The Spanish retail petroleum market: New patterns of competition since the liberalization of the industry

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Energy Policy 36 (2008) 612–626 www.elsevier.com/locate/enpol

The Spanish retail petroleum market: New patterns of competition since the liberalization of the industry Alejandro Bello, Sandra Cavero Department of Business Administration, Public University of Navarre, Campus de Arrosadı´a, 31006 Pamplona, Navarre, Spain Received 25 May 2007; accepted 16 October 2007 Available online 26 November 2007

Abstract In this paper, we study the recent development of the Spanish automotive fuels market, in the context of a long process of liberalization and competition. Our aims are twofold. First, to overview the market’s current patterns of competition, while taking into account the political, structural and strategic aspects that have marked the industry’s recent evolution. Second, to study in depth one competitive strategy that nowadays significantly influences competition and final prices, the vertical relationships between operators and service stations. Our analysis draws attention to several indicators that may demonstrate the success of the opening and liberalization process. Increased levels of competition have stimulated the sector’s growth, development and modernization, and given national firms an excellent platform for competing with newcomers. Furthermore, studying the vertical agreements has produced interesting results. We have found that relative price differences among brands increase in line with perceived quality differences, and that the vertical separation of refineries and retailers eases price competition in the final market. The empirical evidence was backed up with a database of 4164 Spanish service stations. r 2007 Elsevier Ltd. All rights reserved. Keywords: Liberalization; Competition; Retail petrol market

1. Introduction and aims In this paper, we study the recent development of the Spanish automotive fuels market, in the context of a long liberalization and competition process. The specialized literature has focused a great deal of attention on the difficulties of introducing competition into the industry in the 1990s, given the industry’s peculiarities: it was a strict state monopoly from 1927 to 1984, its subsequent transitional deregulation and liberalization from 1984 to 1992, when actions taken to protect national interests resulted in a strong presence of national firms. Generally, barriers were associated with the strong position of the national oil companies, Repsol-Ypf, Cepsa and BP, in the distribution and final commercialization activities; see Contı´ n et al. (1999, 2001) and Arocena et al. (2002). Corresponding author. Tel.:+34 948196085; fax: +34 948169404.

E-mail addresses: [email protected] (A. Bello), [email protected] (S. Cavero). 0301-4215/$ - see front matter r 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2007.10.014

Despite the national industry’s protectionism, and the potential negative effects of these measures on development, as we will later see, the industry has significantly advanced towards competition. After 1992 liberalization intensified the sector, and in 1998 free competition was brought in. Since then important structural and strategic changes have come about. In particular, we would stress the setting up and subsequent privatization of Repsol, the increase in the numbers of service stations in Spain, the reduction of industrial concentration in the distribution and final commercialization, the development of new price-fixing strategies and competitive positioning by firms. We are more interested in studying in depth the most important characteristics of the present day industry, and we will also describe and analyse competitive behaviour by firms in the new environment. This is especially important at present, for two main reasons. First, there have been important changes in the competitive strategies adopted by the firms, and no specialized literature deals with

ARTICLE IN PRESS A. Bello, S. Cavero / Energy Policy 36 (2008) 612–626

this.1 Second, the opening and liberalization of the Spanish oil market provides useful lessons that may be taken into account when considering and analysing the EU’s power and gas market current deregulation processes. Our paper has the two following objectives. First, we review current patterns of competition within this industry, while paying special attention to the downstream business. To do this we will emphasise the aspects of competitive political strategy, structure and controls that have accompanied the transition to competition, and marked the industry’s recent development. Second, we study in depth one competitive strategy that has far-reaching consequences for the competitors and for final prices, the vertical relationships between operators and service stations. We zoom in, from two angles, on the impact of the brand names and on the final price contracts. First, we propose a simple economic model that captures the industry’s competitive structure, in an environment where the competing firms are differentiated. The model recognizes the differentiation in the perceived quality among the recognized national oil companies, the new entrants and the independent unbranded service stations. Second, we empirically analyse the forces that drive the retail petroleum prices. We consider the impact on final petroleum prices of brand names, types of contract, services offered and location; i.e. type of road and distance. Our paper’s main findings are the following. First, analysis of new patterns of competition in the Spanish petroleum industry provides evidence that the final distribution market has favourably advanced towards competition. The market has grown, Spain has maintained and modernized its refinery industry, the network of service stations is larger and more modern, and firms have adopted new differentiation and price-fixing strategies. Political strategy during the transition to competition might have negatively determined the opening and liberalization process. Nevertheless, in terms of competition, the industry has surely experienced significant improvements with national petrol firms being very well positioned against new foreign entrants. On the other hand, by analysing the vertical relationships within the industry, we are able to draw certain conclusions about the impact of branding and integration strategies by oil giants on final prices and vertical differentiation strategies. They have a positive impact on final prices, and this should be taken into account when analysing and observing their price strategies. Given this differentiation, the choice of contract becomes an important strategic tool that must be monitored by the competition authorities, since in certain circumstances firms can use this to reduce competition in the final market.

1 Contı´ n et al. (2006), analyze the behaviour of Spanish oil companies before and after market liberalization, in terms of the asymmetries between input prices and final petroleum prices, using multivariate error correction models and aggregated data.

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The rest of the paper is organized as follows. In Section 2, we review the Spanish petroleum industry. Principally, we describe and analyse the most important characteristics of the new patterns of competition in the distribution and final commercialization. In Section 3, we study in depth the vertical relationships that are currently being established downstream. Empirical analysis, using a database of 4164 Spanish service stations, shows the factors that determine final prices. Section 4 concludes the paper. 2. The Spanish oil industry: an overview This section focuses on describing and analysing the Spanish oil industry’s restructuring, and we emphasise the most important factors that characterize the current levels of competition achieved in the industry. We consider the industry’s history as vital, because during virtually all the last century it was under strict state control; this has undoubtedly and significantly determined the industry’s development in the current stage of liberalization and competition. Next, using the divisions proposed by the Spanish Energy Commission in 20022 as a framework, we summarize the Spanish oil industry’s three most important historical stages and their key aspects. 2.1. 1927–1984: state monopoly This period the industry was characterized by strong state interventionism in what became known as the ‘‘oil monopoly’’.3 During this stage CAMPSA, ‘‘Compan˜ı´a Arrendataria del Monopolio de Petro´leos S.A.’’, held the concession and ran the exploration, production, refining and final commercialization activities.4 At the end of the 1970s and after 50 years of strict state monopoly, the industry was restructured. These changes were brought because of adverse state management; i.e. excess capacity, production imbalances and low-quality service. Given Spain’s impending incorporation into the European Economic Community, the aim was to prepare the industry for greater competition. 2.2. The transition period, 1984–1992 This period marked the transition to competition, when far-reaching decisions would significantly determine the industry’s future role. Spain’s interest in joining the 2 For a description and analysis of the history of the Spanish petroleum industry up to 1998, see Correlje´ (1990, 1994) and Contı´ n et al. (1999, 2000, 2001). 3 The Royal Decree passed on the 28 June 1927 brought about the petroleum monopoly. 4 During this period there were a series of milestones, which did not seek to introduce competition into the sector but have been important for the industry’s subsequent development. Among others are setting up CEPSA in 1930, the Instituto Nacional de Energı´ a (National Energy Institute) and the Instituto Nacional de Hidrocarburos (National Hydrocarbons Institute) in 1981.

