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Information and the organization of distribution

Shin, Kwang-Shik, Ph.D.

T he Ohio State University, 1987

U M I 300 N. ZccbRd. Ann Arbor, MI 48106 PLEASE NOTE:

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University Microfilms International INFORMATION AND THE ORGANIZATION OF DISTRIBUTION

DISSERTATION

Presented In Partial Fulfillment of the Requirements for

the Degree Doctor of Philosophy In the Graduate

School of the Ohio State University

Kwang-Shik Shin, B.A., M.A.

• * * * *

The Ohio State University

1987

Dissertation Committee Approved by

Howard P. Marvel

Patr Id a B. Reagan p .

Stephen A. McCafferty AdvIsor Department of Economics CopyrI ght by

Kwang-Shik Shin

1987 TO

My Father and Mother,

Whose Love and Prayer Provided

Great insp t rat Ion

I I ACKNOWLEDGEMENTS

To my advisor, Professor Howard P. Marvel, I wish to express my

special thanks for his Invaluable guidance, encouragement, and generous donation of his time throughout my graduate work and dissertation. From the earliest stage of this research, he has read each segment of my paper carefully, offering numerous suggestions concerning both content and style.

I have benefited greatly from the advice of Professor Patricia B.

Reagan, who has provided Important assistance In the theoretical development of the dissertation. I especially appreciate her enduring

Interest in the progress of this research. I also would like to thank

Professor Stephen A. McCafferty for helpful comments.

Partial financial support from the Ohio State University Seed

Grant 221742 Is g ratefully acknowledged.

Finally, I wish to extend my special thanks to my wife,

Youngshll. for her great patience and support during my graduate studies and dissertation.

I I I VITA

February 2, 1954 ...... Born In Seoul, Korea

1978 ...... B.A., YonseI University SeouI, Korea

1981 ...... U.A., YonseI University

1981-82 ...... Instructor at University of Ulsan, Ulsan. Korea

1982-86 ...... Teaching Associate, Department of Economics, the Ohio State University, Columbus, Ohio

FI ELD OF STUDIES

Major Field: Economics

Studies In Industrial Organization

Studies In International Trade

Studies In Econometrics TABLE OF CONTENTS

ACKNOWLEDGEMENTS ...... Ill

VITA I V

L 1ST OF TABLES ...... vl i

CHAPTER PAGE

1. INTRODUCTION ...... 1

II. PRIVATE BRANDING AS A SUBSTITUTE FOR VERTICAL

RESTRAINTS ...... 11

1. The Locus of Private Branding ...... 13

2. Traditional Explanations of Private Branding ...... 22

2.1 Excess Capacity ...... 22

2.2 Price Discrimination ...... 27

3. Free Riding and Private Branding ...... 30

3.1 Vertical Restraints: Efficiency Rationale .... 30

3.2 Information and Private Branding ...... 37

4. Private Branding and Manufacturers' Branding ...... 47

I I I . JAPAN'S GENERAL TRADING COMPANIES ...... 60

1. An Overview of General Trading Firms ...... 65

2. Transaction Cost Economics ...... 79

v 3. Transaction Cost Analysis of Agency Delegation ...... 87

3.1 The Nature of General Trading Company ...... 88

3.2 Contractual Problems of Agency Delegation.... 90

3.3 Agency Delegation vs. Internal Organization .. 97

3.4 Third-Country Trade and Foreign Direct

Investment ...... 114

IV. SUMMARY AND CONCLUSIONS ...... 121

REFERENCES ...... 126

VI L 1ST OF TABLES

TABLE PAGE

1. Distribution of Chains Owning Private Brands by Kind of

Chain, 1931 ...... 16

2. Proportions of Private Brand to Total Sales for 276 Brand

Owning Chains, 1930 ...... 17

3. Average of Proportions of Private Brand Sales for Various

Commodities by Specified Number of Chains, 1928 ...... 18

4. Estimates of Market Share of Private Brands, 1964 ...... 19

5. Estimates of Market Share of Private Brands, 1986 ...... 19

C. WholesaleDistribution Channels of Tobacco Products, 1935 .. 53

7 . Concentration of Manufacture of Cigarettes, 1935 ...... 53

8. Japan's Dependence on Imported Resources and its Share of

World Imports In Comparison with U.S., 1982 ...... 66

9. Exports and Imports of U.S. and Japan as Percentage

Of GNP , 1974-83 ...... 66

10. Exports and Imports of Japanese Traders, FY 1983 ...... 68

11. Trade of Japan's Incorporated Trading Companies, FY 1983 ... 68

12. Share of the Nine Largest General Trading Companies In

Japan's Foreign Trade and GNP, 1970-83 ...... 71

vl I Breakdown of Total Sales of the Nine Largest General

Trading Companies by Type of Trade, 1973-83 ...... 71

Financial A ctivities of the Sogo Shosha, 1981-83 ...... 74

Overseas Investments and Loans by the Sogo Shosha,

March 1981 ...... 74

Ownership Interest of the Sogo Shosha In Overseas

Manufacturing Ventures, March 1980 ...... 74

Resource Development Ventures of the Sogo Shosha, 1980 . . .. 77

Resource Development Loans Extended by the Sogo Shosha

from Japan, January 1982 ...... 77

Share of Exports and Imports of the Ten Largest Trading

Companies by Commodity for Selective Years ...... 99

Share of Exports and Imports of Japan's Traders

by Commodity, FY 1974 and 1983 ...... 100

Commodity Structure of Japan's Exports and Imports ...... 103

Share of Various Commodity Groups In the Nine Largest

Trading Companies' Sales, 1983 ...... 104

Share of Exports and Imports of Japan's Traders by Commodity, FY 1983 ...... 104

Shifts In Trading Companies’ and Manufacturers' Share of

Japanese Exports and Imports, 1952-83 ...... 106

Geographic Structure of Exports of Large Trading Companies,

FY 1973 ...... 1 11

vl I I 26. Geographic Structure of Exports and Imports by Type of

Trader , FY 1983 ...... 1 11

27. Commodity Structure of Third-Country Trade by

the Sogo Shosha. 1960and 1981 ...... 117

28. Overseas Manufacturing Ventures of the Sogo Shosha,

March 1980 ...... 117

29. Regional Distribution of the Sogo Shosha's Overseas

Manufacturing Ventures, March 1980 ...... 117

I x CHAPTER I

INTRODUCTION

Distribution systems have traditionally been conceived of as a

set of convenient warehousIng-coI Iection fa c ilitie s which serve to

fa c ilita te the physical flow of goods from manufacturers to consumers.

Recent literatu re on vertical restraints has provided a new and wider

perspective on the role that distribution systems play in the exchange

process. Beyond the basic function of making goods available to

consumers In convenient surroundings, distribution systems perform the

function of collecting and transferring Information In both directions

between manufacturers and consumers. In view of the Importance of

Information transmission both to and from consumers In the product's

success or failure, obtaining efficient distribution system must be a

major concern for any manufacturing firm. Manufacturers have a wide

range of options for organizing their distribution system. A

manufacturer may choose to undertake Its distribution activ itie s

internally. In many markets there also exist a number of Independent

firms specialized in distribution and marketing, offering an

alternative to the manufacturer's direct Involvement. In choosing

among alternative means of organizing distribution, manufacturers must

ensure that their distribution system e ffic ie n tly perform the function of collecting, processing, and disseminating Information.

- 1 - 2

This paper is addressed to the Issue of division of

responsibilities for distribution between manufacturing firms and

marketing specialists (such as wholesalers, retailers, trading

companies, e tc .). Specifically, we are Interested In answering the

following question.- under what conditions do manufacturers choose to

concede control over various aspects of distribution to outside

marketing specialists? This vertical structure Issue of distribution

w ill be analyzed by means of examining two particular phenomena of

Interest - private branding In the United States and Japanese general

trading firms - with our primary Interest centering upon the

Informational role of the distribution system.

Private brands refer to products that are marketed under the

brand name sponsored or owned by a firm whose primary business Is

distribution. The use of private brands involves more than the mere

shift of brand ownership from manufacturers to distributors. Private brands differ from manufacturers' national brands In that dealers secure exclusive rights for brand names, control over prices and other

features of the product, and the responsibility for promotion and sales.1 Usually the distribution of private brands Is exclusive with brand-owning distributors. The practice of private branding has

Given that the authority to make marketing decisions about a brand is usually vested In the owner of the brand. It is sensible to classify brands on the basis of brand name ownership. Note that It Is conventional to refer to distributors’ and manufacturers' brands as "private" and "national" brands respectively, although the latter distinction Is based on the extent of geographic coverage and thus does not always coincide with the former. 3

been applied extensively In the United States and private labels have

achieved substantial penetration In many consumer goods markets.

Furthermore, an Increasing number of major national brand

manufacturers have chosen to produce private brand goods for some of

their dealers, relinquishing control over distribution to private

brand distributors in several respects.

Why do brand names reside with distributors rather than

manufacturers? While the role of firm reputation or brand name

capital In differentiating products and reducing quality uncertainty 2 has been studied extensively, l i t t le research effo rt has so far

been devoted to understanding the allocation of brand ownership

between manufacturers and distributors. Given that the ownership of

brands has broad Implications for the distribution of products, It Is

Important for analyzing distribution system to examine factors that

may influence manufacturers' brand policy decisions and the conditions

3 under which private branding Is likely to be adopted.

Since the appearance of Akerlof's (1970) lemon model, economists began to address market responses that may arise to counteract the effects of quality uncertainty. Recent literature on quality assurance has focused on Identifying the conditions under which buyers can rely on advertising and other brand-enhancement Investments as a positive signal of likely quality. Important theoretical works include, among others, P. Nelson (1974), B. Klein and K. B. Leffler (1981), and R. E. Klhlstrom and M. H. Rlordan (1984). 3 Three brand policy options are available to manufacturers. A manufacturer may choose to produce only Its own brands and be a pure national brand manufacturer. It also can be a dual brand manufacturer by producing both manufacturers’ and distributors' brands under a mixed brand policy. Finally, It can be a pure private brand manufacturer by specializing in the production of private labels. 4

The introduction and promotion of private brand goods has commonly been Interpreted either as an attempt by a monopolistic producer to discriminate In price or as a method of seI 11ng add 11Iona I units In the presence of excess capacity. While such traditional explanations seem to be applicable to a number of private branding cases, they are shown to be Incomplete and unsatisfactory for many other applications of the practice. In the next chapter, we develop a model of a retail market that looks at another source of private branding, namely, InformatlonaI free-riding among competing dealers, and demonstrate that the free-rider explanation may help account for the many unexplained Instances of private branding.

Efficient distribution of a product may require large fixed investments by distributors In various Informational a c tiv itie s . The provision of expert consultation or the demonstration of the product would serve as an example of dealer Informational services Increasing final demand. However, so long as the product Is branded or otherwise easily Identified by consumers, opportunistic dealers may attempt to free ride on the Information provided elsewhere by cutting price so low as to attract consumers. Jeopardizing the provision of Information

In the distribution channel. Of course, vertical restraints such as resale price maintenance (the practice of establishing prices at which products are resold by dealers) or retail territorial restrictions

(the practice of assigning territories to Individual dealers) may be adopted by manufacturers as a means of Implementing e ffic ie n t forms of distribution by protecting the Information flow from erosion through 5

free-riding. Manufacturers In the U.S., however, frequently find It

too costly to Impose such contractual limitations on downstream

distributors primarily due to unfavorable antitrust treatments of

these restrictive practices as well as the development of large 4 discount retail organizations. We argue that In such

circumstances, the use of private brands can be an attractive

contractual alternative to counteract Informational externalities at

the retail level. To the extent that consumers rely on brand names

for differentiating products, offering private brands may allow manufacturers to avert free-rider problems through an effective segmentation of the retail market by type of dealers. Thus private branding can properly be regarded as an optimal response to situations where there are limitations, legal or economic, on manufacturers' ability to protect their brands. When it is too costly for manufacturers to establish and protect their brands. It may be optimal to let distributors own and promote private brands.

After examining the limitations of both excess capacity and price discrimination argument, we present an economic analysis of private branding In a simple model of a retail market where the rote of dealers In Informing consumers of the product Is essential for sales and price Information is costly. It Is demonstrated that the unconstrained equilibrium In the free-entry retail market Is suboptlmal from the manufacturer's viewpoint due to two kinds of

See R. H. Bork (1978), PP. 280-91, for a critic a l discussion of legal rules concerning vertical restraints. 6

externalities, and that private branding together with either minimum

volume requirements or franchise fees can profitably be adopted to

neutralize such externalities. In this retail setting, private

branding emerges as an element of the e ffic ie n t manufacturer-reta I Ier

contract, motivated by the manufacturer's desire to have Information on Its product passed along efficien tly to consumers. Our analysis

suggests that under certain conditions, resale price maintenance and private branding are substitutes.

5 Japan's huge general trading companies (sogo shosha), often credited with playing a key role In promoting Japan’s external trade, seem to possess several peculiar characteristics and thus have frequently been a topic of study by many commentators (mostly business economists). Thus far, however, writers on general trading firms do not seem to have been overly successful in explaining the nature of these commercial Institutions as well as the pattern of their transactions. The majority of them have focused on the description of their historical evolution or diverse business operations.

From the viewpoint of Industrial organization, the Japanese sogo shosha offer a unique opportunity to analyze various Issues concerning the organization of trading activities as they Illustrate an interesting example of division of labor In foreign trade between manufacturing firms and marketing Intermediaries. In chapter three.

The term "general trading company" Is the literal translation of the Japanese words "sogo shosha." The nine largest trading companies In Japan are commonly referred to as the sogo shosha. Note that In Japanese sogo shosha Is both a singular and plural noun. 7 we characterize the Issue of general trading companies as the problem of choosing between two alternative means of organizing exchange

(Internal organization and agency delegation), and propose a transaction cost analysis of their trading activities.

In our analysis, Japanese general trading companies are seen to offer a contracting alternative that links manufacturing firms to foreign markets at low cost by capturing specialization economies.

Since Investments In Information are ex post fixed and market information frequently has value for a multiplicity of manufacturers, substantial scale/scope economies can be realized In the collection and use of market Information If a group of manufacturing firms delegate their marketing or purchasing functions to a common agent.

This arrangement of common agency delegation can Increase efficiency, for It enables manufacturing firms to expand Into new markets without duplicating efforts to collect and process market Information.

But Incomplete contracts Imply that such delegation arrangements are subject to considerable strain. In particular, the trading company makes sizeable up-front Investments In acquiring market

Information and obtaining distribution, expecting to recover Its sunk costs through the continued handling of clien ts' transactions.

However, the manufacturer may opportunistically attempt to divert its business to other channels for short term advantages, which would make

It d iffic u lt for the trading company to recoup Its fixed Investments.

On the other hand, once the trading company obtains private

Information on foreign market conditions, It may have an incentive to 8

distort or conceal the Information as an attempt to extract harsh

terms In dealing with the manufacturer. Given such conflicts of

interest and the potential for ex post opportunism, autonomous

b ilateral governance structures need to be devised to secure efficien t

exchange relations by facilitating the transfer of Information and

reducing opportunism.

If the fixed investments Involved are not relation-specific, the

Incentive deficiencies associated with specialized assets will be

minimal. With imperfect, costly monitoring, the hazards of Incomplete

contracting then reduce to the classic agency problem. It Is shown

that the ex post compensation of the trading agent on the basis of

actual transactions In conjunction with the threat of terminating

trading relationships will provide an effective safeguard against

opportunism in the collection and exchange of Information. But when

underlying transactions require Investments In assets Idiosyncratic to

the exchange, the threat of opportunistic behavior w ill be a potent

one. In many cases of complex consumer products, for Instance,

e ffic ie n t marketing requires specialized Investments in building

brands and providing product Information to consumers. However, once

the manufacturer's brand name gets established and the product turns out to be a success, the manufacturer may be tempted to broaden Its distribution or to bypass the trading company. This ex post opportunistic behavior against the pioneering distributor would erode

returns to the trading company on successful products, denying the

trading company the opportunity to recover Its fixed costs. In such 9 cases the ownership of brand names by the trading company may arise as a contractual response to attenuate this potential appropriation probIem, Unfor tunate I y , however, t he scope of Its application w ill be severely restricted because of d iffic u ltie s of engaging the Interests of the manufacturer. Not only does the manufacturer experience suboptimal incentives to produce high quality, but it w ill be reluctant to Invest In specialized production assets.

When the market offers some scale/scope economies but the use of external agents can be very costly, decisions concerning the choice of trading channels Involve a trade-off between the specialization economies of the market and the coordinating properties of Internal organization. By comparing the costs and benefits of the delegation contract relative to the alternative of Internal governance, we attempt to delineate situations that will lead to agency delegation In a discriminating fashion. We proceed first by providing a brief description of a wide scope of business a c tiv itie s that general trading firms are undertaking. This allows us to obtain a few salient characteristics and tendencies with respect to their diverse trading operations. We then discuss the transaction cost theory of economic organization as the theoretical basis for assessing alternative trade channels. Contractual difficulties of agency delegation as well as the efficacy of various contractual safeguards for a potentially long term trading relationship are examined to develop circumstances where

Japanese manufacturers would prefer to rely on trading firms. Our results reveal that contractual d iffic u ltie s with the use of outside 10

trading agents account for the trading structure of Japanese general

t rad Ing fIrm s.

While the Issue of central Interest In this dissertation Is the

division of labor for distribution between manufacturing firms and

marketing specialists, it should be noted that problems analyzed In

our two Illustrations are rather different. In private branding, the

major concern is the problem of Informational externalities that arise

In conjunction with a branded good. If distributor's actions give

rise to Interaction effects, failure to ensure that benefits of

Informational services will be fully appropriated by the originator

will result In suboptimization. One way of defining property rights

to such information may be private brand sales. In Japanese trading

firms, problems arise because of the contractual Incompleteness along

with asymmetric access to Information. The governance cost problems

associated with specialized assets have profound Implications for the

organization of trading activities. In particular, the integrated

mode of distribution can be ascribed to the hazards of Incomplete

contracting posed by the existence of a heretofore disregarded

specialized asset-brand name capital. But both results Illustrate ore

general point that the distribution system Is more than a simple

conduit for physical distribution of commodities. The approach that emphasizes the informational role of the distribution system enables us to obtain a better understanding of how distribution Is organized

In a different manner In different circumstances. CHAPTER I 1

PRIVATE BRAND IMG AS A SUBSTITUTE FOR VERTICAL RESTRAINTS

Since the private brand Issue began to draw attention of

marketing experts In the 1930's, several explanations for the use of

private brands have been advanced. A widely accepted explanation for

the occurrence of private branding is based on the possibility that

the practice may provide a manufacturer with an extra sales outlet for

Its output In the presence of excess capacity. It has been maintained

that as manufacturers of national brands encounter the problem of

excess capacity because of unanticipated drops In demand during

Intermediate-term periods, they may find a mixed brand strategy

attractive as a stop-gap measure to level out fluctuations In demand

by selling additional units through private brand distributors.1

Another, more general explanation of private branding Is that the practice serves as a vehicle for price discrimination by a monopolistic manufacturer. An efficient way of effectuating price discrimination may be to offer an essentially Identical product under a variety of brand names with different appeal to consumers. This

See, for example, E. B. Weiss (December 1950), P. Vautln (March 1963), and W. AppJebaum and R. A. Goldberg (1976).

- 1 1 - 12 argument has been Illustrated In a number of antitrust suits including 2 the Borden private label case.

This chapter proposes the free-rider explanation of private branding which rests on the “exclusivity" feature of private brand names. Because private brands are for the most part distributed exclusively by brand-owning distributors, they can selectively be

Introduced as a device to cope with free-rider problems through an effective segmentation of the retail market by type of distributors.

Since either resale price maintenance (RPU) or retail territorial assignment Is also available to manufacturers as an Instrument to fight against Informational free-rldlng among dealers, private branding can be viewed as a substitute for such vertical restraints.

Our free-rider argument for private branding Implies that the breakdown of price maintenance w ill stimulate private brand sales. In some cases, the failure to maintain adequate re ta il prices may cause upscale distributors (e.g .. specialty and department stores) to move

3 to their own labels In search of higher margins. In other cases, well-established national brand manufacturers may choose to provide large discount stores with unadvert Ised store brands.

FTC V. Borden Co. 383 U.S. 637 (1966), reconsidered, 391 F, 2d 175 (1967). 3 As a matter of fact, reasons given by retailers for selling private labels revolve around protection of retail margins against price competition from discount outlets. Other frequently mentioned motives for developing private brands Include diversification of supply sources, promotion of dealer goodwill, lower purchase costs, and control of product quality. See the U.S. FTC (1933), pp. 2-17, P. Vautln (1962), p. 130, and J. G. Daklns (1963), p. 6. 13

The following section outlines the locus of private branding In

the U.S. This Is followed by a discussion of Inadequacies of both

excess capacity and price dIscrIminatIon argument. Section 3 presents

an economic analysis of private branding. Building upon the work of

Mathewson and Winter (1984). a simple model Illustrates how the

arrangement of selling private brands can be an alternative

contractual solution to the same problem that the manufacturer may

wish to resolve by means of vertical restraints on distribution.

Section 4 characterizes circumstances under which manufacturers would

prefer to adopt private branding. This section also examines a

particular use of private branding, that In the cigar trade, which

appears to be compatible with the free-riding argument for private

branding advanced here.

