A theory of contract choices with reference to petrol retailing : risk, incentives, and competition

Working paper

In UK petrol retailing, the vertical relationship between manufacturer (refiner/wholesaler) and retailer is governed by a menu of possible contracts, characterized by different typical unit margins. In ‘agency’ terms, each contract type thus incorporates an implicit risk/incentives trade-off, with higher margins providing higher-powered incentives for retailer’s effort, but also increasing his share of the risk. At the same time, the difference in the margins also suggests a possible ‘strategic’ function of contracts: in an oligopolistic context, manufacturers might choose a particular contract type with the objective of indirectly influencing the final price set by the retailer, and possibly reduce the intensity of competition in the market game. This paper addresses the issue of contract-assignment, proposing a model where both ‘agency’ and ‘strategic’ considerations are featured in contract design. Agency considerations are explicitly incorporated in a simple duopoly, with manufacturers delegating the retail function to risk-averse retailers, and retailers competing against one another in prices. The manufacturers’ profits (payoffs) are thus obtained as the net result of two distinct influences: the agency costs of delegation, which are higher the more risk-averse (or less able) the retailer; and the strategic benefits from delegating to such a retailer, in the form of higher wholesale and retail prices. The key result of the model is that the net effect of these costs and benefits depends crucially on the intensity of local competition. Where competition is slack, the agency cost borne by the delegating manufacturer is not offset by the benefit to be gained by signalling his commitment to a less aggressive pricing strategy. The outcome is different, however, where competitive conditions are locally tight, i.e. final demand for each retailer is very sensitive to the other retailer’s price. In that case, the agency cost of employing a more risk-averse retailer is outweighed for the manufacturer by the strategic benefit from being able to commit to a higher retail price. This generates a series of testable propositions in the context of petrol retailing.

Authors: Caffarra, C

• Publication status: Published
• Peer review status: Reviewed (other)
• Publisher: Oxford Institute for Energy Studies
• Series: OIES paper
• Publication date: 1994-01-01
• Edition: Publisher's version
• Paper number: EE19
• ISBN: 0948061820
• Language: English
• Keywords: risk; contract choice; oil contracts; contract assignments; petrol retailing; OIES; incentives