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European Economic Community brought about the implementation of various measures directed at opening and liberalizing the sector. The new maximum price-fixing system, which was based on European prices for petroleum and diesel should be emphasised, as should the freeing up of importing crude oil and petroleum derivatives.5 At the end of the 1980s, the Royal Decree 4/1988 modified the minimum distances law, and this gave a strong impetus to the setting up of a parallel network of petrol stations.6 2.3. 1992–2006, liberalization and free competition The opening and liberalization process culminated in free competition. Throughout these years, a raft of regulatory measures pushed the process through. These were the 34/1992 Law passed on 22nd December to regulate the petroleum sector, the Royal Decree no. 155/ 1995, the 34/1998 Hydrocarbons Sector Act and the Royal Decree 6/2000 on Urgent Measures for Intensifying Competition in Goods and Services. These and other measures gave rise to the following:

     



The 1992 recognition of the freedom of business activity in all the market’s sectors, and for the import and export of crude oil and petroleum products. The setting up of a parallel network of service stations in 1992. The establishment in 1994 of the Corporacio´n de Reservas Estrate´gicas de Productos Petrolı´ feros, the strategic reserves corporation for oil products. The entry of new operators and the extension of the service station network by eliminating minimum distances in 1995. Setting up the National Energy Commission in 1999 as a regulatory body for the Spanish energy market. The establishment in 2000 of company capital for the Compan˜ı´ a Logı´ stica de Hidrocarburos, the hydrocarbon logistics company, which has a monopoly over distribution. This is an essential facility for the industry, and participation by Spanish refineries is restricted. Restrictions, since 2001, on the market participation of the two big Spanish oil companies Repsol-Ypf and Cepsa.

All these measures have given rise to free competition and facilitated a new competitive environment. Our main goal is to advance the study of the new patterns of competition adopted by companies, especially in the distribution and final commercialization in the Spanish petroleum industry. To do this we will now analyse the four 5 All these measures were brought about by the Royal Decree/Law 5/ 1985 passed on 12 December. 6 The Royal Decree 4/1991 ‘‘Urgent Measures for the Progressive Adaptation of the Petroleum Sector to the Community Criteria’’ was passed on 29 November; it reduced the legislated minimum distances between service stations, which gave rise to strong competition and the free market.

areas that we believe to be the principal forces that characterize the industry’s current development. 2.3.1. Political–strategic aspects: the creation of the Repsol, the industry leader The opening up of ‘‘strategic’’ sectors within the Spanish economy, such as electricity, gas, petroleum, telecommunications and banking to competition have been characterized by the Government’s desire to leave Spanish companies competitively well positioned in the new arena. It could be said that the Spanish opening and privatization process both reflects and is marked by the conflict between the advocacy of market liberalization and the protection of national interests, and this has stimulated the formation of national champions in the utilities sectors; see Arocena (2006). Until the transition period, and the law on ‘‘Restructuring of the Petroleum Sector’’ that promoted forward vertical integration, Spanish refineries had not taken part in final commercialization. The sector now began to seek greater national industrial strength, in an arena of international competition. The priority was to create a ‘‘national champion’’, and in 1987 the Repsol Group was set up to manage the state’s petroleum and gas activities, later it was privatized; the process began in 1989 and finished in the mid-1990s. In 1992, it was decided to split the former CAMPSA, including some essential assets, among three companies, in line with their refining capacity; Repsol had five refineries that accounted for 58% of national refining capacity, Cepsa three refineries and BP Spain one refinery. The Government achieved its goal as the national companies, especially Repsol, were in a clearly dominant position. This supremacy also existed in distribution as they controlled the CLH, the hydrocarbon logistics company, and in final commercialization where it directly controlled virtually all Spain’s network of service stations. At this point it is worth considering how difficult it is to introduce competition into a sector that is dominated by three national companies. The dominance of the service station network and control of CLH’s essential distribution assets could foster opportunism from the firms, and constitute high entry barriers for new operators. In 2003, Dı´ az Ferna´ndez7 affirmed that once Spain had entered the EEC the process could have been carried out differently; for example, dissolve the monopoly, auction the state enterprises to the highest bidder, and let the private firms sort it out among themselves as best they could. However, he stated that, ‘‘The most likely outcome is that now Spain would not have a national oil industry.’’ The national industry’s gradual demonopolization and strategic positioning has undoubtedly determined the speed and 7 Jose´ Diaz Ferna´ndez was the chairman of CAMPSA, CLH Repsol Petro´leo (Repsol Petroleum) and Repsol Comercial de Productos Petrolı´ feros (Repsol Petroleum Product Marketing). He is currently the chairman of the Fundacio´n Repsol YPF (Repsol YPF Foundation) and of the Spanish Association of Energy Economics.

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Table 1 Evolution of the number of service stations and market share by brand, in the Spanish retail petroleum market, 1995–2005 Operator

Repsol Cepsa BP Shell Total Galp Meroil Disa Continental Oil Agip Petrocat Avanti Esso Esergui Tamoil Kuwait P. Texaco Others Total C1 C3 HHI

1995

2001

2005

Outlets

Market share

Outlets

Market share

Outlets

3500 1500 400 120 127 120 70 100 25 75 50 45 25 30 20 20 15 85 6327

55.32 23.71 6.32 1.90 2.01 1.90 1.11 1.58 0.40 1.19 0.79 0.71 0.40 0.47 0.32 0.32 0.24 1.34 100 0.55 0.86 3.653

3704 1437 582 278 187 187 184 140 0 127 69 61 67 65 43 17 50 600 7798

47.50 18.43 7.46 3.57 2.40 2.40 2.36 1.80 0.00 1.63 0.88 0.78 0.86 0.83 0.55 0.22 0.64 7.69 100 0.47 0.73 2859

3618 1521 554 – – 216 203 470 – 303 64 – 89 92 43 39 59 1300 8571

Market share 42.21 17.75 6.46

2.52 2.37 5.48 – 8.37 1.77 1.04 1.07 0.50 0.46 0.69 15.17 100 0.42 0.66 2354

Source: Encyclopaedia OILGAS 1995–2006; and own elaboration.

efficiency of the liberalization process. However, the implementation of a policy of controls, defence and promotion of competition favoured the incorporation of new foreign operators, as did the attractiveness of the Spanish industry. All this has brought about a dynamic and more competitive panorama, which has significantly benefited the final customers who currently use an extensive and modern network of petrol stations. 2.4. Structure in the downstream market As mentioned in Section 2.3, protectionism in the national industry has given rise to high levels of concentration. At the end of the monopoly the Spanish companies, and especially Repsol, controlled all the industry’s downstream business. However, since 1992 important structural changes have furthered a new competitive environment within the industry. At the retail level, the number of service stations has risen considerably, from 4800 in 1992 to 8600 in 2005; see Table 1. Another important aspect is the reduction in the industrial concentration. In 1995, three main operators ran 86% of retail outlets, but in 2005 the C3 index indicated that these operators controlled 66% of the final market. Although it could be said that the level of concentration is still high,8 it 8 The Herfindhal Index is above the 2000 points mark, that is to say higher than the threshold established by the United States competition authorities for categorizing the market as very concentrated. A similar threshold has been established by the European Union.