1. The Locus of Private Branding

The most significant change since the turn of the century In most

consumer goods trades has been the development of mass distribution

channels for manufacturers' branded products. The growth In

importance of manufacturers* national brands may be attributable to

such factors as the concentration of manufacturing facilities, the

vertical Integration of manufacturers Into marketing, and the

development of advertising. Especially withthe advent of mass markets opened up by the transportation and communication revolution,

large-scale manufacturers evolved and began to exploit economies of mass distribution by taking over the functions of coordinating the 14

4 commodity flows as well as branding and advertising. Its major

consequence has been the shift from distributors to manufacturers of

responsibility for the quality of the goods, plus the goodwill

attached to the goods as well as any bargaining power Invested In such

goodwill. However, distributive trades do not seem to have been

dominated completely by manufacturers' advertised brands. In many

consumer goods Industries, distributors' private brands have been

quite successful In obtaining significant market share. The

importance of the re ta ile r's own brand varies from one trade to

another. Practically all major distributors In the U.S. engage In

private branding Insome lines, while In others only a few § distributors offer their own brands. Those distributors who own

private brands also d iffe r greatly In size, ranging from the largest

chain operations to much smaller unafflllated outlets.

According to the Federal Trade Commission's 1933 report on chain g store private brands,early Instances of the use of private

Chandler pointed out that the newly established Integrated enterprises were clustered In Industries where technology lends Itself to mass production and where volume distribution benefits from specialized scheduling or services. For a discussion of the formation and growth of the modern Integrated enterprise, see A. D. Chandler, Jr. (1977), particularly, part four. 5 For Instance, few corporate food chains fall to offer private brand food Items among their assortments. See W. Applebaum and R. A. Go Idberg (1967). ft This report, which was prepared In conjunction with a congress Iona I chain storeInvestigation, Is the firs t and s t i l l the most comprehensive study of manufacturers' and distributors' brands. The chain stores In the FTC Inquiry refer to "organizations owning a (Footnote continues on next page) 15

branding tended to be clustered among such product categories as

confectionery, tobacco, hats and caps, women's accessories, grocery,

drug, apparel, shoes, and musical Instruments (see Table 1). Based on

the ratio of private brand to total sales by 276 brand-owning chains,

private brands were apparently most Important In women's accessories,

shoes, confectionery, dry goods and apparel, hats and caps, men's

furnishings, and musical Instruments (see Table 2). In these lines of

business, more than half of total sales were made under private

labels.7 Table 3 shows that coffee was the most frequently reported

food product sold under private labels. Other leading private brand

I terns In grocery Included flour, butter, tea, canned fru its and

vegetables, mayonnaise, and canned milk. Cough sirups, corn remedies,

cold tablets, and tooth pastes appear to be major private brand Items

In drug. In tobacco, cigars were most extensively sold under private

* labels. Moreover, nearly 40 percent of cigar sales for private

branders were made In private brands. In comparaslon with food and

drug and cigar products, private labels accounted for much larger proportions of sales for apparel, household, and miscellaneous lines.

In shoes, for example, more than 80 percent of the 25 chains' combined

(Footnote continued from previous page) controlling Interest In two or more establishments which sell substantially similar merchandise at retail," but some specialized chains such as gasoline stations and automobile accessories are excluded from the study.

7 J. C. Penney, which made about 90 percent of Its sales in private brands, was responsible for most of the private brand sales of the dry goods and apparel group. 16

Table 1: Distribution of ChaIns Own Ing Pr 1 vate Brands by Kind of Chain, 1931

K 1 nd of chaIn Total chains Number owning Percent owning reDor tIng Dr l vate brands private brands Confectlonery 29 20 69.0 Tobacco 35 20 57.1 Hats and caps 17 8 47.1 Women's accessories 15 7 46.7 Department store 20 9 45.0 Grocer y 98 43 43.9 Drug 174 75 43.1 Musical Instruments 1 4 6 42.9 Men's shoes 1 2 5 42 .7 Grocery and meat 135 55 40.7 Women's shoes 28 11 39.3 Men's and women's shoes 11 2 27 24.1 Men's ready-to-wear 66 15 22.7 Varlety ($1 IImlt ) 69 13 18.8 Dry goods 15 2 13.3 Dry goods and apparel 77 10 13.0 Hardware 25 3 12.0 Men's and women's ready- to-wear 50 5 10.0 Men's furnishings 21 2 9.5 Furniture 23 2 8.7 MI I I Iner y 24 2 8.3 Meat 52 4 7.7 Varlety ($5 I Imlt) 14 1 7.1 General merchandise 30 2 6.7 Women's ready-to-wear 87 4 4.6 Var lety (uniImfted) 5 0 0 Tota I 1 .247 351 28.1 Source: The U.S. Federal Trade Commission (1933), Chain Stores: Chaln- Store Private Brands, p. 21. 17

Table 2: Proportions of Private Brand to Total Sales for 276 Brand Own Ing ChaIns, 1930

KI nd of chaIn Pr I vate brand sales Women's accessories 98.3 Hen's shoes 93.4 Confectlonery 91.5 Men's and women's shoes 89.5 Women's shoes 86.7 Dry goods and apparel 81 .5 Hats and caps 76.5 Men's furnishings 74.9 Men's ready-to-wear 51 .4 Musical Instruments 51 .4 Department store 27.5 FurnIture 19.3 Grocery and meat 19.0 Men's and women's ready- to-wear 17.9 Women's ready-to-wear 17.5 Drug 17.3 Grocery 1 0 . 1 Dry goods 8.9 Tobacco 5.6 Var lety ($1 lim it) 3.7 General merchandise 3.4 Var lety ($5 lim it) 3.0 Meat 2 .0 M IN I ner y 1 .0 Hardware 1 .0 Varletv (un IImlted) _ Total 24.3 Source: The U.S. Federal Trade Commission (1933), Chain Stores: Chaln- Store Private Brands, p . 32. 18

Table 3: Average of Proportions of Private Brand Sales for Various Commodities by Specified Numbers of Chains, 1928

(a) Food products

Product I Ine ______Number of chains ______Private brand sales Cof fee 20 39.5 Candy 19 82.3 F lour 11 38.2 But ter 10 64.5 Tea 9 44.2 Canned fruits 8 45.6 Mayonna f se 8 48.5 Bread 7 93.6 Canned goods 7 32.4 Canned vegetables 6 61 .1 Canned fIsh 3 26.3 Ammon 1 a 2 51 .0 CereaIs 2 7.0 Canned ml Ik 2 16.7 Cheese 2 28.7 CondIments 2 54.0 Jellies and preserves 2 77.5 mi Ik 2 48.5 ESSS______2______18.3

(b) Apparel, household, and miscellaneous products

Product line Number of chains PrIvate brand sales Shoes 25 80.8 Hosiery 15 70.9 Hats 6 89.2 Clothing 4 70.0 Men *s c loth Ing 4 83.7 Hardware 3 45.2 Men's and boy's clothing 3 64.0 Not Ions 3 19.4 Pianos 3 70.0 Boy's clothIng 2 70.0 Caps 2 90.0 Dry goods 2 2 0 .0 Overa Ms 2 95.0 Radios and supplies 2 70.0 ShIrts 2 97.5 Ties 2 97.5 19

Table 3 (continued)

Product I Ine Number of chains Private brand sales Cigars 5 39.6 To I let goods 5 3.6 Drugs 3 15.0 Tobacco 3 35.3 Co Id tablets 2 25.0 Cough remedy 2 26.7 Patent medicine 2 4.0 Remed fes 2 14.0 To I let goods and druos 2 17,5 _ Source: The U.S. Federal Trade Commission (1933), Chain Stores: Chaln- Store Pr I vate Brands. pp. 55-57.

Table 4: Estimates of Market Share of Private Brands, 1964

No. of product DlstrIbutors' I I nes brand Packaged foods 21 13.8 Household supplies 3 1 0 .1 To I Iet rIes 9 29. i Proprletary drugs and other health aids 12 20.7 GasoI Ine ^ 13.9 Footware (Non-rubber) 51 .0 Replacement tires 35.6 Ma lor aDDI Iances 33.0 * Based on the unit output of the 70 I argest shoe manufacturers. Source: Compiled from V. J. Cook and T. F. Schutte (1967), Brand Policy Determination . pp. 3, 179-82.

Table 5: Estimates of Market Share of Private Brands, 1986

. --- Product category ______12-week dol lar share Beauty and health aids 3.6 Dry grocery: Non-food 8.3 Frozen & refrigerated food 21 .4 Dry grocery: Food 1 0 .8 * Twelve-week period ending January 2, 1987. Source: Compiled from Private Label 9 (May-June 1987), pp. 100-108. 20 sales were made tn private labels. The ratio of pr ivate brand to

total sales was also substantial In hosiery and hats. More recent

information on the Importance of private brands In several product groups Is contained In Table 4 and 5. It Is shown that there exist

large differences In the market share of private brand sales among product lines. In 1964, the private brand share In packaged foods was an average of 13.8 percent, whereas more than half of footware sales was accounted for by private labels. Private brand sales also took a significant market share In to ile trie s , replacement tires, appliances, and proprietary drugs and other health aids.

Private brand merchandise has been strongly advocated especially by large-scale retail establishments. The FTC Investigation discloses that on average pr I vate-brand chains operated more than ten times as many stores as the non-prIvate-brand chains In 1931. But private brand sales are by no means confined to big chain organizations.

Independent department and specialty stores have also been vigorously developing private brands In many product lines. A 1962 survey of 127 traditional department or department I zed specialty stores reveals that

76 percent of the reporting stores carried private brand merchandise g In one or more of their fashion departments. Important private brand items included hosiery, lingerie, blouses and sportswear, shoes, cosmetics, and coats and suits. While most private branders carry both manufacturers' and their own brands, some re ta ile rs, notably

See B. Jude lie (1962). 21

specialty chains, handle private brands exclusively. It Is also not uncommon that both national and private labels from the same manufacturer are sold slde-by-slde by distributors.

To a considerable extent, private brand goods In the U.S. have been supplied by well-known national brand manufacturers. Leading manufacturers of tire s, automobile accessories, appliances, apparel,

liquor, and grocery items, that are usually big national advertisers of their own brands, often compete for the large-volume order of private brand distributors. The study by Cook and Schutte (1967) about brand policy determination of 112 manufacturers Indicates that an Increasing number of leading manufacturers turned to a mixed brand g policy. Although no comprehensive data on the source of private brands are available. Industry observers appear to have a casual empirical Judgement that dual brand manufacturers have comprised the principal source of private brand products, exceeding pure private brand manufacturers both In terms of the number of manufacturers

Involved and In the proportion of private brand production.^

See a I so £ . 8. Weiss (December 1950; November 1964), P. Vautln (March 1963), and W. Applebaum and R. A. Goldberg (1967).

Dual brand manufacturers-companles like Goodyear, General Electric, Mobil, Union Carbide, and Nest Ie-seIdem Identify private brands as theirs. Dealers also agree not to trade on the supplier brand name by making reference to the supplier. See T. J. Gage (1982). This sensitivity to private brand Information explains, In part, why only fragmentary data on private brands exist. 22

2. Traditional Explanations of Private Branding

This section presents a brief overview of two leading

explanations for private branding to point out theoretical

difficulties as well as empirical limitations of these arguments.11

2 .1 Excess Capacity

Some marketing scholars maintain that the existence of excess

industry capacity Is responsible for and stimulates private brand

production. According to this argument, manufacturers of national

brands sometimes build large production fa c ilitie s for some product

line. As they experience an unanticipated decline In demand and

subsequently suffer from the Increasing Idle production capacity, they

look for ways to Increase the degree of capacity u tiliz a tio n through

sales of additional units. One way of accomplishing tills, so It Is

held, is private brand sales under a mixed brand policy. This

argument predicts a significant positive relationship of the extent of

private branding to the level of excess capacity In an Industry.

The excess capacity argument suggests that private brand sales

will be significant particularly In Industries with large sunk capital

and high shutdown-startup costs, like the petroleum Industry. Thus,

the practice by major refiners of frequently diverting some portion of

Other explanations have also been offered for private branding, such as that one Important factor which has fostered the growth of private labeling In the "battle of the brands" Is the enhanced bargaining power of large retailers. See, for example, E. B. Weiss (November 1964), and V. J. Cook and T. F. Schutte (1967). That small re ta ile rs also carry private label merchandise contradicts this view. 23

output to independents for distribution under private labels has often

been ascribed to the problem of excess capacity In that Industry.

Refiners in the presence of excess capacity are alleged to sell excess

output through independents under private labels as an attempt to

12 avoid Incurring high shutdown-startup costs. Also, In the food manufacturIng/processing, excess capacity may arise because both

quantity and quality of food products are affected by factors beyond

the control of the producer. Manufacturers may be contractually obliged to purchase a sizeable quantity of crop whose quality level

falls below their own brands' quality standards. Faced with this problem, manufacturers may attempt to dispose of this lower quality output through private brand sales. Hence It Is stated:

"In the case of bread, margarine, and frozen orange juice concentrate, excess capacity developed for the processing of the raw products. This resulted In excess supplies of wheat flour, soybean o il, and orange Juice concentrate. In addition, many manufacturers of the processed products were anxious to make use of Idle plant capacity and therefore offered private label products to food chains on a contr(butlon-to-fIxed-Investment-cost basIs."

The attractiveness of private brand sales as an additional outlet seems to stem from the manufacturer's expectation that consumers will not recognize products of the same manufacturer under both national and private brands. Marketing private brands under a mixed brand

See V. J. Cook and T. F. Schutte (1967), pp. 73-74.

W. Applebaum and R. A. Goldberg (1976), p. 78. 24

strategy is thus perceived as an appropriate means of generating

additional sales, while at the same time minimizing potential adverse

effects on market prices of the manufacturer's brands. Presumably, a

manufacturer would not have to cut selling prices of Its own brands If

it could sell additional outputs through private brand distributors at

a sufficiently low price to attract additional customers.

A number of theoretical considerations, however, lead us to

believe that this excess capacity argument as It stands Is very unsatisfactory. First of a ll, the theory gives no substantial economic Justification for the supposed reluctance of manufacturers to cut prices of their own brands. Although It may be true that private brand sales serve to expand output without Imposing any significant negative effects on the prices of manufacturers' own brands, we s t ill need to know why marketing private labels would be more advantageous to manufacturers than simply lowering prices of manufacturers' own brands.14

Secondly, production of private brands often requires specialized capital Investments to be made well before actual production. For example, a manufacturer of national brand appliances that considers producing private labels w ill be reasonably concerned about consumers recognizing sim ilarities between the two brands. In order to secure benefits. If any, of marketing private brands, goods under each type

The resulting price structure under a mixed brand policy would appear to be quite similar to that of price discrimination. But note that a different motivation other than price discrimination Is emphasized in the excess capacity argument. 25

of brand must be differentiated m aterially or at least In appearance.

Substantial costs would have to be Incurred In tooling up for the

specification production of private brands as well as In maintaining

larger inventory. These costs associated with producing and selling

private labe is will severely restrain manufacturer s' ability to enter

Into or discontinue private brand production on an In-and-out basis In

response to changing demand conditions. In such instances where

private label production entails significant brand-specific capital

commitments, manufacturers will bo less likely to engage In private

1 5 brand business solely on the basis of short-term considerations.

Finally and most importantly, the theory falls to provide any

answer to what w ill happen to private brand sales when excess capacity

disappears. A logical extension of the argument would be that as

Industry capacity u tiliz a tio n returns to normal, sources of private

brand supply dwindle In number and private brand sales diminish. But

this expectation Is simply Inconsistent with the actual experience of

private brand production. in many Industries In which we observe

considerable private brand sales, there usually exist several

indeed, most observed Instances of private brand production In the appliances Industry Involve the use of the "known cost" contract, where the supplier is required to provide detailed Information on Its cost structure and the transfer price Is determined ex post according to actual costs Incurred for the private brand account. It Is also Interesting to note that this long-term contract often contains provisions of minimum volume requirements and customer ownership of specialized equipment used In the private brand production. See Cook and Schutte (1967), pp. 84-92. 26

producers whose major business Is to supply goods to private brand

d I s t rIbutor s .

Nevertheless, the theoretical considerations outlined above seem

to suggest certain product characteristics that may be conducive to

the adoption of private branding In response to the development of

temporary excess capacity. As long as private brand sales are useful

as a convenient measure to create additional outlets to take up excess

capacity, we anticipate that Industries which have substantial fixed

capital Investments, high inventory costs, and high shutdown-startup

costs w ill display large market share of private brand sales.

Moreover, because of ease of entry Into and withdrawal from private brand production, manufacturers of fa ir ly homogeneous, nondurable goods are more likely to turn to private brand sales. Among product

lines Included In the study of Cook and Schutte (1967), gasoline and

replacement tires seem to possess the characteristics favorable to private brand production. Thus, we expect to find a positive

association between private branding and excess capacity in each of

these two Industries over a period of time. But Cook and Schutte

failed to find such a systematic pattern of relationship. Their simple comparison or estimates of excess capacity and private branding across 26 product lines also showed no significant association between

the two variables. This finding was Independent of the Inclusion of the lagged effect of excess c a p ^ lty .

In short, our theoretical considerations as well as available empirical findings do not seem to suggest that excess Industry 27

capacity Is responsible for many Instances of private branding.

However, the aforementioned empirical Investigations are far from sufficient to make any decisive Judgement on the v alid ity of the hypothesis since they are seriously flawed and very limited In scope.

Indeed, any attempt to examine the relationship between excess capacity and private branding simply by looking at their correlation on an overall basis w ill be misleading because It Ignores other potentially Important product and market characteristics that

1 6 Influence private brand production.

2.2 Price Discrimination

It Is well known that a manufacturer with some monopoly power will have a profit Incentive to engage In price discrimination among

Its consumers. Successful price discrimination requires that the monopolistic manufacturer be able to Identify and separate different segments of the market by preventing arbitrage at low costs. One way of effectuating price discrimination may be to offer the same product

Marvel (1976), In an empirical study of retail gasoline price behavior, provided Interesting results Indicating that the hlgh-prlce segment of the retail gasoline market Is effectively separated from the Influences affecting prices In the low-price segment. He found that prices tend to be more variable at low-price stations than at hlgh-prlce stations, which he traced to the differing amount of price Information that the customers of these two segments choose to acquire. To the extent that low-price stations attract relatively well-informed consumers and face more elastic demand, they are better able to move unanticipated stocks of excess gasoline supplied by major-brand refiners at bargain prices. Their participation In the spot market In response to changing local market conditions adds an additional source of v a ria b ility to low prices. 28

under both manufacturers' and distributors' brands. Confronted with

the choice between two brands which are priced d iffe re n tia lly ,

consumers w ill be Induced to separate themselves according to their

valuation of two types of brand names and pay different prices for the otherwise Identical product.17

The Borden private label case centered on the practice of a manufacturer selling Its product under Its nationally advertised brand at a different price than It charged when the product was sold under a

1 s private label. Borden produced and sold evaporated ml Ik under both the Borden name and various private brands owned by Its customers.

The milk was proven to be physically and chemically Identical, but private labels were regularly sold at lower prices than the Borden brand milk at both wholesale and retail levels. The Federal Trade

Commission, arguing that labels do not differentiate products In terms of grade and quality, charged that the price d ifferential was discriminatory within the meaning of ^2(a) of the Rob I nson-Patman Act.

The Commission further alleged the requisite adverse effect on competition. Borden submitted Its accounting data to demonstrate that some of the price difference reflected savings In selling and handling costs of private labels, but the Commission rejected Borden's claim of cost ju s tific a tio n and Issued a cease-and-desist order In 1962. Two

This explanation can be thought of as a more sophisticated variant of the excess capacity argument.

18 FTC v. Borden Co., 383 U.S. 637 (1966). The firs t Important FTC case which Involved the Issue of the economic value of brand names Is Goodyear Tire & Rubber Co., 22 FTC 232 (1936). 29

years later, the Appeals Court set aside the Commission's order, holding th *; Important brand differences based on consumer preference alone should exempt private brand selling from £2(a). But the

Judgement of the Court of Appeals was reversed In 1966 by the Supreme

Court which ruled that:

"Such transactions are too laden with potential discrimination and adverse competitive effect to be excluded from the reach of $2(a) by permitting a difference In grade to be establishing by the label alone or by the label and Its consumer appeal."

Although the main legal issue In the Borden case was the proper construction of £ 2(a) of the Robinson-Patman Act, I.e ., whether difference In brand names and market acceptability should be considered In the Jurisdictional Inquiry under the statutory 'like grade and quality' test, the case clearly Illustrates an example of the use of private branding as a device for discriminating In price.

However, given the wide range of circumstances In which private labeling occurs and since manufacturers have a more convenient alternative of accomplishing the same end by offering several differentiated products bearing different brand names controlled by themselves, It seems unreasonable to claim that the price

FTC v. Borden Co., 383 U.S. 637, 643-44 (1966). On remand, however, the case was decided for Borden by an appellate court which oplnloned that "where a price differen tial between a premium and nonpremium brand reflects no more than a consumer preference for the premium brand, the price difference creates no competitive advantage to the recipient of the cheaper private brand product on which Injury could be predicated." Bordon Co. v. FTC, 381 F.2d 181 (1967). 30

discrimination argument Is the only explanation. We believe that the

majority of Instances of private branding Involve more than the simple

price discrimination Incentive of the monopolistic manufacturer.

3. Free Riding and Private Branding

This section presents an economic analysis of the Incentives for

the use of private branding In distribution. Before proceeding to a

formal model of private branding, It will be useful to set out a brief

review of various efficiency arguments for vertical restrictions on

d i s t rI but I on.

