The Effects of Revenue-Sharing Contracts on Welfare in Vertically-Separated Markets: Evidence from the Video Rental Industry

In this study I analyze the implications of contractual innovation in verticallyseparated industries, using the example of the video rental industry. Prior to 1998, video stores obtained inventory from movie distributors using simple linear pricing contracts. In 1998, revenue-sharing contracts, which include inventory restrictions, were widely adopted. I investigate the effect of using revenue-sharing contracts on firms’ profits and consumer welfare, relative to linear pricing contracts. I analyze a new panel dataset of home video retailers that includes information on individual retailers’ contract and inventory choices, weekly rentals and sales, and contract terms (prices and quantity restrictions) for 1,114 movie titles and 6,594 retailers in the U.S during each week of 1998 and 1999. A structural econometric model of firms’ behavior is developed and estimated, and counterfactual experiments are performed. The results indicate that total upstream and downstream profits increase by three to six percent, and consumers benefit substantially when revenue-sharing contracts are adopted. I also examine the effects of the observed quantity restrictions. I find that these restrictions serve to increase profits for upstream firms and decrease profits for downstream firms, relative to revenue-sharing contracts without inventory restrictions. ∗Department of Economics, Harvard University, Cambridge, Massachusetts 02138. E-mail: [email protected]. †I thank Dan Ackerberg, Ken Corts, Jim Dana, Rachel Griffith, Tom Hubbard, Guido Imbens, Ben Klein, Phillip Leslie, Bentley MacLeod, Richard Mortimer, Ariel Pakes and Jean-Laurent Rosenthal for many helpful discussions and valuable advice. I also thank seminar participants at Brown University, Florida International University, Harvard University, MIT, Northwestern University, NYU, Stanford University, UC Berkeley, UCLA, UC San Diego, University of Chicago, University of Maryland, Washington University, Yale University and the Society for Economic Dynamics 2002 Conference for many helpful comments. The data for this study were generously provided to me by Rentrak Corporation, and I thank Robert Liuag, Ellen Dannenberg and Amir Yazdani for their help in collecting the data. Financial support from a UCLA Dissertation Year Fellowship and the Social Science Research Council’s Program in Applied Economics with funds provided by the John D. and Catherine T. MacArthur Foundation is gratefully acknowledged. Any remaining errors are my own.