is important to note the slow but constant reduction in concentration rates, and the increase in the number of service stations. Various structural changes include the entry of foreign operators, due to the elimination of administrative and strategic entry barriers,9 and a noticeable increase in the number of small independent retailers. CLH has undergone important structural changes but still distributes under monopolistic conditions. As previously mentioned, after the splitting up of CAMPSA’s assets, the CLH capital became the exclusive property of three Spanish refineries, save for a small shareholding owned by Shell. CLH’s ownership undoubtedly formed an entry barrier for new and potential competitors, as its assets are essential for the distribution of what to all intents and purposes may be a natural monopoly. To resolve this, the Royal Decree 6/2000 resulted in significant changes on competition within the industry; it demanded that the original owners jointly held no more than 50% of CLH, and that none owned more than 25%. This gave an impetus its CLH’s capital shareholding, and Table 2 shows its development. Finally, important structural changes in refining took place in the 1980s in Spain. The number of companies was gradually reduced from eight to the current three, while at the same time major investments in improving refining 9 Government actions have included eliminating the minimum distance restriction between service stations, which until 2000 prevented Repsol and Cepsa from opening new service stations, and reducing the Spanish oil companies’ control of CLH from 100% to 50%

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Table 2 Percentages of CLH’s capital shareholdings 1994–2004

Repsol (Repsol-Ypf+Petronor del Norte S.A) Cepsa British Petroleum Shell Embridge Capital APS Disa Peninsula Disa Financiacio´n Oman Oil Holding Spain China Aviation Oil Corporation Galp Energı´ a Spain Others

1994

2004

59.49 25.10 7.61 5 – – – – – – –

25 14.15 5 – 25 5 5 10 5 5 0.85

Source: CLH 1994–2006 and own elaboration.

efficiency and capacity were made. Currently, the combined production capacity of Repsol-Ypf, Cepsa-Elf and BP is 61 million tonnes of crude oil and raw materials per year. Repsol owns 58% of the refining capacity (Enciclopedia Oilgas, 2004).10 Despite the technological advances in refining the levels of still demand exceed national production; this is especially true for diesel. This deficit means that huge volumes of imports are needed to satisfy demand. In 2005, net imports of 19.7 million tonnes of hydrocarbons were required, ref. Boletı´ n Estadı´ stico de Hidrocarburos (the Gazette for Hydrocarbon Statistics).11 To sum up, although the levels of industrial concentration are relatively high, it is important to note the constant reduction in the ratio of horizontal concentration that has taken place within the sector in recent years, especially in distribution and final commercialization. This has all taken place in the context of significant growth in consumption, increases in the service station network and with national companies being well positioned competitively against new competitors.

to foster competition; they include the elimination of the minimum distances between service stations, the liberalization of final prices, financial measures that have helped hypermarkets open service stations, and restricting the quotas of large oil companies in the final distribution market. Cepsa has been prevented from opening service stations for 3 years, Repsol-Ypf has been stopped for 5 years and their CLH capital ownership has been opened to new investors. By setting up organisms, such as the National Energy Commission (CNE) and promoting the Tribunal for the Defence of Competition (TDC) the Government has sought to control oil companies’ opportunistic activities and prevent them exercising their market power in breach of national and European competition laws. In the last decade, it has generally been associations of service station managers that have reported cases of anti-competitive behaviour. These complaints have brought about further controls, and on various occasions sanctions, by the Tribunal for the Defence of Competition. Most of the sanctions were for the imposition of anti-competitive vertical restrictions; examples are fixing fuel resale prices, unilateral extensions of the use of the brand name, and fixing restrictive conditions for commercializing and/or promotion of other products in the service station establishments. Here is a small selection of cases: Case 118/95 Repsol/BP/Cepsa, Case 118/95 Repsol/BP/Cepsa, Case 499/00 IMT/Repsol, 449/99 Repsol /Service Stations, Case 536/02 Service Stations, Case 493/00 Cepsa, Case A 325/2002 BP and Case A361/2006 Distribuidores Andalucı´ a.12 These sanctioned cases clearly show the sector’s different agents and operators that, even though they can act freely, the Government imposed system establishes a mechanism for controlling and following up the different business decisions and strategies, such as price fixing, contracts and vertical restrictions.

2.5. Competition policy 2.6. Price and non-price competitive strategies The structural and strategic political aspects we have commented upon have undoubtedly greatly determined the policies for controlling and promoting competition in the sector. Specialists and public opinion have successfully pressurized the Governments into creating measures to eliminate the administrative and structural barriers to competition, and into promoting a strict and efficient code of conduct for the industry’s different operators. We must mention the administrative and structural barriers that have either been reduced or removed, in order 10 After 1980s, these refineries were modernized and restructured under an intensive programme aimed at increasing efficiency and the versatility of the assets, in order to respond to fluctuations in demand and growth in lighter products. Due to strong demand the refineries are currently operating at over 95% capacity. 11 Petrol exports were 2.86 million tonnes, whereas diesel imports were 13.2 million tonnes; ref Boletı´ n Estadı´ stico de Hidrocarburos (Gazette for Hydrocarbon Statistics) (2005).

The firms’ strategies in the new competitive environment are key to this paper. In Section 3, we strategically analyse in greater detail the vertical relationships within the industry, and their effects on final prices. We will show the important changes in patterns of competition within the sector that have arisen due to the new strategies adopted for fixing final prices, which go against rival firms seeking better competitive positions. It is possible to identify new patterns of fixing final prices by firms in the Spanish market, not only at a strategic level, but also by comparing the aggregate development of Spanish and European commercial margins and prices. In this vein, a recent paper by Contı´ n et al. (2006) compares the pre-tax sale price for Eurosuper 95 petrol in 12 The sanctioned cases have been published on the Tribunal for the Defence of Competition’s website www.mec.es/TDC/.

ARTICLE IN PRESS A. Bello, S. Cavero / Energy Policy 36 (2008) 612–626 Table 3 Variance analysis of the prices by province and brand, 2003 Variance

Sum of squares

Variance analysis of the prices by province Inter-groups 5252.2 Inter-groups 7841.6 Total 13093.7

F

Sig

126.073

0.00

Variance analysis of the prices by province for major brands Inter-groups 3469.2 120.475 Inter-groups 3839.1 Total 7308.5 Variance analysis of the prices by province for minor brands Inter-groups 517.6 10.221 Inter-groups 971.4 Total 1488.9

0.00

0.00

Source: Department of Industry (2004) and own elaboration.