3.1 Vertical Restraints: Efficiency Rationale

Contrary to the simple, price-mediated exchange of the spot

market usually portrayed In the traditional economic theory, there

often exist complicated contractual limitations placed on

distributors' pricing, output, and location decisions. However, economists traditionally have paid little attention to this area,

regarding distributors as lit t le more than simple warehouslng- collectlon fa c ilitie s for manufacturers. When the role of distributors Is viewed as narrowly confined to the basic warehousing

function, a number of sophisticated contractual relations between manufacturers and distributors cannot be properly understood. For

Instance, one of the puzzling questions to economists for a long time has been the apparent concern of certain manufacturers with the price at which their products are resold to final consumers. Since a 31

manufacturer who prescribes a minimum resale price for Its product Is

in effect setting limits on sales, some manufacturers' willingness to

impose and enforce RPM agreements seems not to be in their best

Interest. Ordinarily, a manufacturer appears to benefit most when Its

distribution system Is so competItIveIy organized as to deliver its

product to consumers at the lowest price. What, then, can explain

certain manufacturers' strong preference for controlling price and

other dimensions of competition among retailers?

Stimulated by Telser's (1960) seminal paperon RPM, economists

began looking for efficiency explanations for various contractual 20 constraints placed on distributors. Some have extended Telser's

special services argument for RPM, while others have applied It to

other variants of vertical restraints. In what follows, we briefly

examine these efficiency explanations. This will permit us to

highlight how vertical arrangements between manufacturers and

distributors become necessary as an efficiency-enhancing device,

rendering the distribution system more e ffic ie n t than It would otherwise be.

Many vertical restraints have long been regarded as anticompetitive. For example, It has been argued that colluding manufacturers may adopt RPM as part of their overall scheme to obtain monopoly rents. Another explanation of the use of RPM Is the so- called dealer cartel theory where colluding distributors force the unwilling manufacturer to Impose and enforce RPM on their behalf as an attempt to raise re ta il margins. The extensive applications of RPM In drug trade have been attributed to the pressure on manufacturers put by the National Association of Retail Druggists. For a detailed description of sustained efforts by the druggists to acquire margin protection through RPM, see Palamountaln (1955), pp. 90-106. 32

Buyers often cannot costlessly learn of the quality and

characteristics of prospective purchases. When consumers choose among

competing brands on the basis of signals and Incomplete Information,

they may rely on their distributors for auxiliary Information.

Presumably, because distributors are In direct contact with consumers,

they are often In a better position than manufacturers to Inform

consumers of the product. In such markets, many Important variables

that may influence consumers' perception of product quality and

therefore the demand for the product are within the re ta ile r's

control. To a considerable extent, the manufacturer's expected profit

will depend on decisions taken by distributors as to the provision of product Information and services, and their cooperation In this regard will be IndIspenslble for establishing and maintaining the manufacturer's brand name and thus upgrading quality reputation among potential consumers.

Unfortunately, however, the level of Informational services the profit-maxImlzIng retailer chooses to offer often diverges from that

the manufacturer would wish to obtain. This lack of coordination arises when retailers' activities create rents that are not fully appropriated by those retailers incurring costs due to various forms of free-riding In the re ta il market. In other words, the transmission of nformation to prospective consumers cannot occur e ffic ie n tly unless property rights to such information are created, permitting those who bear the costs of Information provision to benefit from their efforts. Otherwise, the rational retailer would underprovlde 33

services that are essential to the efflcent distribution of the

product. The manufacturer can respond to this potential market

failure by adopting various vertical restraints. Vertical restraints,

by helping to establish such property rights, serve to facilitate the

provision of information by dealers and thereby render distribution

system more e ffic ie n t.

The classical case of the free-rider problem Is the provision of i presale services to prospective consumers a la Telser. The presale

demonstration of a product and the tailoring of Information to a

customer's needs are only two examples of special dealer services that

w ill shift out the demand schedule. A re ta ile r who elects to offer

such special services w ill ask for a higher price than does a no-

servlce outlet If It Is to recover Its higher costs. A customer,

however, may have an Incentive to avoid paying higher prices by patronizing the nearest no-frllls, low-price outlet once he obtains

21 Information from the service-providing retailer. As a result, retailers cannot profitably provide services which the manufacturer believes to be necessary to promote its product effe c tive ly. As suggested by Telser, one method of averting this free-rider problem Is for the manufacturer to Impose vertical pr'ce restraints on Its distributors. By foreclosing discount stores, RPM serves to prevent

Note that the shift In business among competing re ta ile rs is due to the peculiar nature of the services Involved. As Telser notes, these retailer services subject to free-riding must be product- specific. Moreover, they are separable from products while they cannot be sold separately. 34

Informational free-rldlng and support re ta il margins to enhance

retailers' Incentive to provide product information.

The example of tangible presale services, however, may understate

the generality of this problem. As Marvel and McCafferty (1984) point

out. If consumers perceive some retailers as having superior a b ilitie s

to evaluate the quality or stylishness of products, these reputable

distributors are able to signal product quality to consumers simply by

carrying only those selected items whose quality levels seem to be 22 consistent with their overall reputation. But If the product Is

branded, and If branding ensures consistent quality of the product

across dealers, this slgnallhg activity of high quality re ta ile rs Is

also vulnerable to erosion through free-rldlng. Without re ta il margin

protection via RPM, manufacturers are not likely to obtain quality

cer11f IcatIon of their products from reputable dealers who can

contribute to upgrading consumers' perceived quality of the product.

When the quality of a product Is Jointly produced by the

manufacturer and Individual retailers, final demand will be Influenced

by the quality reputatIon of both the manufacturer and retailers.

However, If consumers cannot Identify the exact source of lower

quality than anticipated, there may exist Incentive disparity between

the manufacturer and Its dealers. That Is, due to the possib ility of

For the reta ile r reputation to be a credible signal of quality, It must be more profitable for reputable retailers to carry high quality products than low quality products. For the analysis of signaling equilibrium, see, for example, M. A. Spence(1973), and R. E. Klhlstrom and M. H. Rlordan (1984). 35

free-rldlng on the manufacturer’s reputation, retailers' Incentive to

produce high quality would be less than optimal from the manufacturer's viewpoint. By supporting high retail margin through

RPM, the manufacturer may be able to Increase retailers' Incentive for 23 high quality retail services.

The Telser argument for RPM has been extended to non-price 24 restraints as well. Where retailers' Incentive for product promotion Is Inadequate for the Joint profit maximization, the

assignment of retail te rrito ria l monopoly power may Improve retailers'

incentive by protecting high retail margin against Intrabrand competition. Thus, exclusive territories are seen as being equivalent

In effect to RPM. However, since exclusive territories eliminate

Intrabrand competition altogether, It Is believed that this practice will necessarily be accompanied by ancillary restraints such as franchise fees or sales quotas.

In addition to disseminating product Information to consumers, distributors also can provide manufacturers with market Information.

The role of distributors In obtaining Information about consumer

Arguments similar to this formed part of the defense In the Schwinn case. U.S. v. Arnold, Schwinn & Co., 388 U.S. 365 (1967).

24 fi. H. Bork (1966) and R. A. Posner (1977) argued that vertical te rrito ria l restrictions serve the same purpose as the RPM. 25 Blair and Kaserman (1985) suggest that the manufacturer can Impose either maximum re ta il prices or output quotas on Its dealers to counteract the successive monopoly problem posed by exclusive te rrito rie s . In a recent paper, Marvel and Reagan (1986) have analyzed the manufacturer's problem of controlling dealer monopolies under asymmetric Information about local demand conditions. 36

tastes and local demand conditions will be particularly Important when

the manufacturer attempts to Introduce a line of differentiated

products with uncertain prospects. To find out the relative market

acceptability of each of the variants, the manufacturer must firs t

make sure that the product line Is displayed In Its entirety by

ensuring an ex ante competitive return on the whole line. Since full-

line retailers Incur costs on failed products, the requirement of an

ex ante competitive return Implies that losses from unsuccessful

variants must be recouped through ex post supracompet 11 I ve returns on

popular Items. However, this compensation scheme w ill be defeated by

opportunistic retailers who carry only successful products once such

information Is revealed. Accordingly, the provision of market

Information w ill be Jeopardized as pioneering distributors who have

provided exposure for the entire line cannot capture any rents on

successes. Vertical restraints such as RPM or fu ll-lin e forcing can

be adopted by manufacturers to compensate fu ll-lin e distributors for

their market research either by simply precluding the delaying tactics of retailers or by preventing price competition.

The failure of Joint maximization in various retail environments mentioned above stems from the In ab ility of those retailers who provide services to cover their higher costs on the market. The provision of special services and information often requires

For example, manufacturers of such products as books, toys, and records usually make available a number of variants of their products simultaneously on the market. significant fixed Investments by retailers. For example, costs of providing fa c ilitie s for presale demonstration or of maintaining high quality standards are largely fixed. As such, these a c tiv itie s are 27 not likely to Influence the marginal cost of dIstrI but Ion. Under these circumstances, the unfettered competition In the competitive retailing sector would fall to give rise to appropriate returns to these fixed Investments because the competition from free-rldlng dealers tends to drive the market price towards the marginal cost.

Vertical restraints, by supporting retail margins sufficient to cover these Investments, enable the manufacturer to Induce the appropriate

level of fixed Investments from Its dealers.

3.2 Information and Private Branding

Vertical restraints have come to be viewed as a means of obtaining efficient distribution by counteracting Informational free- rldlng In a competitive retail market. Vertical restraints, however, are not the only avenue for coordinating the Incentives of retailers with the objective of Joint profit maximization. In the analysis that follows, we attempt to Identify circumstances In which private brand sales serve as an alternative Instrument to Internalize the

Informational externality across retailers.

As Marvel and McCatferty (1964) pointed out, this assumption of constant marginal cost Is consistent with the occurrence of free- rldlng. if Informational services increase retailers* marginal cost of distribution, free-rider problems would be absent because retailers could charge for their services directly. 38

Let us consider the distribution problem of a monopolistic manufacturer whose branded product Is resold to final consumers

through Independent retail outlets. The retail market Is

characterized by free entry and consumers have Imperfect Information on both product and price. In order to be more specific about the

Information problem In the distribution of the product, we make the

following set of assumptions. at. Potential consumers know that a specific branded product Is

available in the market but they must be Informed of the

product's characteristics prior to purchase. a2. Retailer's local advertising or personal sales effort (all

retail Informational a c tiv itie s are simply referred to as

advertising from here on) Is the only channel available through

which such Information can be conveyed to prospective

28 consumers. A retailer Incurs a cost of bA In Informing

consumers of the product, where b and A represent respectively

per unit cost of advertising and the number of advertising

messages disseminated. a3. Some of the potential consumers get Informed of the product by

randomly encountering an advertising message from a particular

re ta ile r. The effectiveness of local advertising in informing

consumers is summarized by the customer generating function

If all aspects of product Information can be provided to consumers equally efficiently through national advertising, then the case for vertical restrictions w ill become much weaker. 39

g(A,n), where n Is the total number of Informing outlets (to be

determined within the model), G*>0, a * .<0, g <0, g >0, and A AA n nn

g. <0. In other words, the number of potential consumers An Informed by an Individual retailer Increases with Its

advertising intensity but declines as there are more competing

reta I Iers.

a4. However, for a given A of existing Informing outlets, the

probability of a particular consumer being Informed of the

product changes with the total number of Informing outlets.

That is. d[ng(A.n)]>0.29 on a5. Consumers have different preferences and buy at most one unit of

the product. The proportion of consumers who decide to purchase

Is given by fCp), where p denotes the retail p ric e .30 Once

Informed of the product, consumers do not care where they obtain

their own supplies of the product. a6. Informed consumers require price Information. Specifically,

each consumer has a complete knowledge of prices being quoted by

all retailers, but does not know the location of these retailers

29 Demand for a product may depend not only on re ta il services but also on the number of outlets. In a model of a perfectly competitive retail market, Gould and Preston (1965) demonstrated that such a dependence could lead to RPM. See also B1111Ingmayer ( 1983) and Mathewson and Winter (July 1983) for the p ro fita b ility of RPM In spat I a I markets. 30 That Is, f represents a distribution of reservation prices across consumers. In this Interpretation, f '< 0 Implies that a higher proportion of consumers Informed of the product choose to buy the product as the retail price falls successively below their reservation prIces. charging each price except the particular store that has

Informed him. a7. Consumers have either zero search cost or prohibitively high

search cost for prices. A proportion a of consumers has high

search cost, where 0

independently of preferences across consumers. a8. Entry Into the re ta il market Is free. A common re ta ilin g cost

function Is comprised of two components, the wholesale price p^

(variable cost) and Information provision cost bA (fixed cost).

Upon entry, each retailer decides on whether and how much to

provide Information. a9. The manufacturer produces a differentiated product at a constant

per unit cost of c and sells It to the downstream retailers at

Pw* ^he manufacturer cannot contractually specify retailer

Informational activities.

V ertically Integrated Manufacturer

The profit of the Integrated manufacturer Is given by:

TT(p,A,n) - n g(A,n) f(.p) (p-c) - nbA (1)

Profit maximization yields:

^ - n g(A,n) [i^'(p) (p-c) + f(p)] - 0 (2) op ^ - n gA(A,n) f(p) (p-c) - nb - 0 (3)

^ - /(p) (p-c) [g(A,n) + n g (A,n)] - bA - 0 (4) on n * * * These three equations define the first-b est equilibrium (p ,A ,n ) for the manufacturer. Note that the possibility of profitable price 41

discrimination is excluded since consumers' reservation prices are

assumed to be unrelated to their search costs. In what follows,

alternative contractual arrangements for the distribution of the

product w ill be evaluated with respect to these common reference

condItIons.

Due to variation In consumer search costs, there exist two types of

retail outlets in the free entry retail market equilibrium, namely,

hlgh-prlce Informing stores and non-InformIng discount stores. Of the

consumers captured for the market by Informing re ta ile rs , those with

zero search cost (1-a) purchase from discount stores. Informing

retailers retain only a fraction a of the Informed consumers. This

division of customers Is not dependent on the price d ifferen tial

between the two sectors of the retail market.

An informing retailer faces a demand function of the form:

q(p.,A n) - a g(A ,n) ftp.) (5)

Its profit Is defined as:

TfR( p j ,Al ,n> - a g[A! ,n) f ( p ( ) (p (- pw) - bA ( 6 )

For a given set by the manufacturer, each of the profit-maximizing retailers decides on Its retail price Pj and advertising density

Free entry ensures zero re ta il profit In equilibrium. Assuming symmetry across retailers, the equilibrium In the informing segment of the retail market (p 1,A,n) will be characterized by: 42

^ - a g(A.n) [/'(p)

PmR g j - a g^CA,n/ f(p ) (P-Pw> - b - 0 ( 8 )

ttR- a g(A,n) f(p ) (P-Pw) - bA - 0 (9)

The equilibrium price p1 charged by Informing stores will be £PW- f (p ) / f ( p ) ]. the re ta il monopoly mark-up over p Since only high

search-cost consumers patronize Informing outlets, these retailers

have monopoly price-setting power over their customers.

So long as a fraction (i-a ) of customers generated by Informing outlets has zero search cost, some re ta ile rs will find It profitable

to offer l i t t le product Information and set correspondingly lower prices to attract such consumers. Since retailers Incur no fixed costs other than Information provision cost bA, competition among discount stores w ill set the price at p^ and yield zero profits.

Hence, the equilibrium In the discount retail sector w ill be:

( 10)

Now consider the question of whether the non Integrated manufacturer using alone can achieve the first-best optimum defined by (2)-(4). The profit for the manufacturer will be:

tr(pw;p1 ,A,n) - n g(A,n) [af(p1) + d-a)/(pw)] (11)

The upstream manufacturer chooses p^ to maximize (11), subject to the equilibrium conditions (7)-{10) In the downstream retail market. Note that the price d iffe re n tial In the re ta il market does not Increase total sales because customers are generated only by Informing outlets and tastes are Independent of search costs. Since the unconstrained re ta il market equilibrium Involves two different prices, it Is obvious

that the non Integrated manufacturer cannot e lic it the first-best

optimum when only uniform price contracts are feasible.

Proposition 1: ^ <0 and >0 when evaluated at the equilibrium of op dA the Informing retail segment (p ,A ,n ) that corresponds to the profit m m m maximizing choice of p^ by the non Integrated manufacturer. From the

viewpoint of the upstream manufacturer, informing retailers set p too

high and A too low.

Proof: The non integrated manufacturer sets pw over c, and f< 0 .

Therefore, (2) Implies that the left-hand side of (7) Is negative at

(p ,A ,n ). Sim ilarly, (3) Implies that the left-hand side of (8) Is m m m positive when evaluated at (p ,A ,n ). Q.E.D. m m m This failure of Joint profit maximization is due to two externalities at the retail level. if the product Is sold under the manufacturer's brand name and If the brand name serves as an

Indication of standardization, there arises an opportunity for discount houses to free-rlde on informational services of hlgh-prlce outlets. As a result. Individual retailers have suboptlmal Incentives

to offer product Information. In addition to this horizontal externality on Information, there Is a pure vertical externality.

Because retailers with price-setting power do not appropriate the gains In profit accruing to the monopolistic manufacturer through the wedge between p^ and c, their incentives to set low prices as well as to inform consumers are Inadequate. Vertical Restraints

But the nonintegrated manufacturer can completely resolve these

incentive conflicts with retailers and elicit the first-best optimum

via various vertical restrictions on retailers' action.

Proposition 2: Either franchise fees and RPM or minimum volume

requirements and RPM will be minimally sufficient to achieve the

first-b est solution for the manufacturer.

* Proof: RPM at p-p allows Informing stores to retain all consumers they have generated as price dispersion In the retail market Iseliminated.

Accordingly, with a fixed franchise fee F, each outlet now faces a profit function given by:

■ttR( p*,A ,n) - g{A ,n) f(p ) (p -p^) - (bA + F) (12)

Retailer profit maximization and free entry Imply: D rttT * m - gA(A,n) f{ p ) (p -Pw) - b - 0 (13)

ttR - g(A,n) /(p*) (p*-pw> - (bA + F) - o (14)

If Is set at c, the retailer profit maximizing condition on A will be Identical with the first-best condition (3). Then F can be * selected to Induce n through the zero profit condition (14). Next, consider quantity forcing and RPM. When retailers are required to

A accept a minimum volume q at p^ as well as to maintain a retail price * at p , each of them maximizes:

TTR(P*,A,n) - g(A,n)f‘(p )(p -pw)-bA - q(p ,A,n)(p -pw)-bA subject to q(p*,A,n)£q. The resulting equilibrium conditions are: 45 R * « it - q (p -P^) - bA - 0 (16)

The first-best condition (3) can be rewritten as-.

b - 0 (17)

With q - q(p .A ,n ), \ « pw-c- and P - P . O 5) coincides with (17). * R Then p can be determined to get n via tt - 0. Q.E.D. w

Private Brand Retailer Market Equilibrium

in this retail setting, RPM is not the only Instrument available to

the manufacturer to avert the free-rider problem In the provision of

re ta ile r Informational services. If, Instead of providing all retailers with goods bearing the same manufacturer's brand name, the manufacturer elects to supply Its product to retail outlets for sales under their own brand names, Informational externality will be perfectly Internalized, i.e ., Informing stores w ill retain all consumers they generate. To the extent that low search-cost consumers fa ll to recognize that private brands are essentially an identical product except for the brand labels, discount stores can no longer attract this type of consumers Informed by hlgh-prlce stores. Hence,

If discount outlets are to make any sales, they also have to engage In their own promotional e ffo rt.

The profit of a private brand retailer Is defined as:

1TR(p,A,n) - g(A ,n) /(p ) (P~PW> - bA (18)

The retail equilibrium conditions now consist of:

- fl(A.n) [/'(p )(p -p w) + / ( p ) ] - 0 (19) Proposition 3: Either private branding and franchise fees or private branding and minimum quantity requirements constitute a minimally sufficient set of Instruments to resolve the extern alities confounding reta I lers ' act Ions.

Proof: The proof of proposition 3 Is similar to that of proposition 2.

When re ta il outlets have to offer the product under their own brand names, discount outlets are deprived of a method by which they can divert customers from Informing stores because they carry the product

labeled with different brand names. Informational free-rldlng will not occur. Then either franchise fees or minimum volume requirements can be used to rectify distortions caused by vertical externality.

Our discussion of private branding so far Is based on the assumption that consumers are Ill-Informed of the product's characteristics. Further understanding about the brand name ownership and the corresponding division of marketing responsibilities can be gained by considering what would happen If the sale of the product also requires brand name advertising to Inform potential consumers of the product's existence. Inasmuch as the technology of national advertising is superior to that of local advertising presumably because of scale economies In disseminating Information on the product's existence, the private brand manufacturer w ill be unable to achieve the first-best outcome of the Integrated manufacturer. 47

Furthermore, If the transfer of brand ownership and other control over

marketing to distributors serves to Improve their bargaining position

in relation to the manufacturer, private branding w ill also be

accompanied by the loss of monopoly rents to private brand retailers.

Such trade-offs Involved In private brand sales may lead manufacturers

to adopt a mixed brand strategy.

4. Private Branding and Manufacturer's Branding

The analysis In the previous section has established that private

branding can be an alternative contractual solution to the same

problem that the manufacturer may wish to resolve by means of vertical

restraints such as RPM. Given that a manufacturer may very well elect

to employ a private brand sales arrangement to deal with free-rider

problems, there remains an Important question about the particular

circumstances where private branding provides for a more efficien t

method of distribution. This section examines the conditions in

certain important retail lines In which private branding has been

employed extensively, and Illustrates our free-rider explanation of

private branding with the example of the practice In the distribution

of tobacco products.

