e., countervailing buyer power). We obtain two main results. First, the store with no buyer power responds to the presence of the large retailer by increasing its quality, a finding that is consistent with recent efforts by traditional retailers to enhance shoppers’ buying experience. Second, the presence of a large retailer causes consumer welfare to increase. There are, however, two reasons for the increase in consumer welfare: consumers gain from the large retailer’s low price because the upstream discount is partially passed on to the retail price and from the high quality offered by the traditional retailer. Contrary to the conventional wisdom, most of the consumer welfare gains seem due to the latter. The intuition for this result is that price competition softens substantially as a result of firms’ quality differentiation. We also investigate the effects of buyer power on retail and wholesale prices as well as on producer welfare.