Spain and Europe13 with the evolution of international wholesale petrol prices and Brent crude. Their results indicate the international pricing and average annual sales prices of petrol are highly correlated, in terms of rises and falls in price, though they are slightly asymmetrical.14 They also demonstrate that in 1993 prices and margins in Spain were higher than those in Europe, from then on prices and margins fell sharply and converged with the European standard, until in 1998 it was decided in 1998 to eliminate the maximum price-fixing system for petrol. After 2000, the Spanish margins, which were already below the European average dropped sharply; this was largely due to the 1996–2004 Spanish conservative government publicly requesting oil companies not to increase prices in response to the increases in crude oil tariffs, in order to alleviate inflationary pressure. After 2001, Spanish prices rose slightly above European prices and margins also continued to increase, whereas the European margins remained relatively stable. This last and very important fact should constitute a motive for analysis and control by the competition authorities. On the other hand, if we analyse the Spanish prices separately, differentiating by brand and region, we find there are statistically significant differences in weekly retail prices among the brands and regions; see Table 3.15 This constitutes a significant change, given that during the ‘‘transitory period’’ the oil companies fixed their prices at the formula’s cap price in all Spanish regions; this is indicated by Contı´ n et al. (1999). 13 An average was taken of the pre-tax retail price of Eurosuper 95 petrol in the six nations that are a reference for fixing the maximum price tariffs; the six are Germany, Belgium, France, Holland, Italy and the United Kingdom. 14 There is extensive literature that gives a breakdown on both the weekly and monthly price asymmetries between the international rates and retail prices; see Borenstein et al. (1997), Asplund et al. (2000), Eckert (2002) and Contı´ n et al. (2006). 15 The analyses are based on the weekly 2003 prices of 4164 service stations in 22 Spanish Provinces.

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Bello and Cavero (2006) have recently studied these price differences among companies and regions. The authors analysed the final fuel distribution market’s competitive structure in the different regions, its socioeconomic characteristics and the competition. Their results indicate a greater probability of finding a recognized national brand name service station in a market with higher levels of income and population density. They also found that price differences among regions can be partly explained by the response of the competitive structure to the socioeconomic characteristics of the market. Nevertheless, the firms have developed other strategies to improve their competitive position in the new environment. We wish to draw readers’ attention to the brand differentiation strategies and the inclusion of new services, location, and vertical integration decisions. We will describe these next:







Brand differentiation strategies: In recent years, we have witnessed highly significant promotion efforts, the modernization of points of sale and brand publicity, principally by Repsol and Cepsa, the two main operators.16 This is the way the firms have sought to consolidate their position in the local market, and maintain good competitive positions against new entrants. Nonetheless, the numbers of service stations that focus their efforts on more aggressive price competition have increased; independent service stations, hypermarkets and cooperatives are cases in point.17 We are witnessing a polarization of the final market, where competing branded service stations make concerted efforts to promote themselves against minor brand and unbranded service stations. New services offered: The new competitive environment has pushed the service stations to expand into the ‘‘nonoil’’ business. We have noted a general trend for all operators to incorporate convenience stores, restaurant services, sales of spare parts and speedy garage services; see Table 4. Location strategies: In addition to the previously mentioned branding decisions and the relationship among the market characteristics, the type of road where the service station is to be located is another important element. Analysis of the aggregate data for the 22 provinces, in Table 6, reveals no clear relationship that differentiates the location strategies of the various operators. The greatest numbers of service stations are concentrated in urban centres, followed by main roads.

16 In terms of marketing investment, the Repsol Group is one of the top 20 brands, according to Infoadex it spent h16 million in 2003. However, in their 2003 and 2004 annual reports Repsol-Ypf, Cepsa, and BP emphasized the investments they had made in retailing and modernizing their networks. 17 The Spanish service station network’s strong growth in recent years has been characterized by a significant increase in independent unbranded service stations; they now form the third most important grouping, after Repsol-Ypf and Cepsa.

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Table 4 Percentage of dependent service stations offering services, 2004 Brand

Convenience store

Automated or hand car washing

Quick repairs

Cafeteria

Restaurant

Hotel

REPSOLa CEPSA BP AGIP AVIA ERG ESSO GALP MEROIL PETROCAT Q8 SHELL TAMOIL TEXACO

75 43 80.6 91.5 95 85 95 98 95 100 35.5 70 100 80

55 No data available 63.2 51.5 66 30 68 No data available 80 30 30 35 3 70

9 No data available 11.8 3.8 15 0 0 No data available 20 0 3 2 0.02 70

31 No data available 25.5 53.1 20 73 73 24 20 16 35 3 4 45

25 No data available 20 27.7 17 40 73 24 5 16 32 3 2 20

7 No data available 1.8 1.5 8 0 0 3 3 0 3 0 0 0

Source: Revista Estaciones de Servicio no. 168, 2004. a Includes Repsol, Campsa and Petronor. Table 5 Vertical integration strategies by operator Operator

Total no. of stations Vertically integrated

Branded

Repsol-Ypf CEPSA BP AGIP AVIA ERG ESSO GALP MEROIL PETROCAT Q8 SHELL TAMOIL TEXACO Total

3653 1649 595 130 67 64 77 162+109 (total) 184 66 35 316 46 56 7209a

74% No data available 53% 40% 5% 72% 43% 55% 100% 85% 40% 15% 13% 29% 5385b

26% No data available 47% 60% 95% 28% 57% 45% 0% 15% 60% 85% 87% 71% 1824b

Source: Revista Estaciones de Servicio 2004, no 180. a This does not include independent service stations. b This does not include Cepsa service stations.



However, in the suburbs, for example on industrial estates, with hypermarkets the service stations are generally independent, and major brands are a scarcity. Importantly, the greater presence of branded service stations is on motorways, where service area concessions are generally put out to tender, and the bidders are normally oil companies’ not independent firms. Integration strategies: Finally, the decisions about vertical integration are highly relevant, as they have an important impact on all price and non-price strategies.18 Table 5 shows that, in the Spanish network, a greater 18

Unfortunately the Spanish Ministry of Industry, Trade and Tourism does not publish information on the contracts that regulate the relationships between the service stations and their suppliers. The data we have

proportion of service stations operate under the terms of vertical separation contracts, as opposed to being owned and managed by the oil companies. The new operators that have entered the Spanish market are the huge oil multinationals, such as Galp, Esso, Texaco, Tamoil and Avia; and they have done so for the most part using their own vertically integrated service stations. Nevertheless, small operators such as ERG, Petrocat and Meroil tend towards vertically separated contracts, which reflects a lesser financial capacity to establish their own networks. The traditional national oil companies, Repsol-Ypf, Cepsa and BP, usually operate with branded service stations; as we will see in Section 3, this is a strategic decision by the companies to reduce the intensity of the competition in the final market. However, in the last few years they have made concerted efforts to increase the numbers of service stations that they exert total control over. These strategic actions may result from strong pressure by the competition authorities, who in turn have responded to the norms of Spanish and European competition; considerable control has been exerted over operators, with respect to their affiliated petrol stations.