Under the free-rider explanation of private branding, discount

competition pushes manufacturers Into private brand sales. This

Implies that the argument Is most likely to f i t product lines where

retail cervices are an essential factor In establishing brands and the manufacturer cannot exercise effective control over distribution 48

because of d iffic u ltie s In policing the flow of goods In distribution

channels. The arrangement of marketing private brands w ill be

particularly valuable to manufacturers selling goods which are

purchased Infrequently or which have considerable style or quality

aspects. It Is In marketing goods with these characteristics that the

role of high quality retailers in promoting sales w ill be most

significant. For instance, In the distribution of differentiated

fashion goods such as shoes or apparel Items, reputable department and

specialty stores play a major role In building a particular brand by

"endorsing" the product's quality. In good part, retailers act as the

consumer's agent, expending resources on verifying quality or

stylishness of their merchandise. As long as consumers rely on retail

stores as signal of product quality, manufacturers will prefer to have

their merchandise marketed at leading stores or specialized outlets In

order to benefit from retailer quality certification. This requires

selective distribution, but reputable stores frequently find their

featured brands turning up In discount outlets at reduced prices often

without the knowledge of the manufacturer. Beset by cut-price

competition, re ta ile rs with high quality standards w ill be forced to

drop those brands as they are unable to charge premium prices to cover

higher costs, and consequently the manufacturer cannot obtain their

c e rtific a tio n services. Under such circumstances private brand sales may be arranged as an appropriate device for securing the services of

high quality re ta ile rs by protecting these outlets from discount competition. The quality c e rtific a tio n argument advanced by Marvel 49

and McCafferty (1984) to explain manufacturers' reliance on RPM

applies equally well to the practice of private branding.

indeed,- private branding has been most common In areas where

quality c ertific a tio n Is at Issue, such as shoes, apparel, hosiery,

hats, candles, and cigars. Consider the characteristics of these

goods which make them suitable for private branding. In cases where a

style or quality element enters Importantly into the consumer's buying

decisions, as In markets for these products, manufacturer's

advertising alone Is not sufficient to Induce purchases. Instead the

manufacturer must rely on reta ile r Inputs of services to resolve the

consumer's decision problem In favor of Its brand, either because

purchases are Infrequent or a typical consumer cannot easily ascertain

the quality or stylishness of the product. This explains why a

manufacturer needs to sell through hlgh-margln, hlgh-servlce outlets

and avoid low-quallty discount stores. If a manufacturer can

establish Its brand well In the public's mind through advertising, It

should be Indifferent to the quality of the retail outlets selling Its

product. The manufacturer In this position would aim for extensive,

low-cost distribution to minimize consumers' total costs. Since the

manufacturer is able to convey product Information Independently of

dealers, margin protection via private branding would be unnecessary.

A manufacturer can attempt to obtain "quality** retailing by

supporting retail margins on Its brand through RPM. But the benefits of RPM to a manufacturer are necessarily related to Its a b ility to

assure adherence to RPM agreements. Beginning with the Supreme 50 31 Court's Dr. Miles decision, the long prevailing legal treatment of

RPM In the U.S. was that of per se Ille g a lity , viewing the practice as

analogous to horizontal price fixing. Subsequent court decisions

against RPM had denied manufacturers the power to make RPM effective

and the practice continued to be per se Illegal for goods Involved In

Interstate commerce untilthe passage of the MI Iler-TydIngs Act In

1937. Legal considerations aside, effective enforcement of RPM can be

very costly where conditions are favorable to the diversion of the commodity to discounters. The relative ease or d iffic u lty of enforcement of RPM has to do with the characteristics of goods as well as the complexity of the organization of the marketing processes since enforcement Is usually made through refusal to deal and selective selling. In product lines where private brands have made great progress, such as hosiery, shoes, men's clothing and furnishings, women's ready to wear, and confectionery, the distribution channel typically consists of a wide variety of heterogeneous outlets ranging from specialty shops, department stores, to large scale distributors.

Also seasonal, style, or other obsolescence factors require that re ta il prices be adjusted quickly In response to changing local demand conditions. For these reasons manufacturers find It excessively 32 expensive to set and enforce resale prices In manay instances.

Dr. Miles Medical Co. v. John D. Park & Sons, 22 U.S. 373 (1911).

32 Perhaps the most well-known instance Is that of Sheaffer, which was forced to drop RPM for Its pens even when the practice remains legal. In 1955 the company announced that despite a two-year compalgn of tracking down and carrying out legal proceedings against price (Footnote continues on next page) 51

When the cost of RPM becomes too high because of unfavorable legal

rules or enforcement obstacles, one alternative open to manufacturers

is distribution under private brand contracts.

The tobacco trade offers an Instance to Illu s tra te the

proposition that private branding can be a means of "purchasing"

dealer promotional services. Private branding was extensively used In

this trade. According to the FTC Investigation (1933), private brands

were sold In 20 out of the 35 tobacco chains reporting In 1931. Of

the 26 kinds of business Included In the study, only the confectionery

trade exceeded the tobacco trade In the proportion of private brand

chains. The private brand sales accounted for about 6 percent of

total sales by private bran* distributors. This relatively low

proportion of private brand to total sales was no doubt due to the

fact that most private brands of tobacco dealers were In cigars:

almost 40 percent of cigar sales were made In private brands.

Cigarettes which comprise the bulk of the tobacco business were

practically without exception nationally advertised brands as were

also most of the smoking and chewing tobaccos handled.

In order to understand the experience of the tobacco trade with

respect to branding practices, the distributive structure of the

(Footnote continued from previous page) cutters, and repurchasing pens from discount houses, at a cost In excess of $1 m illion, "we found that Sheaffer merchandise s t ill found Its way Into discount houses." Earlier in the same year Westlnghouse also stopped Its RPM practice for electric housewares and bed coverings as It became Increasingly unenforceable. Advertising Age (December 12, 1955), p. 1 , 8 . 52

tobacco trade In conjunction with certain peculiar characteristics of

the sale of tobacco products must be examined. Few products pass

through as many types and as great a number of wholesale and rets'J,

distributors as tobacco products. Tobacco products are handled not

only by dealers who are specialists In that field but also by a vast

array of dealers of variable types far removed from the tobacco trade.

According to a survey of the National Association of Tobacco

Distributors In 1939, there were approximately 1,700 Jobbers engaged

principally In the distribution of tobacco products and approximately

3,000 grocers and other wholesale distributors who handled tobacco

33 products merely as a side line. Table 6 Indicates the extent of

overlapping by various types of dealers In the wholesale distribution

of tobacco products. It shows that the most Important wholesaling

agency In 1935 was full-service and IImIted-functIon wholesalers of

tobacco and Its products with sales of over 587 m illion dollars.

Among the wholesalers who carried tobacco products as a side line were grocery, liquor, drug, and general merchandise dealers. The extent of

intermingling of lines Is particularly marked In the retail distribution of tobacco products. Almost all forms of retail outlets

including dept stores, supermarkets, food chains, Individual food stores, drug stores, confectionery stores, newsdealers, gas stations, mall order houses, liquor stores handled tobacco products as

"accessories." In 1939, there were approximately 850,000 retail

U.S. Tobacco Journal (January 27, 1940), p. 5. 53

Table 6: Wholesale Distribution Channels of Tobacco Products, 1935

X Of * Sales of tobacco X of tobacco commod1ty products saIes to totaI coverage (S1.000) sales Full-service and limited— function wholesalers: Tobacco and Its products 89.5 587,407 83.7 Full 1 Ine grocer 1es 50.6 65 ,353 6 .6 Specialty line groceries 8 6 .2 15,817 1 .1 Beer, wines, and liquors 94 .4 4 ,087 .6 Full llne drugs 72 .4 3,975 1 .7 General merchandise 92. 1 1 ,886 .6 Specialty line drugs and 94. 1 270 .2 drug sundr1es Manufacturers' sales branches With stocks 1 0 0 .0 404,137 99.2 Without stocks 82.2 260,026 1 0 0 .0 Aaents and brokers _ 95,5 1 .375 94.2 * Commodity coverage Is defined as the ratio whIch sales made by establishments reporting commodity figures bear to the total sales of all establishments In the same classification. Source: The U. S. Federal Trade Commission (1945), Report of the Federal Trade Commission on Resale Price Maintenance, p. 449.

Table 7: Concentration of Manufacture of Cigarettes, 1935

Manufacturer Brand No of clgarettesfbI I I Ion) Percent R. J. Reynolds Came I 36.8 26.29 American Tobacco Lucky Str Ike 34.0 24.28 LIggett & Myers Chesterfleld 33.5 23.93 P. Lor I I lard Old Gold_____ 5.2 3.71 Total Of Big FOUJl- 109.5 78.21 P h II1 Ip MorrIs & Co. Phi 11 Ip MorrIs 3.5 2.50 Ax ton-F 1 sher Twenty Grand 4.0 2 .8 6 Brown & W1111amson W 1 ngs 9.0 6 . 43 A1 1 other companies and brands 14.0 1 0 .0 0 o o o o Total _ . 140.0 Source: The U. S. Federal Trade Commission (1945), Report of the Federal Trade Commission on Resale Price Maintenance, p. 452. 54

tobacco outlets, exclusive of vending machines. The existence of a

large number of wholesalers and retailers carrying tobacco products as

a side line Is one of the principal causes of the breakdown of the

price structure In that trade.

The Increased competition from outside the regular trade In the

sale of tobacco products was reflected In the reduction of the number

of specialized tobacco dealers. During the 7-year period from 1929 to

1935, the number of cigar stores and stands decreased from 33,248 to

15,350 which comprised about 2 percent of the total number of retail

tobacco outlets. There also has been a material decrease In the

dollar value of sales by re ta il outlets. For Instance In 1929 the

sale of tobacco products by cigar stores and stands amounted to more

than 410 ml I I Ion do!lars as compared to 183 ml I I Ion do Ilars In 1935

34 representing a 55 percent decrease during the same period. It

appears that the Importance of cigar stores and stands as a retail

outlet for tobacco products was rapidly diminishing and that other

types of retailers were Increasing In Importance.

Between commodity classes, there was a wide variation In the

Importance of the various retail types and thus the change In distributive structure of the tobacco Industry had contrasting

implications for the different classes of manufacturers. Cigarettes are frequently bought and regularly used by the larger portion of the population. Because of the 'convenience good' nature of cigarettes,

34 FTC (1945), p. 450. 55

manufacturers’ interest lies In getting their products on the shelves

of as many outlets as possible. No selling efforts are required of

dealers, since demand Is built by the manufacturer, chiefly through

advertising. Under these conditions dealers remain passive agents and

the manufacturer w ill attempt to hold consumer prices and dealer

margins as low as possible. The extent and relative effectiveness of

advertising by manufacturers Is Indicated by the fact that a few

popular cigarette brands dominated the market (see Table 7). Even 35 under a new legal set-up permitting RPM, the manufacturers found

their best Interests served by depending upon advertising and other

promotional efforts of their own to create a strong consumer demand.

Since a brand can become sufficien tly welt established in the

consumer's mind through advertising, cigarette manufacturers are not

dependent upon the maintenance of specialists and their specialized

sellIng ass i stance.

The distribution network of the specialty dealers is not for the

most part In connection with the sale of standard cigarettes but In

the sale of cigars, smoking tobacco, and tobacco accessories. Hence producers of major brands of cigars apparently are Interested In upholding specialized outlets In the distribution sector, for unlike cigarette manufacturers they do need the help of "specialists" to

Beginning with California In 1933, a number of states enacted fair trade laws applying to Intrastate commerce. Then the Ml Iler- Tydlngs Amendment of 1937 removed the bar of Ille g a lity to RPM contracts covering commodities sold In Interstate commerce. By 1941, 45 out of 48 states adopted fair trade laws. market their goods. As pointed out by Grether, "The sale of cigars

requires more expert and personal selling attention than cigarettes.

The physical condition of the stock In the hands of the dealer Is also an Important sales factor. Therefore, cigar manufacturers, by contrast with cigarette manufacturers, are greatly concerned about the relative prosperity of their dealers and have attempted to stabilize 36 price competition." If retailer services are Indeed crucial to the e ffic ie n t distribution of cigars, some of the manufacturers may find the strategy of marketing private brands In their Interest. As already explained, selling private brands can be an attractive means of seeking the cooperation of specialized dealers in developing consumer acceptance of the product, particularly when RPM proves to be difficult to establish and enforce because of the legal prohibitions.

What exactly Is the nature of retailer services that cigar manufacturers attempt to obtain via private branding? Inventory and ancillary services (such as credit and return policies) of retailers may be Important In the sale of cigars. Note, however, that there seem to be few possibilities for free-rldlng In these retailing activities. From the manufacturer's viewpoint, two sorts of dealer services will be critical to market cigars efficiently. One Is the quality endorsement function of reputable retailers. This certification service contributes to consumers' perception of quality, but Is subject to free-rldlng. Discounters can take advantage of the

E. T. Grether (1939), p. 157. favorable Impression created by high quality outlets by stocking the

same brand. Private branding prevents discounters from Interfering

with high quality stores' quality signalling function. The other Is

the proper care and control of cigars In order that cigars be kept

"fresh" until they reach consumers. Without a particular set of

dealer services, the quality of the cigar (e.g., flavor and moisture)

is likely to be damaged in the distribution process. Since

dissatisfied consumers may blame the manufacturer for low quality

because of their Inability to ascertain the source of low quality,

retailers w ill have suboptima! Incentives to provide adequate quality

maintenance services. Such Incentive disparity will be absent In the

selling of private brands, for Individual dealers bear all the

37 consequences of their own quality control efforts.

We conclude our discussion by offering a tentative analysis of

the probable effects of RPM on the use of private brands. L ittle Is actually known, empirically, about the effects which the ending of RPM

38 has on the extent and scope of private branding. Sound procedure at this point would be the analysis of a series of case studies

illu s tra tiv e of specific situations. Instead, the discussion here

The use of vertical restraints to avoid the degradation of product quality at the distribution stage Is exemplified by the Coors case. Adolph Coors Company, 83 FTC 32 (1973). It Is noteworthy In this connection that cigars were sold for the most part through wholesalers who had exclusive te rrito rie s . See SeMgman and Love (1932), pp. 418-23.

3 S The Congress revoked the states' authority to legalize RPM In 1975. For an explanation of the evolution of the legislative attitude toward RPM, see Marvel and McCafferty (1986). 58

must be limited to a general analysis upon which more specific

applications may easily be built.

An opinion often expressed on this subject was that private

brands would be easier to sell If manufacturers' national brands were

39 price maintained. Implicit In this argument Is the premise that 40 retail prices would necessarily be higher under RPM. Effective RPM

may yield the retailer a satisfactory margin. But, with an Increase

in prices of nationally advertised products, re ta ile rs may find an

opportunity to sell their own private brands at a lower price.

Widespread RPM thus would provide the Incentive to develop and push private brands as a substitute for the price maintained national brand. Such opinions were most often expressed by representatives of

large re ta ilin g organ IzatIons which have comprised a source of opposition for RPM. A major Implication of this line of reasoning Is

that the abolition of RPM would result In erosion of the competitive position of private brand manufacturers.

On the other hand, If RPM Is a method of "purchasing" more effective promotional efforts from dealers by eliminating price competition and ensuring adequate margins on manufacturers' brands, It will provide some degree of protection to manufacturers of nationally advertised brands against the competition of private brand

39 See FTC (1945), p. 134, 259, and FTC (1931), p. 155.

40 On RPM's effect on prices, see Marvel and McCafferty (1985; 1986). They elaborated conditions under which RPM need net raise consumer prices. 59

manufacturers. Successful price maintenance would yield retailers a

satisfactory margin on the manufacturer's national brand and for this

reason they may have less Incentive for pushing private brands. This

suggests that private branding which got Its start prior to fair trade

might well have expanded more rapidly If there had been no fair trade

laws. That the absence of fair trade w ill spur rather than check the

growth of private brands is Indicated by some current developments In

the marketplace. After federal fair trade laws were repeated In 1975,

off-prlce and discounting stores appear to have been proliferating.

According to one estimate, there are around 4,000 to 5,000 substantial 41 outlets for off-prlce brand name soft goods. With an estimated

rate of growth of around 30 percent per year, their combined sales In

1981 reached nearly $6 b illio n , accounting for approxImateIy 6 percent 42 of the total apparel and shoe market. This major breakaway of name

brand soft goods from the exclusive hands of department stores and

specialty outlets to discounters would force traditional distributors

to turn away from national brands to private brands. It Is precisely

In this case where manufacturers' national brands are subject to price

cutting that dealer Interest In private brand sates becomes

significant and private brand manufacturers become an object of

interest as a source of supply.

"The Off-Prlce Phenomenon," Discount Merchandiser (October, 1983), p. 20. Among the leading off-p rlce apparel retailers are Mervyn's, Marshall's, T.J. Max*. Loehman's, Hit or Miss, and Syms.

"Profits from outlets," Forbes (June 7, 1982), p. 128. CHAPTER ( I I

JAPAN'S GENERAL TRADING COMPANIES

The so-called general trading companies In Japan, or sogo shosha,

are trading conglomerates engaged In a wide variety of commercial

activities on a global scale. They are primarily hIghIy-dI vers If Ied,

first-stage wholesale traders, character I zed by both a wide breadth of

products and the sheer volume of sales. The significance of the general trading firms In the Japanese economy Is well reflected In the

large share of foreign trade they handled. In 1983, the nine largest sogo shosha accounted for 46.6 percent of Japan's total exports and

64.9 percent of her total Imports. Their unusual prominence In

International trade has prompted a number of countries, the United

States among them] to try to establish similar trading organizations

In an effort to Improve trade performance, especially exports.

Suppose a manufacturer has decided to enter foreign markets and

Is considering alternative ways of organizing distribution. One method Is to depend on existing trade channels like trading companies.

In August 1982, the Congress passed the Export Trading Company Act to stimulate the formation of U. S. trading companies. This law allows commercial banks to own equity In the export trading companies through bank holding companies and Edge Act corporations. It also sets up pre-clearance procedures for antitrust exemption concerning their exportation of competing lines of goods and services. See Y. Tsurumi (1982) and M. L. Rossman (1984) for the export trading company leg IsI at Ion.

- 60 - 61

A second Is to do the work on Its own. What Is It that favor one of

the modes In relation to the other? Writers on the general trading

company have paid most attention to explaining raisons d'etre of this

unique Japanese Institution. This leads to emphasis on the benefits

from relying on general trading companies for organizing foreign

transactions. Most often, general trading companies are said to

reduce risks and take advantage of economies of scale and scope In

2 various trading a c tiv itie s . it is also suggested that general

trading companies minimize the cost of trading In the complex

International environment, thus freeing manufacturers' resources to 3 develop the production process. But the extent to which general

trading firms are relied on for foreign transactions varies widely

with products, geographical regions, and modes of transaction. Also a

temporal dimension seems to be an Important factor In the choice among

alternative organizational forms. Why are some transactions delegated

to outside trading agents whereas other transactions are directly undertaken by manufacturers? Tho task Is s tIM before the analyst to

To cite a few, there are K. Yamamura (1976), Y. Tsuruml (1976; 1980), and A. K. Young (1979). 3 See, for example, E Daldo (1976), and K. Kojlma and T. Ozawa (1984). Or, perhaps, trading companies may provide a vehicle for achieving a collusive outcome among client manufacturers. Bernhelm and Whlnston (1985), In a model of agency delegation where competing firms Independently decide on agency selection, output prices, and compensation schemes, demonstrated an equilibrium In which common marketing agents serve to facilitate collusion among client firms. Their results critically depend on the assumption of risk neutrality on the part of the common agent. 62

provide a theoretical basis upon which to elucidate the observed

configurations of trade channels.

In this chapter, we develop an analytical framework capable of

providing an Integrated explanation of various phenomena of Japanese

general trading firms' trading a c tiv itie s . Following Coase's

approach, the issue of general trading companies Is characterized as

the problem of choosing between two alternative means of organizing

exchange-lnternaI organization and agency delegation. To assess the

relative efficiency of the two alternatives, the hazards of Incomplete

contracting Involved In the agency delegation arrangement are analyzed

and the structure of self-enforcing contractual mechanisms In support

of the specialization between manufacturing and trading firms are

examined. The focus of our attention In the comparative assessment Is

put on the efficiency with which Information Is collected and

transmitted and the a b ility to curb opportunism of contracting 4 parties. This approach enables us to delineate circumstances that

favor a particular transactional structure as a means of Implementing efficient marketing and procurement In a dIscrImInatIng way. As win

Chu (1982) formalized the rlsk-m ltlgatlng role of the trading company by constructing a model where a risk-neutral monopolistic trading intermediary emerges to offer a contractual arrangement that promises a fixed sum of payment to risk-averse manufacturers whose output levels are stochastic. This approach does not provide a practical basis upon which to evaluate observed contractual arrangements without knowledge of the relative risk preferences of the parties Involved. Following the transaction cost approach, we assume that risk preferences are not an Important factor in determining the structure of vertical relationships between manufacturers and trading companIes. 63

be seen later, our analysis gives answers to such Interesting

questions as: why general trading companies are more Important In

Imports rather than exports, why general trading firms play only a

minor role In the export of color TV sets while playing a major role

in the export of te x tile s , and why Japanese export products are

sometimes Introduced Into foreign markets under the trading firms'

brand names. It may also explain the trend toward direct marketing

(under their own brand names) by major exporters of some developing

countries who used to rely on their U.S. customers or sales agents for

both distribution and brand names In the U.S. market.

