Dynamic Explanation of Industry Structure and Performance
Cotterill
succeeded because management's threat to sell unionized
divisions if they did not consent to wage cuts was now
credible. The high price KKR paid for Safeway could
only be covered if the firm could get wage give backs.
The first division, Little Rock, resisted and was promptly
sold to nonunion operators.11 Workers in other divisions
then gave in. Management's options were constrained
by the financial structure and hence credible. Either
labor and other input suppliers accepted cuts or Safeway
went bankrupt.
A similar interaction between capital market
structure and market power in product markets also
occurred with output price (Bolton and Scharfstein,
1990). Chevalier, in fact documents that LBO
supermarket retailers raised prices to increase short term
cash flow (Chevalier 1995a, 1995b).
In nearly all LBO's a critical short term consequence
is that there is absolutely no or very little internal cash
flow available for investment in the business. (Recall
Michael Jensen's insistence that it be paid out.)
Moreover these highly leveraged firms cannot easily
raise capital by issuing more debt or selling more stock.
The short term game contradicts Jensen's model. Firms
must de-leverage as quickly as possible by merger
and/or divestiture so they can get back to investing in
their business. Otherwise they lose market share to
unleveraged competitors that can invest and expand.
Safeway's 1986 LBO confirms this. Safeway market
share in Washington D.C., for example dropped from
24.6% in 1985 to 23.1% in 1991. Meanwhile Giant's
share exploded from 33.2% in 1985 to 43.4% in 1991
(Cotterill, 1993, p. 178).
Leveraged firms typically saw horizontal mergers as
a quick route to pricing power. Safeway acquired Vons
in 1988. Stop and Shop, a KKR LBO was acquired by
Royal Ahold, owner of Edwards, the number two chain
in New England behind Stop and Shop in 1996.
Pathmark, a firm hobbled by LBO debt recently tried to
merge with Royal Ahold Edwards, their primary
competition in the metro New York area, but was
stopped by FTC scrutiny (Orgel 1999, Cotterill 1999a,
Cotterill et al., 1999). Prevented from monetizing the
excessive and high value that the LBO put on the firm,
Pathmark is now restructuring its debt, in effect forcing
junk bond holders to absorb losses because the
efficiencies and power plays that they believed could
11 The Safeway spin-off Harvest Stores ultimately went
bankrupt and it share dropped from 23% in 1993 to zero.
Kroger aggressively expanded and in 1999 had a dominant
position with 51% of the market (Franklin, 2000). The
financial capitalists certainly would approve of this divide and
conquer approach to food marketing.
cover their cash flow demands when they did the LBO
are not available.
The federal and state antitrust agencies now take a
much tougher stance towards bailing out financial
capitalists than they did in the heyday of LBOs in the
1980's. Industry executives now believe that their
enforcement stance is even tougher than the 1990's
where divestitures often allowed mergers to go forward
(Orgel, 1999, Zwieback, 2000).
5. Successive Monopoly/Oligopoly Requires a New
Approach to Farm to Retail Price Transmission
Somewhat endogenous, but important in its own
right for the vertical organization and performance of the
food sector is prior organization. Our basic point is that
the trend towards tight oligopoly in successive stages of
a market channel will influence the continued evolution
of this channel's structure and its performance. Research
in agricultural economics on cost pass through rates
(CPTR), for example, has concentrated almost
exclusively on homogeneous products and models that
assume for tractability that the market channel is a single
industry with competitive firms (e.g. Gardner, 1975;
Heien, 1980; Kinnucan and Forker 1987). Recently
McCorriston, et al. (1998) relax the competitive
assumption, but they continue to maintain the single
stage (industry) and homogeneous product assumptions.
Outside of agricultural economics Ashenfelter, et al.
(1998) analyze two types of cost shocks-industry wide
and firm specific but they do so only in a residual
demand framework for a single stage or industry. Here
we advance the theory and empirical analysis by
introducing a more disaggregate structural model with
firms in a two stage (industry) market channel. We
identify cross firm price shocks and corresponding pass
through rates as well as industry and firm specific rates.
Given an oligopolistic market structure, a firm specific
shock not only influences that firm’s own price level; it
also causes other firms to react to that price and change
their prices (Cotterill 1994, 1998; Cotterill, et al. 2000).
The farm to retail transmission of prices, i.e. the CPTR,
is affected by the structure of the market channel.
Assume horizontal competition both at the
processing and retail level (a two stage channel) is Nash
in prices. Assume also Bertrand price competition exists
among retailers. To capture the vertical nature of
competition between processors and retailers, we specify
three different games: supermarkets with upstream
integration (complete vertical coordination game), a two
stage vertical Nash model where each supermarket
chooses an exclusive processor and processors and
retailers maximize profit simultaneously by deciding on
Food Marketing Policy Center Research Report No. 53
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