3. The effects of brand name and contractual strategies on price competition In this section, we will more formally analyse the effects of some of the aforementioned aspects, and this will help to understand the strategy of firms in the new competitive Spanish petroleum market. In particular, we carry out an in-depth theoretical and empirical study on (footnote continued) provided comes from the magazine Estaciones de Servicio No. 180, published in March 2004.

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the effects of brand and vertical integration strategies upon the strength of competition in the service station sector. 3.1. The model The general model we propose to explain pricesetting behaviour in the retail petroleum market may be grouped in with the literature on competition in distribution channels with vertically differentiated products in a strategic environment; see Bonanno and Vickers (1988), Coughland and Wernerfelt (1989) and Gal-Or (1990). We differentiate two types of service stations, those backed by a recognized brand name belonging to a large national oil company, and those operating as independent unbranded service stations. The former sell a branded product that customers perceive as higher quality than latter, which offer unbranded petroleum. Upstream, the market’s vertical structure consists of a refinery that makes considerable efforts to advertise its brand, R1. The wholesale market, where other refineries or wholesalers sell petroleum to service stations, is located downstream in the distribution channel. The two service stations, S1 and S2, sell the exact same basic product. They only differ in that S1 is allowed to use the R1 brand name, while S2 purchases the product wholesale and operates without a brand name. The pricing decision is a two-stage process. In the first stage, refinery R1 set its wholesale petroleum price for service station S1, while in channel two refinery R2 sets its wholesale petroleum price for service station S2. After the wholesale prices are set in the first stage, service stations S1 and S2, simultaneously and non-cooperatively fix the final

Wholesale prices

Final prices

619

retail market prices. All firms take profit-maximizing decisions. Alternatively, refinery R1 could vertically integrate, and retail its petroleum directly to consumers via its own service stations. In this case, the wholesale price is set to 0, and the refinery fixes the retail price in the second stage. Figs. 1 show a stylized summary of the industry’s structure, and they also reflect the timing of the decision processes by the firms involved in the different stages of the vertical chain. Fig. 1 represents the general model of vertical separation. Consumers have different preferences for quality, and choose from the available competing products, according to their price–quality relationship. Given the consumers’ and competitors’ behaviour firms determine both the vertical integration and separation prices, in order to maximize their own profits. The formal model for price formation in this situation is shown in Appendix A. Our results show three main conclusions about the Spanish petroleum market that we wish to test in Section 3.2: 1. Retail price increases in line with perceived product quality. Being branded by a big refinery opens up the possibility placing a price premium on the petroleum, in order to maximize profit. 2. The price gap between different quality brands widens as differences in quality between the brands increases. This means that any price differences might be a profitmaximizing response on the part of firms, in order to reflect the variations in quality among the marketed brands.

R1

R2

W1, A1

W2

S1

S2

Pa

Pb

Consumers

Consumers

Demand da

Demand db

Channel 1

Channel 2

t=0 First stage

t=1 Second stage

Fig. 1. Timing of the decision process and structure of the distribution channel. Vertical separation.

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3. Price differences between perceived high- and lowquality varieties are less with vertical integration than with vertical separation. By implication, a station selling perceived low-quality petroleum might expect stiffer competition from a rival, if it is vertically integrated with the refinery.



3.2. Empirical analysis

We have additionally conducted a smaller sample of 83 service stations in a zone that comprises central and southern Navarre, in northern Spain. In order to test the impact of vertical integration strategies on final prices, we need to know the specific type of contract established between refineries and service stations. Unfortunately, we were unable to access any appropriate information from the Spanish Ministry of Industry. To obtain these data, we personally interviewed these service station managers.22 In addition to the previous information, in this sample we have included the following:

In this section, we empirically analyse the factors that determine the Spanish retail petroleum market’s prices, while bearing in mind the previously mentioned results. This section’s main contribution is the data we have gathered on individual service stations, which are rather uncommon both in this country and in this sector. Our results shed light on the patterns of competitive behaviour, and serve to explain the specific retail strategies that the types of oil companies use in the different markets. We used a sample of 4164 service stations, located in 22 different Spanish provinces.19 Two sources were used to locate and categorize the service stations. First, the Ministry of Economy publishes a weekly record of retail petroleum prices (www6.mityc.es/energia/hidrocarburos/ carburantes/index.asp).20 The second source is the Guı´a de Estaciones de Servicio, Proveedores y Operadores, 2003–2004, Tecni-Publicaciones, no. 169. For each service station we collected data on the following variables:

 





Retail Petrol Prices is the variable explained by the displayed refinery brand names, location, intensity of competition and income. We distinguish between major brands and minor brands, depending on their brand promotion efforts and on the brands’ market share in each specific area. According to our theoretical results, we would expect these variables to have a positive effect on final prices. Location21 is more specifically the type of road the service station is on. We have defined four categories: they are toll motorways, main roads, city suburbs with big distribution stores and high-density urban areas; i.e. city centres. We would expect to find higher prices for those service stations located on toll motorways, since drivers face higher search costs. Intensity of competition is given by the number of service station per surface unit. We would expect that a greater number of service stations in a given area would lower the final prices.

19 The provinces covered by the sample are: Asturias, Badajoz, Balearics, Barcelona, Burgos, Cantabria, Castellon, Ciudad Real, Corunna, Cuenca, Guipuzcoa, Jaen, Madrid, Malaga, Murcia, Navarre, Orense, Salamanca, Soria, Valencia, Valladolid and Saragossa. All the Spanish Autonomous Communities are represented in this database. 20 All the prices were published in the week of 22 March 2003. 21 Geographic location may have an impact on prices, because it is an important factor in horizontal differentiation; see Shepard (1991, 1993), Slade (1998) and Blass and Carlton (2001).









We feel having storage and refinery capacity in the area might have a negative impact on final prices, since it could account for a reduction in the distribution costs. Itis likely that higher average net incomes within a region where the service station is located mean higher prices for all the products sold in that area.

The type of contract that regulates relationships between refineries and service stations; i.e. vertical integration, branded and independent unbranded. Given our results we would expect branded service stations functioning under the terms of a vertical separation contract to be higher priced than stations that are vertically integrated with the refinery. We would expect the different levels of services offered to consumers at retail outlets to positively affect their final prices, in the same way they have on the loyalty indexes and consumer satisfaction levels; see Betancourt and Gautschi (2004). The distance between two neighbouring service stations and the number of points of sale heavily influences the intensity of competition and hence final prices; see Barron et al. (2004).

Table 6 shows the descriptive statistics for the national database of 4164 service stations and the Navarrese database of 83 service stations. To statistically validate the significance of the results observed in the theoretical subsection we have carried out an ordinary least squares (OLS) analysis. First, we verified the absence of heteroscedasticity with the Goldfeld–Quant test, and the non-existence of multicolinearity using the Condition Index test and Variance Inflation Factor.23 22 Other empirical studies of the retail petroleum industry have also used a specific region to perform the analysis. Shepard (1991) studied four counties within Eastern Massachusetts, and Hastings (2004), used a sample consisting of 20% of the service stations in metropolitan San Diego and Los Angeles. 23 We have tested the model’s robustness by comparing it with a Censored Regression Model of petroleum prices in h/litre, ranked between 0 and 1, using the Tobit model. The results are very similar to those of the OLS method. Consequently, we have decided to present the latter method, since it is more widely used in the relevant literature; see Shepard (1993) and Borenstein and Shepard (1996).