Our explanation of general trading companies from a transaction

cost perspective Is contrasted with the common b elief that the manufacturer's choice of trade channels simply reflects technological aspects of the transactions Involved. In particular, manufacturer's direct Involvement In distribution Is widely held to be the organizational means by which technologically complex products are brought to the market e ffic ie n tly . It Is said that existing marketers are Inadequate to handle such products because they are Ill-prepared to provide special presales engineering as well as after-sales customer services which require manufacturing expertise.^ We submit, however, that the Integrated mode of distribution can properly be viewed less as a consequence of technology and more as the result of contractual d iffic u ltie s surrounding the arms-length exchange

For this technology-based argument, see, for Instance, Y. Tsuruml (1976), pp. 141-43, and N. Shloda (1978), p. 154. 64

relationship. So long as manufacturing and distribution are ft technologically separable and outside marketers can offer economies

of scale or scope In the sales activities, there Is no compelling

reason to prefer Internal organization over market procurement other

than governance cost economies. Only when marketurned I ated contracts

break down, will the transaction In question be removed from the

market and organized Internally. Specifically, we trace the limited

role of trading firms In certain types of commodities to the

contracting complications posed by the existence of a hitherto

unremarked specialized asset: brand name c ap ital.7

Section 1 outlines some distinguishing features of trade operations and other trade-related a c tiv itie s of the Japanese general

trading firms. Section 2 provides an overview of the transaction cost

theory of economic organization as the theoretical basis for examining

the trade structure of general trading companies. The final section examines efficiency Incentives for agency delegation as well as contractual difficulties with the use of outside trading agents.

Implications of the transaction cost approach for the choice of trade

That many manufacturers of sophisticated products continue to rely on Independent distributors reflects the technological separability between these two stages.

7 Williamson regards the external effect of the distributor's action on the fIrm-specIfIc reputation In conjunction with specialized physical assets (e.g., refrigeration facilities) as central to explaining forward Integration Into distribution around the turn of the century. See 0. Williamson (1985>, pp. 107-14. 65

channels are developed to explain the pattern of agency delegation

experienced by the Japanese sogo shosha.

1. An Overview of General Trading Firms

Japan Is a trade-oriented economy. Due to almost total lack of

domestic resources of raw materials, Japan Is heavily dependent on

imports of natural resources and other materials (see Table 8).

Exports are also needed to pay for Imports. In 1983, Japan's exports

and imports represented 12.7 and 10.9 percent of her gross national

product respectively. These figures are much larger than those for

the U.S. (see Table 9).

The general trading companies are often viewed as a distinctive

Japanese Institution which has been Instrumental In Japan's trade-

based economic growth by serving to discover favorable foreign sources

of supply of raw materials, food, and specialized machinery and to O develop new sales outlets abroad for Japanese manufacturers.

In itia lly created as the In-house marketing arm for their respective g business groups, they have developed Into highly-diversified

multinational business, extending the range of their commercial

On the role of trading companies In Japan's Industrialization, see, for Instance, M. EmorI (1971), A. K. Young (1979), ch. 5, Y. Tsuruml (1980), and K. Yoshlhara (1982), ch. 6. a A typical Japanese business group (zalbatsu) Is composed of a trading company, a major bank, and a host of manufacturing firms, which are interrelated by Intercorporate stockholdings and inter lockIng dIrectorates. For a discussion of the zalbatsu formation and growth, see Caves and Uekusa (1976). 66

Table 8: Japan’s Dependence on Imported Resources and Its Share of World Imports In Comparison with U.S., 1982

■ ------——*----- Import Dependency Ratio Share of WorId Impor ts CommodI tv Japan U.S. Japan U.S. Iron ore 99.7 23.8 40. 1 12.9 Copper ore 95.9 31 .4 29.3 9. 1 Lead 67.0 52. -> 6 .0 9.1 11 nc 64.2 58.8 9.9 25.2 Baux 1 te 1 0 0 .0 79.9 24.9 20.4 N1 eke I 1 0 0 .0 96.9 6.4 40.7 Coa 1 82.9 -16.9 30. 1 0.4 Petro leum 99.8 32.9 14.2 15.9 Natural gas 91 .4 4.1 12.4 13.2 Timber 64.3 1 .2 18.7 16.9 Wool 1 0 0 .0 25.7 16.4 2.5 Cot ton 1 0 0 .0 -104.0 17.6 0 .2 Soybean 95.1 -70.0 15.4 0 .0 Corn 1 0 0 .0 -29.8 19.6 0 .0 Wheat 8 8 .0 -119.2 5.3 0 . 1

* Import dependency ratio - — :—; ------, ne*—Inipor t — net Import + domestic production

Thus, negative values Indicate degree to which a country depends on export markets. Source: Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Trade White Paper), pp. 391-92, Tokyo: Tsusho Sangyo Chosakal, 1984.

Table 9: Expor ts and Imports of U.S. and Japan as Percentage Of GNP, 1974-83, (blI I ion do 1la r ; X)

U.S. Japan GNP Export Import GNP Export Import 1974 1,434.2 6.9 7.7 458.5 1 2 .1 13.5 1975 1,549.2 7.0 6 .8 498.2 11 .2 11 .6 1976 1,718.0 6.7 7.7 558.7 1 2 .0 11 .6 1977 1,918.3 6.3 8.4 6 8 6 .6 11 .8 10.4 1978 2,163.9 6 .6 8 .6 963.3 1 0 .2 8.3 1979 2,417.8 7.5 9.2 998.9 1 0 .2 1 1 .0 1980 2,631 .7 8.4 9.8 1,040.1 12.5 13.6 1981 2,957.8 7.9 9.2 1,142.6 13.3 12.5 1982 3,069.3 6.9 8.3 1,063.1 13.0 12.4 1983 3.304.8 6 .1 8 .2 1.156.3 12.7 .. 10.9 Source: IMF, Internationa) Financial S tatistics, Oecember 1S84. 67 activities far beyond their affiliated manufacturing firms. The group-related business accounts for only a small fraction of the sogo shosha's business.1^ They either act as commission merchants concentrating on volume transactions or engage In buying and selling for their own accounts.

The sogo shosha are not the only Japanese firms engaged In foreign trade, nor are they the only trading companies. At the end of

Japanese fiscal year 1983 (April 1, 1983 - March 31, 1984), there were

12,023 firms that carried out export/Import business. More than 70 percent of these firms were trading companies; 27 percent were manufacturers; other traders accounted for the remaining two percent

(see Table 10). Of this large group of foreign traders, the nine largest sogo shosha have a dominating position. They are, In order of sales In 1983, Mitsubishi, Mitsui, Marubeni, C. Itoh, Sumitomo,

Nissho-lwal, Toyo Menka, Kanematsu-Gosho, and Nlchlmen.11 Their combined sales In that year were about 30 percent of Japan's gross natlonaI product.

The sogo shosha are differentiated from other types of traders by their overwhelming weight In Japan's foreign trade. Table 11 shows

About 20 percent of Mitsubishi's business came from Its member companies In 1970. Mitsui was less cohesive, with 13 percent of Its sales coming from Its member companies. K. Lin and W. R. Hoskins (1981), pp. 22-24. Sumitomo Industrial group was estimated to be responsible for 24 percent of Sumitomo's purchases and 7 percent of Its sales In 1982. The Oriental Economist (March 1983), p. 36.

11 Until Ataka was absorbed by C. Itoh In October 1977. there were ten general trading companies. 68

Table 10: Exports and Imports of Japanese Traders, FY 1983

F 1 rms Number Share Export share ImDort share Trading companies 8,504 70.7 57 .2 71.1 Manufacturers 3,253 27.0 42. 1 28.8 Others 367 2.3 0.7 0 .1 Total_ 12.023 1 0 0 .0 1 0 0 .0 1 0 0 .0 * Under Japan's Ministry of International Trade and industry (MiTi) classification, trading companies refer to wholesalers, retailers, and department stores that undertake foreign trade. Source: Compiled from Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Trade White Paper), Tokyo: Tsusho Sangyo Chosaka I , 1985.

Table 11: Trade of Japan's Incorporated Trading Companies, FY 1983

Sea Ie of Flrms transactions (ven) Number % Export share Import share Less than 10 mI I I Ion 72 0.9 10-50 m II11 on 441 5.7 50-100 mi I I Ion 545 7.1 0 .1 100-500 m1 11 1 on 2,302 29.9 0.9 0.5 500-1,000 ml I I Ion 1 , 155 15.0 1 .2 0.7 1-5 bI I I Ion 2,037 26.4 4.6 3.2 5-10 b ill Ion 444 5.8 1 .9 2 .0 10-50 b lII Ion 518 6.7 5.8 5.1 50-100 b 111 Ion 79 1 .0 2.3 1 .4 100-1 ,000 b I I Mon 102 1 .3 10.7 11 .9 1-3 trI I I Ion 6 0 .1 6 . 2 1 .4 More than 3 trI 11 Ion 10 0 .1 66.3 73.8 IfilaJ______7.711 100.0 ______HJJLJl______100.0 Source: Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Traie White Paper), p .764, Tokyo: Tsusho Sangyo Chosaka I, 1985. 69

that there exists vast discrepancy In size among 7,711 Incorporated

trading companies. In fiscal 1983, the ten largest trading companies,

of which nine were sogo shosha, accounted for 66.3 percent of the

7,711 firms' export total and 73.8 percent of these firms' Import

total. A significant portion of ordinary trading firms are 12 subsidiaries of large manufacturing companies, usually with lower

share of foreign trade In total sales compared to the sogo shosha.

The sogo shosha also differ from ordinary trading firms In the number

of products handled, the scope of a c tiv itie s undertaken, and the

geographic coverage. While most trading firms export or Import a

limited variety of products, narrowing down the kind of services and

products they handle for either domestic or particular overseas

markets, each of the large general trading companies deals In a large

number of products - as many as 20,000 Individual I terns ranging from

complex industrial plants and large oil tankers to raisins, Instant 13 coffee, and noodles. Equally significant Is the scope of their

trading activities on a global scale, encompassing domestic trade,

Imports and exports, and third-country trade.

To name a few such companies, Toyota Motor Sales Is a subsidiary of Toyota Motor; Kawasho of Kawasaki Steel; Matsushita Electric Trading of Matsushita Eciectrlc Industrial; and Hitachi Sales of Hitachi. K. Yoshlhara (1982), pp. 6-9.

13 This explains why sogo shosha are called "general- trading companies as d istinct from "specialized" traders known as senmen shosha. MITI defines specialized product (regional) traders as those whose transactions In one product group (geographic area) exceed 50 percent of their total transactions. 70

The substantial role of the general trading firms In the Japanese economy can be Inferred from the large share of International trade

they accounted for (Sue Table 12). Their share in Japanese trade has exhibited some fluctuations around 50 percent in export and 60 percent

In Import during the last two decades. While Japanese manufacturers are heavily dependent on general trading companies for both exporting their products and importing foreign raw materials and equipment, the extent of manufacturers' reliance on trading firms varies depending on goods, geographical regions, and modes of transaction. The relative * Importance of general trading companies vis-a-vis manufacturers In overseas marketing and procurement also changes over time. Overall, general trading firms have played a much smaller role In handling highly-differentiated consumer goods compared with standardized

Industrial products and raw materials. Also their competitive position in foreign trade relative to manufacturer has been declining.

But manufacturers' direct transactions seem to be largely confined to such well-established markets as the U.S. and Europe. Trade with small and new markets tends to be delegated to general tracing firms.

The sogo shosha are not exclusively Involved In foreign trade.

Despite some significant declines In the past few years, domestic trade s t i l l remains the most Important component of the sogo shosha's business (See Table 13). In 1983, the share of domestic trade In total sales of the nine largest sogo shosha amounted to 40.3 percent, much larger than the 20 percent share o f export and the 23.6 percent share of Import. One rapidly expanding part of the sogo shosha 71

Table 12: Share of the Nine Largest General Trading Companies In Japan's Foreign Trade and GNP, 1970-83, (b illio n yen; X)

Fiscal Jaoan Soao Shosha year (A) (B) (C) Tota1(a) (b) (C) GNP Export ImDor t sa les a/A Export b/B Import c/C 1970 73,046 7.290 6,967 20,565 28.2 3,509 48.1 4,365 62.7 1971 81,577 8,471 6,823 22,475 27.6 4,317 51 .0 4,143 60.7 1972 94,729 9,071 7.659 26,591 28.1 4,559 50.3 4,797 62.6 1973 115,605 10,877 12,369 37,217 32.2 5,736 52.7 7.938 64. 2 1974 136,339 17,080 18,276 46,880 34.4 10,336 60.5 10,412 57.0 1975 149,092 17,026 17,396 46,278 31 .0 9,600 56.4 9,675 55.6 1976 170,290 20,669 19,713 49,916 29.3 10,656 51 .6 10,408 52.8 1977 188,804 21,790 18,509 47,009 24.9 10,706 49.1 9,358 50.6 1978 206,763 19,985 17,059 46,021 22.3 9,604 48.1 8,731 51 .2 1979 222,702 24,482 27.610 61 ,735 27.7 11,798 48.2 15.055 54.5 1980 239,115 30,059 31.477 72,853 30.3 14,640 48.7 17,624 56.0 1981 251,536 34,362 32,245 80,112 31 .8 17,026 49.5 19,209 59.6 1982 267,351 34,068 31,762 83,151 31 .1 17,857 52.4 20,094 63.6 1983 ._278.21£_ 36.131 30.601 84.042 .2 Q^2_ 16.807 46.6 19.847 64.9 * Figures over the period 1970-1977 are for the ten largest general trading companies. Sources: Sogo Shosha Nenken (General Trading Company Yearbook), p .15, Tokyo: Seikei Tsushinsha, 198 d , and K. A rlta, Sogo Shosha: Mira I no Kozu, pp.23-24, Tokyo: Nihon Kelzal Shlmbunsha, 1982.

Table 13: Breakdown of Total Sales of the Nine Largest General Trading Companies by Type of Trade, 1979-83, (b illio n yen; X)

Fiscal Total Domestic trade Exports Imports ThIrd-country year sales Value Share Value Share Value Share Value Share 1979 61,735 28,332 45.9 11,798 19.1 15,055 24.4 6,550 1 0 .6 1980 72,583 31 ,612 43.6 14,640 2 0 .2 17,624 24.3 8.707 1 2 .0 1981 60,112 33,136 41 .4 17,026 21 .3 19,209 24.0 10,741 13.4 1982 83,151 33,673 40.5 17.857 21 .5 20,094 24.2 11,797 14.2 1983. __84.Q5 2 33.887 40.3 16.807 , ,20.0 . 19.842_ 23.6 13.511 16.1 Source: Sogo Shosha Nenken (General Trading Company Yearbook), p .15, Tokyo: Selkel Tsushlnsha, 1985. business In recent years Is the so-called third-country trade, I.e .,

trade between two foreign countries handled by Japanese trading firms without direct Involvement of Japan as a source of supply or market.

In 1983, this type of trade represented more than 16 percent of the nine sogo shosha's total sales. Illustrations of third-country trade

Include the sales of U.S. power plant equipment to the Philippines and 14 Canadian pulp to Europe.

General trading firms serve as a financial Intermediary by extending credit and providing capital to customer manufacturers, 15 particularly to small ones for whom access to capital Is d iffic u lt.

These manufacturers are frequently either subcontractors producing components for large-scale producers of steel, petrochemical, heavy machinery, and automobiles, or Independent manufacturers In labor- intensive light Industries. Much of the general trading firm's ability to provide valuable financial services stemsfrom Its banking connections through which It borrows large amounts of money. Since each of the sogo shosha Is closely associated with one or more of the thirteen large city banks, often It can obtain large sums of money at 16 relatively low Interest rates. Moreover, since the general trading

14 K. K, Wlegner, "Outward bound," Forbes (July 4, 1983), p. 97.

15 The sogo shosha's loans and investments to small and medium-sized manufacturers are estimated to be between 30 to 40 percent of their total outstanding debt. Y. Tsuruml (1980). p. 10.

16 For example, Dai-icht Kangyo Bank owns nearly 10 percent of C. Itoh & Co. Fuji Bank owns over 7 percent of Marubeni Corp. “A Business In B illions, A Profit In Thousands," Forbes (July 10, 1978), p. 90. 73

company Is In a better position to assess the risks involved In extending credit to small producers because of Its close business ties with them, It can supply small loans at lower cost than banks can do and concurrently serve as the financial Institutions' risk buffer.17

In 1983, loans extended by the general trading firms accounted

for approximately 45 percent of their total equity and debt

Investments (see Table 14). These loans are generally tied to specific uses: they often take the form of supplying Imported raw materials on credit. financing Investments In new production fa c ilitie s , or payment for exports before actual sales to foreign buyers. Long-term loans are more frequent and made In larger amounts

in connection with overseas natural resource development. Also the sogo shosha often have minority equity share of client manufacturers.

General trading companies have Increasingly been Involved In overseas manufacturing, resource development, and other trade-related ventures by way of direct capital investments and loan extensions. As of the end of March 1981, overseas Investments and loans made by the 18 sogo shosha totaled about 995 b illio n yen (see Table 15). Their overseas Investment a c tiv itie s exhibit a few Interesting features: (1) high propensity to form Joint ventures; (?) high Incidence of minority

17 This point Is made by L. B. Krause and S. Seklguchl (1976), P. 390, A. K. Young (1979), PP. 62-64, and T. Roehl (1983), pp. 130-33.

18 Outstanding overseas investments were estimated to be around 749 b illio n yen, accounting for roughly half of Japan's total Investments abroad. In 1981, the top six general trading companies ranked among Japan's 10 largest foreign Investors. T. Cappletlo (1982), p .27. 74

Table 14; Financial Activities of the Sogo Shosha, 1981-83, (bI I I Ion yen)

F I sea l Borrowings Investment Loan year Short-term Long-term Securities A ffilia te d Long-term A ffilia te d firms firms 1981 3,776 3,969 422 935 519 533 1982 4,761 4,217 464 997 603 612 1983 5.667 4.033 471 1.016 685 536 Source Sogo Shosha Nenken (General Trading Company Yearbook), P. 21 , Tokyo; Selkel Tsushlnsha, 1985.

Table 15: Overseas Investments and Loans by the Sogo Shosha, March 1981

No. of overseas Outstanding balance aff 11 lated fIrms fbl I I Ion ven) Mitsui 260 243.2 Mitsubishi 154 185.7 Marubeni 246 179.3 C. Itoh 222 118.7 Sumitomo 143 76.4 Nlssho Iwal 125 72.8 Toyo Menka 98 49.0 Nichi men 87 35.9 Kanematsu-Gosho 71 33.8 Total 1.426 994.8 Source: The Oriental Economist (January 1982), p. 32.

Table 16: Ownership Interest of the Sogo Shosha in Overseas Manufacturing Ventures, March 1980

Eaultv DartIciDation Number of ventures % 1 - 9% 184 26.9 10 - 29% 327 47.9 30 - 49% 100 14.7 50% 16 2.3 51 - 79% 19 2 .8 80 - 100% 26 3.8 n . a . 10 1 .5 Total by comDany 682 1 0 0 .0 Source: K. KoJIma and T. Ozawa, Japan's General Trading Companies, p. 98, Paris: OECD, 1984. 75

ownership; (3) frequent use of direct overseas loans; (4)

concentration on technologically standardized, labor Intensive

Industries. This set of characteristics distinguishes sogo shosha's

foreign Investments from those of American and European multinationals

where Internalization Is the key feature.

The most common arrangement for overseas manufacturing Investment

Is to organize and participate In Joint ventures Involving a Japanese

manufacturer, a trading firm, and a local or third-country Interest.

At the end of March 1980, these trip a rtite ventures accounted for 129

19 (66.3 percent) of the sogo shosha's 682 manufacturing Investments.

Approximately 10 percent were bilateral ventures with local

entrepreneurs. The wholly-owned ventures were rare, accounting for

only 1.6 percent. Compared to manufacturing, the trading companies'

propensity to form trip a rtite ventures Is less prominent In resource

development. Investments of this type represented 48.2 percent (34 out of 139), much lower than 66.3 percent share In manufacturing.

B ilateral Joint ventures with local Interests amounted to 30.9 percent, higher than the 10 percent share In manufacturing. There were 16 wholly-owned ventures (11.5 percent), most of them prospecting 20 or exploration projects In minerals and fuels.

K. KoJIma and T. Ozawa (1984), p. 42. These figures are based on the number of Investment participations by Individual trading firms. Thus double counting Is Involved, for some ventures are Jointly owned by two or more trading companies.

K. KoJIma and T. Ozawa (1984), pp. 55-56. 76

As far as the ownership pattern Is concerned, equity

participation of less than 30 percent accounted for about 75 percent of the nine traders' manufacturing ventures abroad (see table 16).

The 10 to 29 percent range of equity ownership was the most frequent

(47.9 percent), followed by the 1 to 9 percent range (26.9 percent).

As In manufacturing, the sogo shosha hold minority ownership In most of their resource development projects. Ventures with less than 50 percent ownership accounted for as much as 76.3 percent. The 10-29 percent range of equity ownership was the most frequent (31.7 21 percent). But on average the sogo shosha maintain larger equity

Interest In resource development than In manufacturing.

Investments In resource development are often made In exchange for long-term contracts to purchase a share of output from the

22 project. Of the total of 139 ventures in 1980, 21 were for Iron ore and 13 for coal (see Table 17). Nonferrous metals, which Include copper, zinc, lead, bauxite, nickel and tin , together accounted for 32 ventures (23 percent). General trading companies also extend direct loans to overseas resource developers In connection with their long term purchase contracts. More than half these loans were extended to

Independent resource producers overseas In which the trading companies

K. KoJIma and T. Ozawa (1964), p. 57.

22 For Instance, Mitsubishi set up Brunei LNG Ltd. In 1969 in partnership with Shell ON and the Government of Brunei. As a minority shareholder with 33.3 percent, It has a 20-year contract to buy 5 m illion tons of LNG from the Bruno! company and sells to the electric power and gas companies under a long-term contract. K. KoJIma and T. Ozawa (1984), p. 58. 77

Table 17: Resource Development Ventures of the Sogo Shosha, 1980

CommodI tv Number of ventures .% iron ore 21 15.1 Non-ferrous metals 32 23.0 Coa l 13 9.4 01 I and naturaI gas 6 4.3 Combination of above 3 2.0 Agriculture and animal husbandry 24 17.3 Fishery and processing 22 15.8 Forestry and lumberIna 18 12*9 Total by company 139 100.0 Source: K. KoJIma and T. Ozawa, Japan's General Trading CompanIes, p . 105, Paris: OECD, 1984.

