Vertical Control of a Distribution Network - An Empirical Analysis of Magazines

How does an upstream firm determine the size of its distribution network, and what is the role of vertical restraints? To address these questions we develop and estimate two models of outlet entry, starting from the basic trade-off between market expansion and fixed costs. In the coordinated entry model the upstream firm sets a market-specific wholesale price to implement the first-best number of outlets. In the restricted/free entry model the upstream firm has insufficient price instruments to target local markets. It sets a uniform wholesale price, and restricts entry in markets where market expansion is low, while allowing free entry elsewhere. We apply the two models to magazine distribution. The evidence is more consistent with the second model where the upstream firm sets a uniform wholesale price and restricts the number of entry licenses. We use the model to assess the profitability of modifying the vertical restraints. A government ban on restriced licensing would reduce profits by a limited amount, so that the business rationale for restricted licensing should be sought elsewhere. Furthermore, introducing market-specific wholesale prices would implement the first-best, but the profit increase would be small, providing a rationale for the current uniform wholesale prices.