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Table 6 Descriptive statistics for the national and Navarrese databases National database (4164 service stations) Major brands

Minor brands

Number of service stations 2956 763 82.024 81.68 Random pricea Maximum price/minimum price 85.90/72.90 85.5/71.6 Standard deviation 1.5726 1.83125 Variance analysis for prices F ¼ 116.566, Sign. ¼ 0.000 The Ryan–Einot–Gabriel–Welsch F test identifies three homogeneous groups for a ¼ 0.05 % of service stations located on toll motorways 5.78 10.48 % of service stations located on main roads 33.86 19.79 % of service stations located in city centres 60.01 66.84 % of service stations located in city suburbs 0.34 2.88 Random of economic level (1–10) 6.21 6.01 Random of density of service stations 2.4 2.51

Independents—unbranded 445 80.95 86.90/69.50 2.164

0.67 24.72 67.41 7.19 6.17 2.13

Navarrese database: 83 service stations Branded

Vertical integrated

Number of service stations 53 83.75 Random priceb Variance analysis for the prices F ¼ 116.566, significance ¼ 0.000 The Ryan–Einot–Gabriel–Welsch F-test identifies three homogeneous groups for a ¼ 0.05 % of service stations located on toll motorways 14.03 % of service stations located on main roads 57.89 % of service stations located in city centres 19.30 % of service stations located in city suburbs 8.77 Distance between service stations 6.24 Number of services 3

Independents—unbranded

24 83.525

6 81.95

25 35 35 5 3.67 3

0 50 16.66 33.33 3.83 3

Source: own elaboration. a Price published on 22 March 2003. b Price published on 15 April 2002.

The empirical test for conclusions 1 and 2, has been developed by applying linear regression to the larger 4164 service station database, and is presented below: PRICEi ¼ a þ B1 Major brandsi þ B2 Minor brandsi þ B3 Road i þ B4 Intensityi þ B5 Refineryi þ B6 Incomei þ m, where PRICEi is the retail price of unleaded 95-octane petroleum at service station i. Major brands is a dummy variable that has a value of 1 when the service station operates under a recognized brand name, such as Repsol, Cepsa or BP, and 0 if not. Minor brands is a dummy variable that takes a value of 1 when the service station operates under a minor brand name, such as Galp, Avia, Petrocat, Esergui, etc., and 0 if not. Road is a variable that measures the potential impact of market power on final prices, in accordance with the type of road the service station is on. It has a value of 0 when the service station is located in a city suburb, 1 when in a city centre, 2 when on a main road and 3 when it is on a toll motorway. Intensity is a quantitative variable that measures the number of service stations per surface unit, in the region where service station operates. Refinery is a dummy variable with a value of 1 when the service station operates in an area where there is a refinery, and 0 if not. Income is a quantitative

variable that measures the net per capita income in the region where the service station operates. The OLS results are shown in Table 7. We will now focus on explaining how well they fit the first and second main conclusions drawn in Section 3.1. The coefficients B1 and B2 capture the brand name’s effect on the retail price. The first main conclusion states that retail prices increase in line with perceived product quality; therefore, these coefficients can be expected to take values greater than zero. As Table 6 shows, the values of these coefficients are indeed greater than zero, and are statistically significant. This result means we can conclude that consumers interpret the brand name at a service station as a sign of quality and reliability. This fact could justify the positive price differences, compared with the independent service stations that sell unbranded petroleum, and may also confirm that the big oil companies develop differentiation strategies through their major brands. The price at major brands service stations is h1.046/100 l higher than the petroleum sold at unbranded service stations. We can also see that the petroleum sold at minor brand service stations is h0.732/100 l higher than at unbranded service stations. The second main conclusion is that prices vary in accordance with perceived quality differences. If consumers were to perceive a greater quality differential between the

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622 Table 7 OLS estimations Variables

Constant Major brands Minor brands Road Density Refinery Income N R F

No. standardized coefficient

80.959 1.066** 0.725**

t

1295.48 15.203 7.037

Confidence interval Min.

Max.

80.836 0.928 0.523

81.08 1.203 0.926

4.164 0.23 116.566

No standardized coefficient

80.320 1.015** 0.729** 0.334** 0.062** 0.239** 0.020** 4.164 0.314 75.644

t

459.318 14.636 7.239 7.426 9.956 3.443 2.872

Confidence interval Min.

Max.

79.977 0.879 0.531 0.246 0.074 0.376 0.006

80.663 1.151 0.875 0.422 0.050 0.103 0.033

Dependent variable: price in European cents, National Database of 4164 service stations. We verified the absence of heteroscedasticity using the Goldfeld—Quandt test: F (calculated SR2/SR1) oF (tables); we also verified the absence of multicolinearity using the Condition Index (C.I.) and the Variance Inflation Factor (VIF).

petroleum at major brand and independent stations than between minor brands and unbranded petroleum, then we ought to observe a higher estimate for coefficient B1 than for B2. The estimates show the price of major brands to be h0.29/100 l higher than the price for minor brands, and this in turn is h0.73/100 l higher than the petroleum sold by unbranded service stations.24 Our estimations back up the hypothesis that independent stations compete more aggressively with minor branded, than with major branded service stations. These results add to the empirical evidence that endorses a vertical differentiation model for explaining firms’ behaviour in this market. Our results suggest that the major brands are indeed very well known in the market, and that their higher prices reflect a profit-maximizing policy. The variables of location on price competition are the service stations’ ability to use their market power to compete and their capacity to fix prices on the basis of horizontal differentiation. The type of road the service station is located on can affect prices. Consumers seemingly pay different prices, depending on whether the petrol is bought on a motorway, in a high-density urban area, in a low-density urban area, or at a station belonging to a big distribution store in the city suburb. You would not expect consumers to leave a motorway and drive into a city to find a cheaper substitute. This hands great market power to service stations on motorway and main roads, allowing them to fix higher prices. Our results show that petroleum sold in city suburbs is the cheapest, and the estimated coefficient B3 clearly demonstrates this (B340). On the other hand, we would expect that a service station with a small area of influence would find it difficult to fix high prices, since consumer search costs are low.

Indeed, as verified in Table 7, the estimation of coefficient B4 is negative and statistically significant. Finally, we found that the presence of a refinery in the region where the petroleum is sold negatively affects prices; this may be due to service stations located in these regions enjoying lower distribution costs. The third main result states that the relative price differences between the perceived high-quality product and the perceived low-quality product are greater with vertical separation. To test this empirically we need to know the specific type of contract that regulates the relationship between the refineries and service stations. To do this we have used the aforementioned sample of 83 Navarrese service stations, and we propose the following model25:

24 A Fisher linear restriction test was performed, and the hypothesis of equality of the coefficients B1 and B2 was rejected (FoF(95%)).