Table 18: Resource Development Loans Extended by the Sogo Shosha from Japan, January 1982

Number of loans % Eaultv Interest None 25 54.3 Below 49% 8 17.4 50 - 79% 5 10.9 80 - 100% 8 17.4 Total . __ 46 100.0 secton AgrIbus Iness 2 4.3 F I shery 4 8.7 Forestry 7 15.2 0 11 and gas 4 8.7 1ron ore 8 17.4 Copper ore 17 37.5 Other non-ferrous metals 3 6.5 Coa 1 1 2.2 Total 46 100.0 Source: K. KoJIma and T. Ozawa, Japan's General Trading Companies, pp. 108-9, Paris: OECD, 1984. 78

have no equity Interest. Generally speaking, the sogo shosha seem to

be more w illing to provide Joans to ventures In which they have lower

equity ownership (see Table 18). Copper ore ranked fir s t (37.5

percent) In direct resource development loans. Iron came second with

23 17.4 percent share. These loans are usually long-term and are

offered on a concesslonary basis.

By far, the sogo shosha's largest Investments abroad are In their

wholly-owned trading subsidiaries. In the U.S., for example, the

paid-up capital of their trading subsidiaries amounted to 24 approximately 1,615 million dollars. These companies not only

import goods from Japan and other countries, but export goods produced

In their host countries. In 1980 U.S.-based subsidiaries of the sogo

shosha handled exports from the U.S. valued at 22 b illio n dollars, an estimated 10 percent of total U.S. exports. Around 25 percent of

those exports went to countries other than Japan.

In 1980 there were a total of 245 auxiliary trading ventures set up by the nine general traders. Of these, 33 (13.5 percent)

specialized in primary commodities such as agricultural, marine, and 25 forestry products, minerals, and fuels. Ventures specialized in

in 1979, Japan secured approxImate'y 50 percent of the copper ore and 30 percent of the Iron ore It Imported under toan-and-Import arrangements. Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Trade White Paper), 1980, p. 247.

24 T. Capplello (1982), p. 28.

25 A case In point is Mitsui’s acquisition of grain elevators In the U.S. from Cook Industries In 1978. With its own elevators, Mitsui was able to export U.S. grain to Europe as well as to Japan. 79

26 particular lines of manufacture were 196. In the early years of

Japan's export expansion, manufacturers frequently depended on trading

companies to set up a sales and customer service company abroad

particularly In Industrialized regions such as North America and

Europe. But later with the growth of export volume, manufacturers

seldom have chosen traders as Joint Investors.

2. Transaction Cost Economics

This section presents a brief overview of the transaction cost

approach laid by Coase (1937), Klein, Crawford, and Alchlan (1978),

Williamson (1971; 1979; 1985) and others as the theoretical basis tor analyzing exchange relations. The discussion Is not Indended to give an expansive survey of the literature on transaction cost but to provide some of the primary theoretical foundations and implications of the transactions cost approach that bear directly on the issue of the organization of distribution In international markets.

Transaction costs refer to real resource expenses associated with establishing and administering a contractual relationship. These costs encompass the costs of drafting, negotiating, and safeguarding contractual agreements, costs of monltering and enforcing contractual performance, and costs of resolving contractual disputes. The basic proposition of transaction cost economics Is that the economic

Institutions have the main purpose and effect of economizing on

K. KoJIma and T. Ozawa (1984), p. 36.

t 27 transaction costs. This approach puts greater emphasis on

organizational as against technological features of economic

Institutions and attempts to understand them as governance structure

defined as the "Institutional matrix within which transactions are 23 negotiated and executed." A number of refutable Implications can

be drawn upon addressing problems of economic organization from this

perspective. In particular, the proposed theory maintains that

transaction costs are economized by assigning transactions with

different attributes to alternative governance structures In a

dIscrImInatIng way .

Comprehensive contracting is not a realistic organizational

alternative In the presence of uncertainty. The In ab ility of economic

agents to acquire and process all relevant Information at sufficiently 29 low cost would necessitate an Incomplete contract. Simply put, It

Is uneconomical, if not Infeasible, to write a once-for-all contract

that specifies the full range of contingencies and clearly stipulates

the appropriate responses of contracting parties In every possible

state of nature. This poses serious ex post execution problems, for

failure of transacting parties to write a full contingent contract

See 0. Williamson (1985) for a comprehensive treatment of the nature and significance of the transaction cost approach to the study of economic Institutions.

'PR 0. Williamson (1979), p. 239.

2 9 Williamson calls the limited cognitive ability of human agents "bounded ra tio n a lity ," and disputes the argument that It may be stated alternatively that contractual Incompleteness Is a consequence of costly Information. See 0. Williamson (1985), pp. 45-46. would give rise to a bargaining situation with the corresponding

potential for opportunism - the efforts of contracting parties to

alter the distribution of surplus from the transaction after both

sides have committed. Faced with the prospect that autonomous traders

may experience hazards of incomplete contracting, contracting parties

will have an Incentive to devise governance structures that mitigate

the parties' a b ility to act opportunistically and thereby promote more

e ffic ie n t exchange. Safeguards can take several forms, the most

obvious of which Is common ownership or vertical Integration. But

transactions need not be removed from the market to protect the

exchange relationship from the contracting hazards. A continuum of

potential transactional structures exists that fills In the range

between the extremes of discrete market transaction and hierarchical

organization of the firm.

Which of the alternative modes of organization Is most

efficacious turns critically on particular character 1s t Ics of the

transactions Involved. The principal dimensions with respect to which

transactions are differentiated are asset specificity, uncertainty,

and frequency, of which asset specificity is considered to be the

single most important factor influencing the organizational choice.

The principal Issue of Interest then becomes what governance structure w ill be employed to handle transactions with specific combination of

these characteristics. Transaction cost economics are mainly concerned with the economizing consequences of assigning transactions to governance structures In a discriminating way. The condition of asset specificity arises when durable

Investments are undertaken In support of particular transactions, the

value of which Investments Is much lower outside the comtemplated

relationship than within the relationship. Four different types of

asset specificity are usefully categorized: site specificity; physical

asset specificity; human asset specificity; and dedicated assets.

Site specificity Is present when buyer and seller are In a Mcheek-by-

Jowl" proximity to each other to realize Inventory and transportation

economies and relocation Is costly. Physical asset specificity

prevails when one or both parties to the exchange make Investments In

equipment and machinery with design characteristics specific to the

transaction. Human asset specificity arises when contract execution

generates transaction-specific know-how or skills In a learnlng-by-

dolng fashion and transfer of such knowledge to outsiders Is costly.

Dedicated assets are created when discrete Investments are made that

would not take place but for the prospect of selling a significant

amount of product to a particular customer. Premature termination of

the contract would leave the supplier with significant excess

capacIty.

Such unique features of assets set the stage for what Williamson

refers to as the "fundamental tranformatIon," whereby a competitive

condition at the ex ante bidding stage Is transformed Into a condition of bilateral relationship during contract performance and at contract 83 30 renewal Intervals. Once assets specialized to the particular needs

of contracting parties are put In place, only Imperfect market

alternatives exist In that the value of these assets In other uses

31 w ill be much smaller than the specialized use o rig in a lly Intended.

The specialized nature of assets Implies th:,t the supplier Is exposed

to the risk of rent expropriation to a significant degree. The hazard of opportunistic recontracting Is symmetrical. The buyer also cannot switch to alternative sources of supply without loss of cost advantages supported by specialized assets. This would lock the buyer

Into dependence on the Incumbent supplier as well. Since the benefits from Idiosyncratic exchange relations accrue only so long as the relationship Is maintained, harmonizing the contractual Interface so as to effect adaptability and promote continuity becomes the source of real economic value. Upon recognizing that each Is strategically situated to bargain over the disposition of gains from the transaction, therefore, parties have an Incentive to devise safeguards

See 0. Williamson (1985), pp. 61-63.

31 It is assumed that Investments In specialized assets are necessary to support cost-mInImIzIng transaction and the transfer of specialized assets to a third party Is not costless. Otherwise contracting problems which transaction cost economics focuses on would vanish. Also use versus user distinctions are relevant In this connection. Klein, Crawford and Alchlan define the quasi-rent value of an asset as "the excess of its value over Its salvage value, that Is, Its value In Its next best use to another renter. The potentially appropriable specialized portion of the quasi rent is that portion, If any. In excess of Its value to the second highest-valuing user." Klein et a I . (1978), p. 298. 84

to support cost-mInImIzIng exchange by protecting Investments of the

transaction-specific kind.

The proposition that the Idiosyncratic attributes of transactions

have profound and systematic organizational consequences has been 32 advanced In conjunction with the study of vertical Integration. In

cases where assets are fungible, spot market contracting w ill be the

preferred organizational mode. Not only can an outside supplier more

fu lly exhaust scale economies by aggregating several buyers' demands,

but the threat of ready replacement disciplines performance. In

contrast. If assets are specialized to a relationship, the parties are

lacked Into bilateral exchange with the corresponding hazards of

opportunism and ma ladapatation, on which account autonomous trading

may be supplanted by unified ownership to m itigate these hazards. The

Integrated mode of organization Is better suited to attenuate

opportunism and accomplish effic ie n t adaptations by virtue of its

access, audit, and Incentive advantages. Other things being equal,

nonmarket mode of organization should be more e ffic ie n t to structure

transactions supported by durable, transaction-specific Investments.

Although Internal organization has the obvious monlterlng and

adaptation advantages, this is not without problems of Its own.

Besides the potential sacrifice cf scale or scope economies, the

Integrated mode of organization experiences serious Incentive and

Several transaction cost-based arguments for Integration have been made which emphasize the benefits of "control" In the presence of specialized assets. These include Coase (1937), Klein et al. (1978), and Williamson (1971). 33 bureaucratuc disabilities. Wore efficient organizational

arrangement may obtain If a long-term contract can be devised and

implemented by which parties can assure a continuing relation and

thereby encourage relation-specific Investments. But, given that It

Is Impossible to stipulate and enforce contlngence performance, long

term contracting may suffer from Its lack of fle x ib ility In the face

of fluctuating circumstances. Moreover, the reliance on court

ordering for settling disputes Is thought to be problematic because of

the ex post verification difficulties, hence contract execution should

fall heavily on the Institutions of private ordering. Parties will

therefore wish to choose contract terms that not merely minimize the need for costly adjudication but maintain Incentives for appropriate state contingent adaptations. Many nonstandard or unfamiliar contracting practices can be employed as protective safeguards to effect optimal Incentives. Some type of severance payment as penalty for premature termination can serve as a check upon Incentives to behave opportunist lea Ily by realigning Incentives. Also the expansion of the contractual relation to effect symmetrical exposure to 34 opportunism can support and signal continuity Intentions.

See Grossman and Hart (1986) and Williamson (1985) for recent treatments of the limits of vertical Integration In terms of "control loss" phenomenon. Both papers examine the effects of control loss that attends unified ownership of successive stages and ascribe the Incentive deficiencies of the Integrated mode to the contractual Incompleteness. 34 Williamson (1983) develops a hostage model that Illuminates the uses of nonstandard contracting to effect credible commitments. 86

Empirical research on transaction cost Issues has taken several

distinct approaches to assess the attributes of transactions and their 35 ■contracting consequences. Direct measurement of transaction costs

Is seldom attempted. Instead, most of the empirical Investigations

are addressed to the Question of whether or not organizational

relations and contracting practices line up with the attributes of

transactions as predicted by transaction cost reasoning. Much of the

work In this tradition has been preoccupied with the firm versus

market Issue, typically focusing on the Importance of specialized 36 physical or human assets In the organization of production.

Recently some researchers have begun to concentrate strictly on

market-mediated exchange and attempted to analyze the governance

37 features of long-term contracts. But studies dealing with the 38 organization of distribution are rare.

For a discussion of types of empirical studies In this tradition, see 0. Williamson (1985), PP. 104-5. 36 Examples are Klein et al.'s (1978) examination of the contractual relationship between General Motors and Fisher Body; K. Mont everdo and D. Teece's (1982) study of vertical Integration In the automobile Industry; T. Palay's (1904) analysis of transportation transactions between manufacturers and railroads; and S. Masten's (1964) study of the organization of production In the aerospace Industry.

37 See, for Instance, Joskow (1985; 1987) for analyses of the structure and duration of coal supply contracts between electric u t ilit ie s and coal mines and Masten and Crocker (1985) for an examination of the Incidence of "take-or-pay" clauses In contracts between natural gas producers and pipelines.

An exception Is Anderson and Schm 111leIn's (1984) study of the organization of marketing In the electronic components Industry. 87

To summarize, the study of transaction cost Issues entails an examination of alternative ways by which to govern exchange relations.

Firms, markets, and Intermediate modes are recognized as alternative

Instruments of governance. Which is best suited for mediating a transaction depends on the underlying characteristics of the transaction under scrutiny. The transaction cost theory has developed

into a predictive theory of economic organization as operational content Is added to the theory by Identifying and explicating factors responsible for differences among transactions. In particular, asset specificity Is featured as ciucial In shaping the structure of 39 governance. While this review Is far from exhaustive, It Is sufficient for our purposes to note that the observed disparity In organizational mode and contractual structures governing exchange relations can be traced to the differential attributes of transactions. We now proceed to the examination of the manufacturer's choice among alternative trade channels.

3. Transaction Cost Analysis of Agency Delegation

This section develops a simple conceptual framework based on the transactions cost theory to explore the efficiency ramifications of alternative modes of organizing trading activities. The analysis Is applied to the Japanese general trading companies to understand their product structure and forms of transactions.

Williamson asserts that "asset specificity Is the big locomotive to which transaction cost economics owes much of Its predictive content." 0. Williamson (1985), p. 56. 88

3.1 The Nature of General Trading Companies

Manufacturers who attempt to expand Into a new market need detailed Information about market conditions as they face considerable risks and uncertainty. The difficulty In obtaining market Information would be much greater In the case of foreign trade relative to domestic trade primarily because the former occurs across national boundaries. Despite the great need to secure raw materials from abroad and to find overseas ,u tle ts for manufactured goods, Japanese manufacturers frequently find It quite difficult to acquire Intimate knowledge of foreign markets. Japan Is a remote country from major outside markets like the U.S. and European countries with no close cultural ties to them. UnfamlIiarIty with foreign customs, economic and p o litica l systems, and cultural environment coupled with the lack of foreign language s k ills seems to contribute to the relatively high cost of Japanese manufacturers In obtaining access to external markets. Such environmental elements suggest the usefulness of an

Institution that specializes In foreign transactions to economize on 40 Information costs.

Manufacturers can organize procurement and distribution administratively within firms as well as contractually between firms.

As a marketing specialist with specialized knowledge of foreign

It Is not our intention to address the question of uniqueness of the Japanese sogo shosha. Suffice It for our purposes to state that Japanese manufacturers have particular difficulty In getting into International markets and this can be ascribed to the cultural and language barriers they face. 69 markets, the trading company provides a contractual arrangement whereby manufacturing firms can readily gain low-cost access to

foreign supply sources and markets. To be a viable, alternative channel for foreign transactions,the trading firm must be able to o ffe r procurement or marketing cost advantages to client manufacturing

firms. In most cases, Information on foreign markets has value for several manufacturing firm s .41 Since costs of the additional use of

Information are negligible once Investments have been made up-front to obtain information, significant economies of scale/scope will be captured If a group of manufacturing firms can collectively have an

Independent marketing agent carry out their supply and marketing activities. In other words, by serving as an Information pool, the trading company provides a mechanism through which manufacturing firms can take advantage of Informational economies of scale/scope. Note that the collection of Information and Its use cannot be separated because It is hard to transfer Information through Instantaneous market transactionsdue to the d iffic u ltie s In assessing the value without actual sales and policing resales. A potentially long-term exchange relationship between the trading company and Its client manufacturers must be forged as a way of assigning the Information

Much of the Information concerning overseas markets Is of general use, capable of being u tilized for a variety of transactions and hence subject to economies of scale/scope. For Instance, the knowledge of foreign p o litica l and legal systems, overall economic conditions and government policies, and demographic and cultural characteristics Is apparently valuable to any foreign trader. Also Information from one line of trade may find use In another. 90 collection responsibilities to the trading company and sharing market

Information. This contractual arrangement of common agency delegation will be efficiency-enhancing because the duplication of real resource uses to acquire Information Is avoided. When market Information can be shared with others without additional costs, Investments In collecting and processing the same Information by Individual manufacturers would be wasteful.

3.2 Contractual Problems of Agency Delegation

While the use of common agency such as trading companies allows manufacturing firms to realize economies of aggregation, contractual delegation of trading activities to an Independent agent Is constrained by a number of Incentive and coordination difficulties surrounding the arms-length relationship. First of a ll, contracts are

Invariably incomplete. Many of the contingencies that may arise In the execution of a contract are not foreseeable. Even when all of the relevant contingencies can be specified In a contract, contracts are s t ill open to serious risks since they are not always honored. Open displays of opportunism are not Infrequent and very often litig atio n turns out to be costly and Ineffectual. Furthermore, when the information collection responsibilities are assumed by one of the parties to the exchange, the other party Is subject to the risk that the Information may be filtered and possibly distorted to the advantage of the information gatherer. Inasmuch as contracting parties have asymmetric access to Information, the party which obtains 91 private Information may experience an incentive to exploit Its

Informational advantage at the expense of the other party.

Given that delegation contracts are subject to the ex post performance problems posed by contractual incompleteness and asymmetric Information, it Is necessary to address the following questions to delimit the range of feasible agency delegation; What are the hazards of Incomplete contracting when a manufacturing firm entrusts Its trading activities to an outside agent? What kinds of contractual arrangements can be devised to attenuate the Incentives for opportunism and to facilitate accurate Information transmission?

Upon anticipating that the agency delegation arrangement w ill be plagued by conflicts of Interest and opportunistic behavior, contracting parties wish to adopt autonomous contract enforcement mechanisms that promote harmonious adaptations and preserve the continuity of exchange relations. Whether such binding arrangements can be devised depends c r itic a lly on the characteristics of the transaction. it Is the focus of our study to analyze how the differential character IstIcs of transactions Influence the choice between alternative organizational forms.

When transactions Involved do not require any specific capital commitment to the exchange relationship by contracting parties, expropriation hazards are not likely to be a significant concern. The trading firm makes up-front Investments In obtaining market information and distribution which can be used to export goods supplied by many manufacturers. Since alternative supply arrangements 92 can be made without d iffic u lty , the value of the Investments Is not economically dependent on the behavior of a particular manufacturer.

Also ease of shifting to alternative trade channels. Including direct sales to spot markets, w ill serve as a check on the trading firm's monopolistic behavior In the exchange of Information. Accordingly, as

long as the manufacturer benefits from reliance on the trading firm, a simple contractual relationship can be arranged whereby the marketing responsibilities are turned over to the trading company. In such a situation, the contractual problem reduces to the classic agency problem. If the manufacturer has limited a b ility to observe actions which the trading company takes on Its behalf white the trading company's success depends on Its sales e ffo rts and stochastic state realizations, ex post payment for the marketing services (compensation on the basis of actual sales) w ill o ffer an Insurance against opportunism by the trading firm and provide optimal Incentive to promote sales.

The particular circumstance we single out as likely to produce a more serious threat of ex post opportunistic behavior Is when the underlying transactions require relation-specific capital Investments.

When a manufacturer contracts with a trading company for Its overseas purchases or sales and both parties make Investments In transaction- specific capital, an exclusive vertical supply arrangement obtains where each party Is exposed to the potential hold-up by the other party. The relationship between a manufacturer and a trading company in such cases can properly be treated as an extension of the classical 93 bilateral opportunism. More extensive and complicated business ties must be established than would be necessary under the simple s e lle r- buyer or pr Inc I pa I-agent relationship.

Consider the case when the trading company Is used to open up a new market for a highly-differentiated consumer product. The marketing and distribution of such product requires more Idiosyncratic capital Investments by the trading company. The trading company needs to develop a distribution channrl that is specifically fashioned to meet the marketing needs of a particular product. More specialized

Information on a particular market regarding changes In consumer tastes (such as fashion or style trend), reliability of potential dealers, and price movements has to be obtained. Certain types of marketing a c tiv itie s such as presale promotional effo rts and a fte r sale customer services should be tailored to the characteristics of the product based on the specialized knowledge about design or specifications of the product. Investments should be undertaken to build brand reputation as a way of transferring quality Information to potential buyers. D iffic u ltie s with depending on the external agent

In exporting a specialized line of product are readily apparent. Once the product obtains distribution and the manufacturer's brand name gets established, the manufacturer may be tempted to behave opportunistically against the pioneering trading company by either spreading its distribution or bypassing the trading company.

Certainly, this would lower the return on successful products to the competitive level, denying the pioneering distributor the opportunity to recover Its fixed Investments. This ex post opportunistic behavior

of the manufacturer w ill be avoided If the trading firm distributes

the product under Its own brand name. Hence the trading firm's

ownership of the brand name may be adopted as a contractual device to

assure the compensation of the trading company for Its fixed 42 Investments In Information. Of course, direct payment to the

trading company can be an alternative compensation method. But this

payment scheme would oe inferior because of Its substantial

measurement costs and distort Ivo effects on the Incentives of the

trading company.

The use of the trading firm 's brands has an additional advantage.

Typically, the number of products carried by a trading company Is much

larger than that produced by a manufacturer presumably due to the divergent scale economies. As long as customers react to receiving products of unexpectedly low quality by reducing or stopping purchases of the trading firm's entire line, all the trading firm's nonsaIvageable capital serves to assure the quality of each product it carries. A large trading company has this economy of scale In communicating qua IIty-assurance information to Its customers.

In the U.S., for example, Sumitomo and C. Itoh have set up subsidiaries to market computers and computer-reIated gear under their own brand names. Sumitomo has recently Introduced a 16-blt personal computer built for the company by Matsushita In Japan. C. Itoh also is selling Its own brand o ffic e computers manufactured on consignment basis by Hitachi. Forbes (July 4, 1983). p. 97, and The Oriental Economist (March 1983), p. 36. 95

While the use of the trading company's brands may provide

adequate Incentives to the trading company by serving to create Its

property rights to market Information and brand name capital. It

adversely affects the manufacturer's Incentive to produce high quality

goods. Given the d iffic u lty of e x p lic itly specifying and enforcing

contractually every element of product quality, there clearly is an

Incentive for the opportunistic manufacturer to cheat on quality If

the trading firm's brand name Is used. Because It Is the trading

company which would bear the cost of cheating In the form of reduced

value of Its brand name capital, the manufacturer could make considerable short-run profits by depreciating quality. Some method of preventing the manufacturer from cutting quality has to be devised.

The trading firm may be able to invest In Inspection experience

including direct controls over manufacturer's Inputs, random testing, and monitoring the production process. it also can collect quality

Information from customers. As a means of economizing on direct policing .costs, however, the trading company would share the cost savings associated with the market mode of distribution with the manufacturer by paying a premium to Its manufacturer. If the manufacturer is earning a rental stream whose capital value Is greater than the short-run cheating potential, cheating on quality will be

43 prevented. However, this Implicit contract-enforcement mechanism

This is analytically Identical to the Kleln-Leff ler case of a seller with a reputation who Is prevented from cheating buyers, in their case the seller receives a premium stream for the continued provision of high-quality goods to buyers. See Klein and Leffler (Footnote continues on next page) 96

cannot profitably be employed In circumstances where the cheating

potential Is so large that the extent of short-run profit from

supplying deceptively low quality Is In excess of the total marketing

cost savings. Since the quality-cheating problem will be more severe,

the longer the period of repeat sales and the more costly to specify

and measure quality, one can expect that the use of the trading firm's

brand name w ill be confined to fa irly standardized consumer goods.

Where the quality cheating potential Is substantial, as In highly-

sophisticated consumer durables, manufacturer's own distribution will

be the preferred organizational structure.

It should be noted that the possibility of opportunism Is

symmetrical; the trading company may also act opportunistically. If a

delegation contract confers upon the trading company the privilege of

Intermediating trade for Its client manufacturer on an exclusive agent

basis for efficiency purposes, the a b ility of the manufacturer to take

business elsewhere Is c ritic a l In delineating e fficien t organizational

boundaries. If the manufacturer needs to Invest In production

facilities Idiosyncratic to the exchange relationship, as when it expands production capacity as a response to the expected sales by the trading firm or when it Installs specialized machines to make a product tailored to the tastes of foreign consumers, a situation Is created where the premature termination of the contract would Impose significant loss of value of such assets on the manufacturer. The

(Footnote continued from previous page) (1981). 97

trading company could appropriate the quasi rents of specific assets by taking advantage of Its monopoly position In market Information and distribution. In some cases the manufacturer may attempt to avoid being tied to a particular trading company by developing a second channel that handles a fraction of Its transactions. However, this cannot be achieved without substantial cost penalties, particularly when the trading company controls the brand name or when the trading company gains a first-mover advantage due to the I earnIng-by-doIng process In marketing activities. For Instance, the trading firm may acquire detailed knowledge about Idiosyncratic features of customers and develop special business relationships with them.

3.3 Agency Delegation versus Internal Organization

The foregoing discussion suggests that we should observe considerable variation In the choice of trade channels In response to the characteristics of transactions. In cases where transaction- specific Investments are negligible, opportunism should be minimal and reliance on the trading specialist would be adequate. Standardized commodities that are traded In large quanltles In Internatlonal markets are Ideally suited for the trading firm's business. Raw materials, grains and other food products, and standard Industrial products would be examples. These products are easily traded In large volume but hardly require specialized marketing serlvces. Even when the transaction requires some specialized investments, the market mode of trading may still be favored over direct trading If the trading 98

firm's adventage In scale and scope economies Is large enough to warrant some type of nonstandard contracting. Standard consumer goods such as shoes and te x tile products may fa ll In this category.

However, if both manufacturing and trading firms make substantial transaction-specific Investments, Internal organization ts likely to be desirable to mitigate complicated Incentive and adaptation problems. This would be the case for products which require extensive and specialized marketing activities. Highly-differentiated consumer durables and specialized Industrial machinery appear to be prime candidates for the Integrated governance mode.

Implications of our transaction cost analysis for the choice of trade channels accord with the pattern of agency delegation experienced by the Japanese general trading companies. Table 19 shows the sogo shosha's share In Japan's International trade by commodity groups for each of the three years. It reveals that general trading companies have demonstrated their competitive strength In handling standardized consumer products, raw materials, and Industrial

Intermediate products. In 1980, for Instance, the nine general traders collectively handled 87.2 percent of Japan's metal exports.

61.4 percent of chemical exports, 51.1 percent of te x tile exports, but only 43.2 percent of machinery exports. On the Import side, they were responsible for 92.9 percent of metals, 70.7 percent of foodstuffs, and 56.5 percent of textiles. But their share In machinery Imports was a mere 28.1 percent. Table 20 provides

Information on the competitive position of all trading firms vis-a-vis 99

Table 19: Share of Exports and Imports of the Ten Largest Trading Companies by Commodity

(a) FY 1971

Commodi tv______ExPQf ts ______Imports Food and tobacco 45.9 58.7 Text Iles 56.1 60.5 Wood, pulp, and paper 38.6 69.8 Animal and plant products 43.6 59.4 CoaI, pet roIeum 31 .3 41 .8 Chemical products 51 . 1 34. 1 Ferrous metals, metal products, and ores 68.0 81 .0 Nonferrous metals and ores 26.5 44.3 Mach I nery 42 8 39.2 Others 11-0 50.9 Source; Tsusho Sangyosho (M ITI), Book I gyotal tokelhyo (Foreign Trade Statistic*! by Industries), 1971, as cited In Asia's New Giant (1976), p. 393.

(b) FY 1975

Commodity______Exports ______Imports We ta I s 81 .8 53.5 Mach I nery 47.2 42.1 Chem(caIs 64.7 78.2 Foodstuf f 100.0 81 .3 Text I les 60.8 73.5 Others _ ... . 34.9 ...... 33.1 * Metal raw materials and mineral fuel. Source: Nihon kelzal nl okeru shosha no yakuwar1: genjo to tenbo, p. 7. Tokyo.- Mitsui & Co.. 1976, as cited In A. K. Young (1979), p. 7.

Commodity______Exports ______Imports Meta Is 87.2 92.9 Mach I nery 43.2 28.1 Chem I caIs 61 .4 37.3 Foodstuf f 44.6 70.7 Text I les 51 . 1 56.5 Fue I 50.1 Source: KKC Brlef 15 (January 1984), Tokyo: Kelzal Koho Center. 100

Table 20: Share of Exports and Imports of Japan's Traders by Commodity

(a) FY 1974

Exoor ts Imoor ts Commodity Trading Manu Others Trad 1 ng Manu Others companies^ facturers comoanles facturers Food and tobacco 85.9 13.6 0.5 93.0 6.9 0.1 Tex 11 les 85 . 3 12.9 1 .8 88.5 11.4 0.1 wood, pulp, and paper 91 .2 8.7 0. 1 91 .5 8.4 0. 1 An ImaI and pI ant produc t s 71 .6 28.0 0.4 97.2 2.6 0.2 CoaI, pe t roIeum 52.5 47.5 45 .6 54 .4 ChemlcaIs 80.8 19.1 0. 1 77.8 19.6 2.6 Ferrous metals ^nd met a I produc t s 92 .0 7.9 0. 1 87.5 12.5 Non-ferrous metals and metaI products 88. 1 11 .8 0.1 96.6 3.2 0.2 Machinery and equIpment s 55 . 1 44.7 0 2 82.9 17.0 0.1 Others 71.2 28.2 0.6 89.7 9.6 0.7 Source: Tsusho Sangyosho (M ITI), Tsusho • Hakushc > (International Trade Wh i te Paper), p . 1027,, Tokyo: Tsusho Sangyo Chosakal, 1976.

(b) FY 1983

Exoor ts Imoor ts Commodity Trading Manu Ot hers Trad Ing Manu Others comDan 1es facturers comoanles facturer s Food and tobacco 8 . .6 15.4 3.0 93.8 5.7 0.5 Tex t 1les 92.5 6.9 0.6 90.6 9.3 0.1 Wood, pulp, and paper 88.4 11 .6 89.5 10.0 0.5 Animal and plant products 61 .8 38.0 0.1 90.3 8.7 1 .0 Coa1, petroleum 67.0 33.0 57.7 42.2 0.1 Chem1ca1s 72.9 26.9 0.2 73.6 25.7 0.7 Ferrous metals and metal products 86.6 13.2 0.2 87.6 12.3 0.1 Non-ferrous metals and metal products 78.7 21 .1 0.2 82 .7 15.7 1 .6 Mach 1 nery and equIpment s 51 .7 47.4 0.9 74.6 25.2 0.2 Others . 29*7 69.0 1.3 89.8 9.4 0*8 Source; Tsusho Sangyosho (M ITI), Boekl gyotal tokelhyo (Foreign Trade S tatistics by Industries), p .26, Tokyo: Tsusho Sangyo ChosakaI, 1984. manufacturers In Japan's foreign trade, It also discloses that

trading firms have played an active role In the export of textiles,

wood products, metals and metal products, chemical products, and food

products. By contrast, trading companies have been much less

Important In marketing what Is broadly categorized as machinery and

equipment. This Is where the share of manufacturers In fiscal 1983

was largest with 47.4 percent. Import trade shows a similar pattern.

Trading companies had a commanding position In each category of basic

materials, reflecting their vital role In securing industrial Inputs

for domestic manufacturers. Their share In machinery and equipment

Imports In fiscal 1983 was 74.6 percent, much larger than 51.7 percent

In the case of export. But they had a relatively limited rote In coal

and petroleum Imports (42.2 percent). Overall, these observations

Indicate that the role of trading firms has been far less Important In

highly-differentiated consumer products and specialized Industrial

machinery than In standard consumer and Industrial products, semi

processed products, and raw materials. Manufacturers of such

sophisticated products as automobiles, electric and electronic

products, precision Instruments, pharmaceutical and cosmetic products

have generally bypassed trading firms and successfully organized own 44 distribution network In overseas markets.

In fact,as Japanese exports came to be Increasingly dominated by

such complex consumer durables as color TVs, computers, automobiles,

See, for example, M. EmorI (1971), H. Yoshlhara (1981), A. K. Young (1979), and Y. Tsuruml (1976). 102

diverse appliances, and specialized Industrial machinery, the trend

toward manufacturers' direct sales became prominent and consequently

the position of trading companies has been gradually eroded. Table 21

shows how the product composition of Japan's exports and Imports has

developed over time. Over the past 20 years or so, Japan's relative

dependence on textiles has been greatly reduced. Export expansion has

been most significant In machinery and equipment. In 1983, about 68

percent of Japan's exports consisted of automobiles, ships, electrical

machinery and Industrial plants. Over 47 percent of these exports

were carried out directly by manufacturers. Whereas machinery

transactions were responsible for only 22.1 of the nine sogo shosha’s

total sales, these transactions accounted for more than 75 percent of manufacturers' total exports (see Table 22 and 23). in the case of

Imports, the share of basic materials such as te x tile and metal raw materials has declined considerably, reflecting the rapid

transformation of Japan's Industrial structure. Fuel witnessed the

largest expansion. In 1983, crude oil comprised 31.7 percent of

Japan's total Imports. More than 42 percent of coat and petroleum were directly Imported by manufacturers, accounting for nearly 80 percent of manufacturers' total Imports. But fuel transactions were responsible for only 16.5 percent of the sogo shosha's annual turnover (see Table 22 and 23).

With the structural sh ift In Japan's International trade, an

Increasing number of manufacturers started exporting their products

Independently as well as making their own purchases of foreign raw 103

Table 21: Commodity Structure of Japan's Exports and Imports.

(a) Exports

1960 1970 1983 Foodstuff 6-6 3.5 0.9 Text Iles 30.2 12.5 4.5 Nonferrous metal products 3.6 1 .9 1 .5 ChemIcaIs 4.2 6.4 4.8 Metal products Steel 9.6 13.2 8.7 Others 3.9 6.5 3.6 Machinery and equipment Genera I 5.5 10.4 15.7 Electric 6.8 14.8 20.6 Automob Iles 2.6 6,9 17.8 Sh I ps 7.1 7.3 4.1 Others 3.3 6.9 9.6 Others 16.4 9.8 8.1 Is-tal______10Q.0______H HM 3______100.0

(b) Imports

1960 1970 1983 Foodstuff 12.3 15.0 14.9 Paw mater I a Is Tex 11 le 17.6 5.1 1 .6 Meta 1 15.0 14.3 5.2 Wood 3.8 8 3 3.1 Others 12.7 7.7 4.5 Fue 1 Crude o l 1 10.4 11 .8 31 .7 Others 6.1 8.9 14.9 Manufactures Machinery and equipment 9.0 12.2 8.2 Chemi ca1 5.9 5.3 5.7 Meta 1 5.0 6.8 4.7 Text Ile 0.4 1 .7 2.4 Others 1 .6 3.8 4.3 Others 0.2 0.5 1.9 Total 100.0 100.0 _ 100.0 Source: Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Trade White Paper), p. 802, Tokyo: Tsusho Sangyo Chosakal, 1984. 104

Table 22: Share of Various Commodity Groups In the Nine Largest Trading Companies' Sales, 1983, (X)

F _ u e L Ml tsublshi 29.9 2 2 .2 19.8 8 . 0 12.5 7.6 Mltsul 20. 3 26.0 16.7 11.3 14.9 4.0 6 .8 C. 1 ton 14.5 21 .7 32.9 13.7 4.6 4..6 Ma ruben1 26. 1 19.7 27.4 11.3 9.2 6 .3 Sumitomo 27.4 28.9 25.4 6 .8 2 .6 8 .9 N1ssho-Iwa1 29.8 30. 3 18.8 7.8 5.6 7,.7 Toyo Menka 17.3 2 0 .6 26.8 15.1 15.8 4 .4 Kanenutsu 32. 1 13.3 15.6 3.4 11.1 18.3 6 . 2 Niciiimfin 32.9 29.4 8 .8 13.9 10.4 4 ,6 Tota 1 16.5 22.5 22.1 13.7 1 1 .8 8 .1 5 .3 Source: Sogo Shosha Nenken (General Trading Company Yearbook), pp.70- 71, Tokyo: Selkei Tsushinsha, 1985.

Table 23: Share of Exports and Imports of Japan's Traders by Commodity, FY 1983

Expor ts Imports CommodIty TradIng Tr ad Ing comoanles Manufacturers companles Manufacturers Food and tobacco 1 . 1 0.3 14.8 2 .2 Tex t i I es 5.4 0 . 6 4.2 1 .1 Wood, pulp, and paper 0 .8 0 .2 4. 1 1 .1 Animal and plant products 1 .4 1 .2 2.3 0.5 CoaI, petroleum 1 .8 1 .2 44. 1 79.7 Chemlca1s 5.2 2 .6 3.7 3.2 Ferrous metals and metal products 16.9 3.5 16.2 5.6 Non-ferrous metals and meta1 products 2 .2 0 . 8 2.9 1 .4 Machinery and equ1pment 60.4 75-4 5.3 4.5 Others 4.8 14.2 2.4 0.7 Total 1 0 0 .0 1 0 0 ,0 1 0 0 .0 .100.0. Source: Tsusho Sangyosho (MITI), Seek I gyotal tokelhyo (Foreign Trade Statistics by Industries), p .25, Tokyo: Tsusho Sangyo Chosakal, 1984. 105

materials. Many leading manufacturers In the area of highly-

differentiated consumer products chose from the outset to undertake

their own marketing abroad and succeeded In organizing direct sales In

45 foreign markets. Other large-scale manufacturers, which usually

depended on trading firms to cultivate in itia l sales and develop new

markets, also have begun to take primary marketing responsibilities

away from trading firms particularly In such key export markets as the

U.S. and European countries. The result of this development would be

reflected In a considerable Increase in the manufacturers' share of

both Japanese export and Import and a proportionate drop for trading

companies. Table 24 demonstrates that the Importance of trading firms

In Japan's foreign trade has been steadily decreasing. The percentage of exports handled by the trading companies was 82.7 percent In 1960,

68.9 percent In 1970, and most recently 57.2 percent In 1983. A

similar trend is observed In Imports. Whereas the trading companies

were responsible for 83.8 percent of Imports In 1960, the percent

dropped to 80.8 percent In 1970 and 71.1 percent In 1983.

While trading companies have played a limited role In the

machinery and equipment fie ld In general, they also have experienced

varying degrees of success within this same product category. As

stated e a rlie r, the contractual d iffic u ltie s Involved In the

transaction of specialized consumer and Industrial goods make Internal organization more appealing. Nevertheless, a manufacturer may still

Examples of such companies are Sony, Matsushita, Honda, and Toyota. Forbes (July 10, 1978), p. 90. 106

Table 24: Shifts in Trading Companies' and Manufacturers' Share of Japanese Exports and Imports ,1952-83, (X)

FI sea I Exoor ts ImDorts year Trad Ing Manu - Trad Ing Manu-

comDanles s' d l LL1I Cl a uliici 5 companies facturers Others 1952 90.7 9.3 88.9 1 1 .1 1953 64.4 15.6 8 6 . 1 13.9 1954 82.5 17.5 8 6 .6 13.4 1955 8 6 .0 14.0 82.4 17.6 1956 83.0 17.0 85.2 14.8 1957 82 .0 18.0 86.7 13.3 1958 78.9 21 . 1 82.7 17.3 1959 80. 2 19.8 84.2 15.8 1960 82.7 17.3 83.8 16.2 1961 79.7 20. 3 83.4 16.6 1962 78.1 21 .9 81 .3 18.7 1963 75.2 24 .8 82.2 17.8 1964 75.0 25.0 81 .9 18.1 1965 72 .4 26.6 1 -0 80.9 18.7 0.4 1966 71 .6 26.7 1 .7 81 .4 18.1 0.5 1967 70.9 27.4 1 .7 81 .3 18.1 0 .6 1968 70.6 28.0 1 .4 82.2 17 .3 0.5 1969 69.3 28.8 1 .9 81 .0 18.0 1 .0 1970 68.9 29.8 1 .2 80.8 17.8 1 . 4 1971 69.5 30.0 0.5 79.7 19.1 1 .2 1972 67. 1 32.4 0.5 78.8 19.6 1 .6 1973 67. 1 32.2 0.7 77.7 21 .7 0 .6 1974 70.0 29,7 0.3 70.0 29.8 0 .2 1975 6 8 .8 30.6 0 .6 70.9 28.6 0.5 1976 6 8 .2 31 ,2 0 .6 6 8 .2 30.8 1 .0 1977 65.8 33.4 0 .8 67.5 31 .1 1 . 4 1978 64.5 35.0 0.5 69.3 30.3 0.4 1979 65.1 33.9 1 .0 67.2 32.3 0.5 1980 62.8 36.7 0.5 64.6 35.2 0 .2 1981 62 . 2 36.6 1 .2 6 6 .0 33.7 0.3 1982 60.4 38.2 1 .4 67.9 31 .8 0.3 1983 57.2 42.1 0.7 71 . 1 28.8 Q.1 * FY 1952 and 1953 start October 1 and end September 30 of the fo 1 lowing year. After FY 1954, fiscal year starts April 1 and ends March 31 of the following year, MITI statistics do not give detailed breakdowns untI I 1965. Source: Complied from Tsusho Sangyosho (M ITI), Tsusho Hakusho (International Trade White Paper), annual volumes, 1954-1985, Tokyo: Tsusho Sangyo Chosakal. 107

find It advantageous to rely on trading firms for rarely occurIng

transactions. From any single manufacturer's viewpoint, It may not be profitable to Invest In building up own trade channel for rare and uncertain business opportunities which crop up In various corners of

the world. Potential losses from opportunism and In fle x ib ility are

likely to lower than the setup costs of the Integrated governance mode. As a transaction recurs more frequently, however. Integration becomes more desirable since potential losses from market contracting outweigh the overhead costs of Integrated structure. Accordingly, greater reliance on trading companies Is anticipated for uncertain and random transactions than for regular transact ions.

It Is complex consumer durables such as electric and electronic products, automobiles, watches, computers, and cameras where general trading companies have been bypassed most frequently. For Instance, only five percent of the total home electronics exports In 1976 was exported through the nine general traders. Their combined export of automobiles In that year was less than half of Toyota's total 46 sales. Compared with automobiles and consumer electronics, the sogo shosha have done much better with ships, m ilitary hardware, aircraft, roI I Ingstock, and Industrial plants. It Is estimated that the sogo shosha collectively handled nearly 70 percent of Japan's 47 total plant exports. These products Illu s tra te the kind of

Sogo Shosha Nenken (General Trading Company Yearbook), 1980, pp. 214-15.

47 M. Y. Yoshlno and T. B. Llfson (1986), pp. 73-74. 108

transactions for which the sogo shosha can effectively utilize their

worldwide Information network and exploit their ability to seek and

organize m ulti-party business deals.