25 Due to promotion, advertising and its market share Repsol is the most important and recognized brand in this region.

PRICEi ¼ a þ b1 RepSepi þ b2 RepInti þ b3 OtherSepi þ b4 OtherInti þ b5 Disti þ b6 Road i þ b7 Servicei þ m, where PRICEi is the retail price of unleaded 95-octane petroleum at service station i. RepSep is a dummy variable that takes a value of 1 when the service station operates using the Repsol brand name, and 0 if not. RepInt is a dummy variable that takes a value of 1 when the service station operates under Repsol brand name and is vertically integrated, and 0 if not. OtherSep is a dummy variable that takes a value of 1 when the service stations operate with other brand names, such as Cepsa, Galp, Avia or Esergui, and 0 if not. OtherInt is a dummy variable that takes a value of 1 when the service stations operate with other brand names and are vertically integrated, and 0 if not. Independent service stations have been omitted. Dist is a quantitative variable that measures the distance in kilometres, between one service station and the next. Road is a variable that quantifies the potential impact of market

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623

Table 8 OLS Estimations Variable

Standardized coefficient

(Constant) RepSep RepInt OtherSep OtherInt Dist Road Service N R2 F

81.950 1.975** 1.405** 1.526** 1.172**

83 0.265 7.026

t

(4.975) (3.052) (3.545) (2.453)

Standardized coefficient 81.003 1.398** 0.945** 1.208** 0.752** 0.045** 0.542** 83 0.544 15.548

t

(4.235) (2.435) (3.473) (1.930) (2.288) (5.161)

Standardized coefficient 81.498 1.404** 0.912** 1.278** 0.778** 0.046** 0.509** 0.165* 83 0.557 13.497

t

(4.30) (2.58) (3.69) (2.02) (2.36) (4.16) (1.526)

Dependent variable: price (in cents).h). Navarrese Database (83 service stations). Note: The t statistics are in brackets. **Statistically significant at 95%. *Statistically significant at 90%. We verified the absence of heteroscedasticity using the Goldfeld–Quandt test: F (calculated SR2/SR1)oF (tables); we also verified the absence of multicolinearity using the Condition Index (C.I.) and the Variance Inflation Factor (VIF).

power on final prices, depending on the type of road. It has a value of 0 when the service station is located in a city suburb, 1 when in a city centre, 2 when on a main road, and 3 when it’s on a toll motorway. Service is the variable that measures the level of service offered by the stations, and includes: fidelity cards, cafe´-bar services, convenience stores, repairs and rest areas. It is ranked from 0 to 5. The OLS results are shown in Table 8. In order to analyse the impact of contractual choice on price competition, we first compare the coefficients of RepSep and RepInt, and then those of OtherSep and OtherInt. We would expect the RepSep coefficient to be higher than the RepInt one, and the OtherSep coefficient to also be higher than the OtherInt one. These results show the impact of the type of contract on competition. The petroleum sold in vertically separated Repsol service stations is h0.45/100 l more expensive than the petroleum sold in vertically integrated Repsol service stations, and the same is also true for other brands. Petroleum sold in other branded, vertically separated service stations is h0.45/100 l more expensive than petroleum sold in other vertically integrated service stations.26 These results indicate that branded vertically integrated service stations compete more aggressively with independent unbranded service stations than with vertically separated ones; they also reveal the strategic effects of vertical separation on competition. The variables used to judge the effects of the brand and location on price competition give the same results for this region as they do for the previous model. The effect of variable Dist on prices, as measured by coefficient b5, is positive since a service station with a large 26

We have made a contrast of the F Fisher lineal restrictions; we therefore reject the hypothesis of equality of the coefficients b1 and b2, and b3 and b4 (FoF(90%)).

area of influence would find it easier to fix higher prices, given that consumer search costs are high. Finally, the impact of service mix on final prices can be expected to be positive, since consumers might perceive those service stations offering a large range of services to be more attractive; therefore, they can charge higher prices for petroleum. We see how the model shows this positive effect of services on prices, since the estimated coefficient b7 is greater than zero. In 1991, Shepard also obtained this same result for the Massachusetts market. 4. Summary and conclusions In this paper, we have presented a study of the most important changes to have taken place in the Spanish petroleum industry during the recent free competition stage. This study is currently of special importance for two main reasons. First, after years of state control and intervention, the industry has made great strides towards competition, but no analytical literature is available on the new environment’s conditions of competition. The most recent papers on the Spanish fuels market have focused on the transitory period; i.e. before 1998. No papers have written about the liberalized market, and the new competitive strategies that firms have incorporated. Second, the evidence presented in this paper could be borne in mind when analysing the processes of liberalization and opening in other European energy sectors, such as gas and electricity. This study has taken on two perspectives. One the one hand, we have descriptively analysed the evolution of structural aspects, political strategic decisions and competition policy actions, and the new competitive strategies adopted by firms. At the same time we have also taken into account the sector’s recent history, and the activities carried out during the transition period directed at

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protecting national interests. On the other hand, we have studied in detail one of the most important present day strategic tools, the type of contract between the operators and the service stations. To do so we have proposed a simple theoretical model that brings together the vertical relationships within the industry, and is the basis for empirically analysing the 4164 service stations. We have examined the impact of contracts, brands, services and locations on final prices. Our paper’s main findings indicate that in only a few years Spanish oil industry has shifted from being a state monopoly to competing in a free market, and attention should be paid to the recent dynamic competitiveness. This process has been marked by the final market’s constant growth, development and modernization, which in turn have been stimulated by increases in competition and demand. All this has happened with a well poised national industry that has adapted to the new competitive environment, and that has understood how to take advantage of its excellent position after the monopoly was dismantled; it has taken the lead in adopting new competitive strategies in the final market. Our second finding is that Governmental decisions were key to the ‘‘success’’ of the process, as they promoted a gradual process of opening and liberalization; they have undoubtedly favoured both the national refinery industry, and fundamentally positioned Repsol-Ypf as the industry leader. However, the Government simultaneously fostered the competition, and - codes of conduct. We should indicate the importance in following the Spanish commercial margins, which in recent years have usually been higher than the European average. As a consequence of the Government’s measures, we have witnessed clear reduction in the industrial concentration indexes of the big firms, and a significant increase in the number of service stations competing in the final market. Thirdly, the study of the industry’s vertical relationships brings up very interesting results about the impact of the brand and contracts on final prices, neither of which have previously received in-depth attention from the Spanish fuels market. Our results indicate: The positive impact of the refinery brand name on retail prices has been empirically proven in the Spanish petroleum industry indicates that this market is indeed characterized by vertical differentiation associated with a brand name. The higher prices, frequently observed at service stations branded with a recognized refinery name, could be the result of a - response, which forms part of the refineries’ competitive differentiation strategy. We therefore consider that this aspect should be taken into account, whenever analyses of collusion practices within the industry are carried out. Vertical differentiation among firms means that the best choice of contractual format between the refineries and service stations operating under their brand name is one that features some degree of double marginalization.

This enables refineries to weaken price competition in the retail market. By comparing the equilibrium results with those of the vertical integration model, the strongest competition between premium branded and independent stations can be seen to take place when the service stations are vertically integrated with the refineries. Empirical evidence to confirm this theory was found in the retail petroleum market in the central and southern Navarre. Finally, we have empirically found that other factors like the services offered to consumers, the type of road where the service station is sited and the distance between neighbouring service stations significantly affect retail prices; and this should be taken into account in future price/competition analyses of the sector.

Appendix A. Company behaviour, as described in Section 3.1 can be reviewed with the following economic models: 9 Max pR1 ¼ ðW 1  cÞd a þ A1 > > > > > W 1 ; A1 > > > > > Max pR2 ¼ ðW 2  cÞ d b > > > > > W2 > = s:t : Max pS 1 ¼ ðpa  W 1 Þd a  A1 General Model; > > > pa > > > > > Max pS 2 ¼ ðpb  W 2 Þd b > > > > > pb > > > ; pS1 XU 1 XpS 2 9 > > > > > > > > > s:t : Max pR1 ¼ ðpa  cÞ d a = Vertical Integration Model; pa > > > > > Max pS2 ¼ ðpb  W 2 Þ d b > > > > ; pb

Max pR2 ¼ ðW 2  cÞ d b W2

where W1 and W2 are the wholesale unit prices charged by refineries R1 and R2 to service stations S1 and S2, respectively. A1 is the fixed fee that refinery R1 can charge to service station S1, given that it is allowed to sell a branded product. pa and pb are the respective product retail prices for service station S1 that uses the R1 brand name, and for S2 the unbranded station. da and db are the demand levels at S1 and S2. U1 is the reservation utility of S1, which equals the profits that S1 could obtain with the best alternative business, and limits the fixed fee that R1 can charge to E1 to obtain A1 we assume that the reservation utility of S1 is equal to the profits that S2 reaches in equilibrium. We allow for non-linear price contracts in channel one, in order to make the model easier to generalize. We assume

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constant variable production and that the distribution costs are equal to c for all refineries, which is consistent with the basic product’s homogeneity. We also assume the constant distribution costs are equal to zero, without loss of generality. Finally, the operational costs related to brand promotion activities are fixed costs for all agents, and will not affect the pricing setting process. We assume that consumers have different preferences for quality. The parameter y measures consumer preference for quality, it is uniformly distributed and unit density across the population of consumers is between ybX0 and ya ¼ yb+1. Consumer preferences can be expressed by means of the utility function U, which equals yqi–pi when a consumer purchases one unit of qi quality product at price pi and zero when the consumer does not purchase the product. The qi is a real positive number that quantifies the amount of quality purchased, when buying product i; see Tirole (1990, Chapter 2). We assume that consumer search costs are zero, and that 0oybo1; this allows the two varieties to meet a positive demand in equilibrium. Demand functions are given by the consumers’ positions on the preference continuum, given the available alternatives. Therefore, a consumer whose preference for quality is y40, is just as likely to purchase the lowerquality product as the higher-quality product, if and only if: yqb–pb ¼ yqa–pa. This relationship yields the following demand functions for each type of product: 

  pa  pb d a ¼ ya  ; Q

   pa  p b db ¼  yb , Q

where Q ¼ qa  qb .

Total demand is rigid, normalized to one, and as a result of price and quality differences it is spread among the firms. The two models consist of a two-stage game. We have looked for the Sub-Game Perfect Nash Equilibrium, and have resolved it by backwards induction. The first column in Table A1 shows the results of the general model, whereas the second column shows the results of the vertical integration model. We now proceed to explain the solution for the general model, since the vertical integration is a special example of this model. The first-order conditions of the retailers’ problem yield to the reaction functions (1) and (2). The solution to the first stage comes when R1 and R2 set the wholesale prices they will charge S1 and S2 respectively; they anticipate the reactions of S1 and S2, which are given in (1) and (2). The first-order condition of the first stage allows us to obtain the equilibrium wholesale prices, shown in expressions (3)–(5). By substituting the equilibrium wholesale prices in reaction functions (1) and (2), we obtain the equilibrium retail prices displayed as expressions (6a) and (6b). Our first main conclusion is that prices at both petroleum stations increase as the quality differential (Q) between the two products increases. A further important observation, which comes from the price results shown above, is that as the perceived quality differential between service stations increases, so does the price differential. Price differentials increase with quality differentials, Q, and this result has been put in our second conclusion: 1 Pa  Pb ¼ Qð2 þ 8yb Þ. 9

Table A1 Equilibrium results of the distribution channels General model

625

Vertical integration

Pa ðW 1 ; W 2 Þ ¼ 13ð2W 1 þ W 2 þ Qð2 þ yb ÞÞ

(1)

Pa ðW 1 ; W 2 Þ ¼ 13ð2c þ W 2 þ Qð2 þ yb ÞÞ

Pb ðW 1 ; W 2 Þ ¼ 13ðW 1 þ 2W 2 þ Qð1  yb ÞÞ

(2)

Pb ðW 1 ; W 2 Þ ¼ 13ðc þ 2W 2 þ Qð1  yb ÞÞ

W 1 ¼ 13ð3c þ Qð1 þ yb ÞÞ

(3)

W 2 ¼ 13ð3c þ Qð2  yb ÞÞ

(4)

A1 ¼ 19Qð5 þ 2yb Þ

(5)

W 2 ¼ 12ð2c þ Qð1  yb ÞÞ

Pa ¼ 19ð9c þ Qð10 þ 4yb ÞÞ

(6a)

Pa ¼ 16ð6c þ Qð5 þ yb ÞÞ

Pb ¼ 19ð9c þ Qð8  4yb ÞÞ

(6b)

Pb ¼ 13ð3c þ 2Qð1  yb ÞÞ

d a ¼ 19ð7 þ yb Þ

(8a)

d a ¼ 16ð5 þ yb Þ

d b ¼ 19ð2  yb Þ

(8b)

d b ¼ 16ð1  yb Þ

2 Qð35 þ 19yb þ 2y2b Þ pChannel1 ¼ 81

(9a)

1 pChannel1 ¼ 36 Qð5 þ yb Þ2

4 pChannel2 ¼ 81 Qð2 þ yb Þ2

(9b)

pChannel2 ¼ 19Qð1 þ yb Þ2

(7)

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This result was to be expected since an increase in Q may imply a higher degree of vertical differentiation between the two service stations. This turns out in a weakening of competition, measured in terms of retail price differences between rival outlets. Comparing the equilibrium solutions for retail prices (pa, pb), both in the general and in the vertical integration models shown below, reveals that price differentials among the varieties are greater when the service station and the refinery are vertically separated. This result demonstrates the strategic effects of vertical separation for R1. The price increase in channel 1, as a result of double marginalization, leads to a price increase in channel 2; this allows R1 to weaken competition among firms in the final market. 1 Qð1 þ yb Þ40 ðPa  Pb ÞVS  ðPa  Pb ÞVI ¼ 18

8yb .

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