In general, exporting requires more idiosyncratle capital

Investments than Importing, other things being equal. The trading

company often needs to create physical as wall as Intangible assets

specific to a manufacturer to support the efficient distribution. The manufacturer also may Invest In production facilities contlgent upon a

particular supply agreement. A condition of greater bilateral

dependency thereby obtains, rendering the use of the trading company more difficult. This Is particularly so In the case of differentiated consumer products where the absence of organized markets In conjunction with the specialized character of the product would reduce the p o ssib ility of alternative business arrangements.

On the other hand, the potential for hold-up would be much smaller In the case of purchasing Industrial raw materials and

Intermediate products. Manufacturers usually can secure their Input supplies through various alternative channels. For example, the trading companies lite r a lly enjoy a monopoly for the Import of Iron ore and coaking coal. But this closed-knit relationship between the trading companies and the major resource users are not expected to pose a serious threat of monopoly exploitation, for the manufacturers always have the option of purchasing directly In International markets. Other basic commodities that are actively traded In world markets, such as grains, fertilizers, textiles, and wood products may 109

also bo examples. Moreover, with diverse manufacturers as potential

customers, the general trading company w ill be more w illing to Import

these standard, homogeneous goods without being exposed to the hazard

of opportunistic recontractIng by customer manufacturers. Hence, one

can expect that Import trade w ill be conceded to trading firms to a

greater degree than export trade.

Table 24 reveals that It Is on the Import side that the trading

companies have had a larger role In the Japanese trade. It also shows

that the decline In the Importance of trading firms In Japan's

external trade has been more marked for exports than Imports. The

fraction of Imports handled by trading firms droped from 88.9 percent

In 1952 to 71.1 percent In 1983, whereas their share of exports

declined from 90.7 percent to 57.2 percent during the same period.

Even large manufacturers who gsnerally tend to prefer taking greater

role In exporting their own products have chosen to rely on trading

firms for Imported raw materials and Intermediate products.

Additional Implications can be derived by recognizing that temporal elements. Including manufacturers' learning and varying sizes of transaction, may Influence the organizational choice. The benefits from relying on a trading company will be significant especially for a manufacturing firm whose volume of transaction Is not sufficiently

large to Justify own distribution or procurement. The comparative assessment of specialization economies against governance cost disadvantages favors indirect trade through a trading specialist.

Thus one can expect to observe a larger role of trading firms In new 110

or small markets and for small manufacturers than In established

markets and for large manufacturers. Indeed, the existence of small

Japanese manufacturing firms completely specialized In the production

of export goods Is sometimes attributed to the presence of huge

48 general trading companies.

it can be seen from Table 25 that the preponderance of the sogo

shosha in Japan's foreign trade has been In trade with the developing

and communist bloc countries rather than with the Industrialized

countries of North America and Western Europe. In fiscal 1973, a

dozen or so large trading companies handled 61.2 percent of Japan's

exports to Latin America, 61 percent to Western Asia, 56.1 percent to

the communist bloc, and 53.1 percent to Southeast Asia respectively.

In contrast, these firms were responsible for less than 40 percent of

Japan's exports to North America.

Table 26 Illustrates the geographical structure of the trading

firms' business In fiscal 1983. It also reveals that although trading

firms have gradually been bypassed by manufacturers, manufacturers'

direct Involvement In trading activities Is mainly confined to such

large markets as European countries and the U.S. In export trade,

only in North America and Western Europe did manufacturers outperform

trading companies. In such regions as Southeast Asia, Africa, Middle

H. Patrick and H. Rosovsky (1976), p. 391. In Japan, as elsewhere, large manufacturing firms on average export a larger share of their output than small ones. However, among manufacturers that export, small firms are more export specialized. For a discussion of Japan's production and export structure In terms of firm size, see W. V. Rapp (1976). 111

at Table 25; Geographic Structure of Exports of Large Trading Companies, FY 1973, (hundred million yen)

Geographic region Japan's total Larae tradlna comoanles exoorts(A) Number of fIrms_ ..ExDor ts(B) B/A Southeast Asia 31,511 12 16,723 53. 1 Western Asia 7,250 12 4,425 61 .0 Western Europe 20,344 12 8,396 41 . 3 Nor t h Amer i ca 35,195 12 14,030 39.9 Latin AmerIca 1 0 ,1 1 1 11 6,189 61 . 2 Africa 14,280 12 6,444 45.1 Ocean I a 5 ,853 1 2 2,580 44 .1 Communist bloc 8.504 12 4.768 56.1 * Annual exports exceeding 100 bl 1 1 Ion yen. Source: Tsusho Sangyosho (M ITI), Boek I gyotaI tokelhyo (Foreign Trade S ta t1st les by Indust rIe s ) . PP • 148-49, Tokyo: Tsusho Sangyo Chosaka 1 , 1975.

Table 26: Geographic Structure of Exports and Imports by Type Of Tr ader , FY 1983, (X)

(a) Exborts Tradina companies Manufacturers Others. Tota I Southeast Asia 67.5 32. 1 0.4 100 Western Asia 65.8 29.9 4.3 100 Western Europe 44. 1 55.7 0 .2 100 Nor t h Amer I ca 45.5 54.3 0 .2 100 Latin AmerIca 58.4 41 .5 0 .1 100 AfrIca 62 .9 36.9 0 .2 100 Ocean I a 54.2 45.1 0.7 100 Communist bloc 80. 1 19,7 0 .2 10Q Exoort share 57.2 42.1 0.7 100

(b) Imports______Trading companies _ Manufacturers ___ Others ______Total Southeast Asia 74.1 25.7 0.2 100 Western Asia 47 .5 52.4 0.1 100 Western Europe 75.7 23.9 0.4 100 Nor t h AmerIca 88.3 11.2 0.5 100 Latin AmerIca 80.6 19.4 100 Af rlea 84 .2 15.8 100 Ocean I a 8 8 .6 11.3 0.1 100 Communist bloc 72.6 27.2 0.2 100 Import share 71 .1 28.8 0.1 100 Source: Tsusho Sangyosho (M ITI), Boek1 gyota1 tokelhyo (Foreign Trade Statistics by Industries) , p .28, Tokyo: Tsusho Sangyo ChosakaI. 1984 . 1 12

East, and Latin America, trading firms' share far exceeded that of manufacturers. The bulk of trade with communist bloc countries has -49 also been undertaken by trading firms. There are two major exceptions to this pattern In Import trade: the dominance of trading firms In North America and their Insignificant share In Western Asia.

The former Is explained by their overwhelming weight in the Import of

American grains and raw materials. The latter phenomenon Is mainly due to the long dominance of major International oil companies.

Our analysis also suggests that the trading company w ill be more frequently relied on In the Initial stage of developing new markets.

Once the distribution of the manufacturer's product Is well established In foreign markets and the trading firm ’s private

Information about market demand conditions and marketing cost structure Is revealed to the supplier manufacturer, the manufacturer w ill have an Incentive to avoid the costs associated with using outside trading agency by directly engaging In export activities after the pioneering trading company manages to recoup Its fixed costs during the Initial period of distribution.

The way In which complex consumer goods are exported from Japan has changed In a manner consistent with our expectation. The task of exporting consumer products such as electronic appliances and

Most communist bloc countries as well as some developing countries prefer to engage In barter trade. Since payment is made in goods rather than hard currency, the seller must find buyer for the products received elsewhere. It Is not surprising that such deals are handled by general trading companies. 113 automobiles was frequently delegated to the trading companies In the early stage of market development. But In most of these cases, as the manufacturers gained experience and b u ilt sufficient volume, they terminated or reduced their relationships with the sogo shosha by expanding sales and service facilities independently. Specialized distribution operations came under control of manufacturers with trading companies maintaining only minority ownership. Most of the s t i l l existing tie-ups between producers and trading companies date back to the early period.50 For example, for some time Mitsui marketed Toyota automobiles In some parts of the U.S. and Canada. But as the market expanded, Toyota dropped Mitsui and started selling cars on Its own. Often trading companies are left with the respons lb I I I ty of handling occasional transactions and transactions In new or small 51 markets, such as communist bloc and developing countries.

A similar line of reasoning can help to explain the development of export channels of many developing countries. For years, exports from countries such as Korea, Taiwan, Kong Kong, and Singapore have been concentrated on the U.S. market. In 1984, some 40 percent of their combined export total of $93 b illio n was shipped to the U.S.

With few sophisticated consumers at home, producers In these countries were often baffled by American tastes. Most of them have found it

50 K. KoJIma and T. Ozawa (1984), p. 36.

51 Nissan, the second largest automobile maker In Japan, used general traders for about 3 percent of Its exports In 1980, primarily In A frle a . 114 profitable to buy out existing brand names of their U.S. customers

Including Sears. M attel, and IBM and to entrust the marketing of their 52 products to established U.S. distributors. However, as these manufacturers become more experienced and knowledgeable about the U.S. market, they begin to switch to marketing their products directly

53 under their own brand names, spending large sums of money In advertising and establishing U.S. marketing offices.

3.4 Third-Country Trade and Foreign Direct Investment

As the position of general trading companies In Japan's foreign trade has been eroded with the steady decline of their traditional

Industries such as Iron and steel, petrochemIcaIs, and textiles, general trading firms have promoted offshore trade and overseas manufacturing Investments as an attempt to Internationalize their trade activities. The transaction cost analysis of the trading firms' trade sturcture Is readily transferable to their third-country trade and overseas Investment a c tiv itie s .

General trading companies have attempted to expands their role of trade Intermediation beyond export and Import transactions between

Japan and Its trading partners. Third-country trade, trade between

Business Week (July 22, 1985). P. 136.

53 Among them are Gold Star television sets and Samsung microwave ovens from Korea, Pro-Kennex tennis rackets from Taiwan, Gloria Vanderbilt products from Hong Kong, and Singapore's Tiger brand beer. See Business Week (July 22, 1985) pp. 136-42 and Time (February 10, 1986), p. 67. countries not Involving export from or Import Into Japan, has been

Increasing rapidly. Whereas trade of this type totaled only 350 million dollars In 1960, this Jumped to 47.21 billion dollars In 1983, accounting for 13.4 percent of the sogo shosha's total sales In that year (see Table 27). Offshore trade Is accelerated In part by sogo shosha's Investments overseas and partly by the widespread use of counterpurchase practices of developing countries. But this trade Is stimulated for the most part as the products trad itio n ally handled by the sogo shosha shift to developing and newly Industrialized countries. This Is reflected In the commodity structure of their offshore trade. It can be seen from Table 27 that third-country trade

Is concentrated on Internationally marketed products that are dealt on a large scale and are suitable for barter deals with third countries.

In 1960 more than half of third-country trade was made In foodstuffs.

It has expaneded to encompass a variety of products, such as crude o i l , oil products, Industrial plants, machinery and equipment associated with plant projects. However two products, foodstuffs and fuel and chemicals, accounted for more than 60 percent of third- country trade In 1981.

Trading companies have actively participated In manufacturing activities abroad In partnership with Japanese manufacturers. Most often these Investments are tied to their handling the supply of

Intermediate materials, parts, and components as well as the sales of finished goods. That their foreign Investments are Intended to expand their role as foreign trade agents Is reflected In the commodity and 1 16

geographic profiles of their manufacturing Investments. Overseas

manufacturing investments of the general traders tena to center around

standardized consumer and Industrial products for which trading

companies tra d itio n a lly have served as export agents, such as

te x tile s , metals and metal products, chemicals, and sundries (see

Table 28). In i960, these Industries represented 22.3, 19.6, 17.3 and

12.9 percent, respectively, of the sogo shosha's total manufacturing ventures. Small manufacturers. In particular, have depended on general trading companies to assist them In setting up Investments and promoting manufacturing operations abroad. General trading companies,

however, have not been of great help to large manufacturers of

technologically sophisticated products such as consumer electronics and automobiles. These manufacturers usually invest abroad without

trading companies as Investment partners. The concentration of the

trading companies' manufacturIng Investments In developing countries seems to reflect the fact that most of their ventures are labor-

54 intensive fabrication or assembly-type operations (see Table 29).

Two explanations have been offered for the trading companies' capital participation In client manufacturers. It Is often suggested that general trading companies get Involved In overseas production in partnership with manufacturing firms In order to maintain and expand

Note that the majority of manufacturing Joint ventures are In those Industries In which Japan Is losing its competitive advantage. Therefore, It would be reasonable to argue that Japanese trading firms try to protect their export markets by establishing production bases In foreign countries In partnership with manufacturing firms. 117

Table 27: Third-Country Trade of the Nine Sogo Shosha. (% ; b I I Mon do I I ar )

Fiscal Foods tuf f Textiles Machinery Metals Fuels, Ot her s Tot a I year chemicals 1960 50. 3 27.3 6.4 5.5 3.2 7.3 0.35 1981 33. 1 5.6 10,7 9.6 37.1 3.9 .47.^21 Source : KKC Srlef 15 (January 1984), p. 3, Tokyo: Kelzal Koho Center .

Tab le 28: Overseas Manufacturing Ventures of the Sogo Shosha, March 1980

Commod 1t y______Number of ventures ______% Tex tile s m 152 22. 3 Metals and metal products 134 19.6 Chemlea Is 1 18 17.3 Sundrles 88 12.9 Food processing 63 9.2 Electr Ic machInery 47 6.9 Non-electric machinery 27 3.9 Transport equipment 26 3.8 Iron and steel 15 2 .2 Stone. clav and a I ass 12 1 .8 Total by company 682 1 0 0 .0 * Metals Include only non-ferrous met a Is while metal products Include both ferrous and non-ferrous metal products. Source: K. KoJIma and T. Ozawa, Japan's General Trading Companies. p. 96, Paris: OECD, 1984.

Table 29: Regional Distribution of the Sogo Shosha's Overseas Ventures, March 1980

ManufacturIng ventures AuxI I Iarv tradIna ventures Realons Number X Number X As I a 364 53.4 47 19.2 Lat In AmerIca 134 19.6 15 6 .1 Af r lea 32 4.7 6 2.4 Middle East 17 2.5 3 1 .2 Nor th AmerIca 77 1 1 .2 93 38.0 Europe 28 4 .1 58 23.7 Oceania 30 4.4 23 9.4 Total by compan 682 1 0 0 .0 245 1 0 0 .0 Source: K. KoJIma and T. Ozawa, Japan's General Trading Companies, p. 92, 100, Paris: OECD, 1984. 118 55 "shokan", or trading rights. That Is, the Investment by trading firms In Jointly owned business Is regarded as a means of securing benefits from taking charge of procuring raw materials and marketing finished products on behalf of the Joint venture. It Is then simply alleged that this Is responsible for the low share of ownership of general trading firms with average size hovering below 30 percent.

Note, however, that the trading company could Intermediate transactions arising out of the organization and operation of Joint ventures even without equity participation or credit extension whenever Its Intermediation Is the lower-cost method of procurement and distribution. The second explanation Is based on the argument that the sogo shosha represent a third and probably most efficient way, alongside with markets and Integrated firms, of linking technologically separable units of production Into a coordinated

p n product system. w The trading firm's equity ownership and credit advance then contribute to Its leverage over client manufacturers which the trading company needs to subordinate system members' short term Interests to long term system welfare.

Contrary to these explanations, we submit that equity Investments and loan extensions are required as a long-term commitment on the part of the trading company In conjunction with Its partners' Irreversible,

See, for example, N. Shloda (1978), p. 155. H. Yoshlhara (1981), pp. 70-74, K. KoJIma and T. Ozawa (1984), pp. 72-73, and M. Y. Yoshlno and T. B. Llfson (1986), p. 53.

Yoshlno and Llfson (1986) 119 specialized Investments. Because of their superior access to market

Information and broad distribution network, general trading companies are In a better position to Identify profitable Investment opportunities abroad for manufacturing firms and can offer access to market In exchange for the exclusive right to purchase a significant portion of output. Williamson's dedicated assets, which are defined as those that are put In place contingent upon particular supply arrangements, are created and thus complex contract enforcement problems are posed on accounts of uncertainty In future demand and prices. Should the contract be orematually terminated, the manufacturer would Incur experience significant excess capacity. Once one-time sales of plant equipment and machinery are completed, the trading company may have no continuing Interest In nurturing the new enterprise. The capital commitment In the form of equity or debt

Investments by the general trading company Is required to assure that it hold up Its end of the bargain. The costs of opportunism. If practiced, will have to be Incurred by the trading company Itself.

Such credible commitments operate In the service of efficiency because they are undertaken to safeguard an exchange relationship.

The higher equity ownership ratio and the more frequent use of long-term loans In overseas resource development projects compared with Joint manufacturing ventures are consonant with our performance bond argument. According to the transaction cost theory, other things being equal, the magnitude of the hazards should vary d irectly with the Importance of transaction-specific Investments. This problem of 120 opportunism should In turn affect the nature of contractual

relationships. Development projects In the area of natural resources generally require a great amount of capital outlay than most manufacturing ventures. Larger fluctuations of raw materials prices on a global balsls further contribute to the greater potential for hold-up. Hence greater commitment of the trading company Is necessary to safeguard the long-term supply contract. CHAPTER IV

SUMMARY AND CONCLUSIONS

This dissertation deals with the Issue of division of resoonsI bI I 111es for distribution between manufacturing firms and marketing specialists. Two specific phenomena of interest-U.S. private branding and Japanese general trading flrms-are oxamlned to develop the argument that the need for e ffic ie n t acquisition and transmission of Information has a significant Impact on the way distribution Is organized.

Manufacturers desire to organize their distribution system In a way that yields the e ffic ie n t transmission of product Information to potential consumers. Our analysis of prlvte branding has focused on the implications this has for the allocation of brand ownership between manufacturers and distributors. Specifically, in a model that

Is addressed to the question of when and why manufacturers w ill choose to go Into private brand sales, we have developed circumstances where private branding emerges as an element of the e ffic ie n t manufacturer- retalter contract. Private branding Is motivated by the manufacturer's desire to have Information on Its product passed along to consumers efficiently by eliminating free-fldlng among Its dealers.

The free-rider argument for private branding presented here rests on

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the potential for brand names to separate the re ta il market. To the extent that consumers rely on brand names for d ifferentiating products, private brand sales can profitably be Implemented to alter retailers' Incentive to transfer Information to consumers.

Our analysis Implies that private branding may serve as a substitute for other means of Information transfer such as RPM. The choice between alternative Instruments Is likely to be governed by the relative cost effectiveness of Implementing such contractual arrangements. If discount competition can be prevented by RPM or other means at lit t le or no cost, Instances of private branding w ill be much less frequent. In a comparative Inst I tut Iona I sense, however, private branding can be an advantageous methodof fa c ilita tin g transfer of Information: In certain cases It may be the best genuinely feasible way of coping with free-rider problems because of limitations on manufacturers' ability to establish and protect their brands through other methods of securing control over distributors.

The most obvious question to be answered Is whether the free riding argument has any explanatory power beyond that provided by the traditional excess capacity or price discrimination argument. First, this empirical issue can be addressed by means of examining the relationship between national advertising Intensity and the extent of private brand sales across Industries. The findingof a significant

Inverse relationship w ill lend some support to our hypothesis.

Another way of addressing this question w ill be to Investigate the effects of changes in the legal status of RPM on the extent of private 123 branding. Our analysis of private branding suggests that limits on the use of vertical restraints w ill have significant consequences for

'the organization of distribution.

Japan's general trading companies offer a rare opportunity to analyze interesting issues concerning the the organization of trading a c tiv itie s . We view the manufacturer's task of choosing among alternative trade channels as a version of the "make-or-buy" decision.

A simple analytical framework based on the transaction cost theory Is developed to Identify circumstances where manufacturers may prefer to delegate their trading activities to outside agents. Implications for the optimal organizational choice are then put Into test by way of analyzing the trading structures of Japanese general trading firms.

The trading company offers a contracting alternative whereby manufacturers can gain low cost access to foreign markets without expanding resources In Information gathering a c tiv itie s . But agency delegation contracts suffer from a potentially complicating set of

Incentive and adaptation problems that would not arise if the manufacturer directly undertook foreign transact Ions. Accordingly, a tradeoff framework Is needed to explore the efficiency properties of alternative organizational modes. For transactions supported by substantial specialized assets, one can expect to observe an greater reliance on the integrated governance mode stnce the hazards of

Incomplete contracting vary directly with the Importance of transaction-specific investments. This explains the limited role of general trading firms In sophisticated consumer and producer durables 124 where specialized marketing services are required. These transactions

Involve complicated incentive issues associated with specialized assets, Including brand name capital, which are needed to support efficient distribution. Since these products appear to require extensive after-sale services, the minor role of trading companies In these products has often been attributed to the lack of engineering expertise of trading firms. Here, we present an alternative explanation that features contracting costs as a key factor In accounting for the varying competitive strength of general trading firms. Our results show that the extent of asset specificity Involved

In an exchange arrangement has Important ramifications for the organization of trading activities.

The examination of actual agency delegation contracts based on detailed knowledge of a variety of characteristics of manufacturing and trading firms Is required for furthering the analysis of the organizational choice. Such an attempt w ill be of great help In sharpening our understanding of the linkage betwen the attributes of transactions and the structure of the contractual relationship. At present, however, the opportunity to analyze such microeconomic details of actual delegation arrangements seems to be extremely rare.

The comparative analysis of firms operating In different social contexts (e.g ., U.S. and Japanese trading companies) should enable us to test the robustness of the transaction cost approach to economic organization. This line of research may also help to explain why transactions are organized In a different manner across countries. 125

The cultural and legal environments of transactions have a bearing on the organization of economic activities, and therefore need to be taken Into account.

While the particular problems that are considered In our two

Illustrations are rather different, both analyses make It clear that the distribution system Is not a transparent link between manufacturers and consumers. Our results demonstrate that the approach which focuses on the Informational role of the distribution system allows us to gain a better understanding of the organization of dIs t rI but Ion. References

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