VERTICAL SEPARATION INCREASES GASOLINE PRICES

I. INTRODUCTION The choice and implications of firm structure remain central questions in industrial economics, and for good reason. Analysis of recent U.S. Census data suggests that within firm transactions now create the same amount of value as those between firms (Lafontaine and Slade 2007). However, despite a rich literature describing the potential trade-offs involved in choosing between integration and separation, little is understood about the consequences of a change in form when both are commonly used in an industry. In large part, this reflects the difficulty of estimating the marginal impact of an organizational form as its usage is likely driven by many of the same factors determining economic outcomes. I add to the literature by estimating the marginal impact of vertical separation in retail gasoline markets, where stakeholders have long been skeptical about integrated organizational forms. Some states have even limited refiner ownership of retail outlets despite an economics literature suggesting that such integration can lower prices by better aligning all parties' incentives (Cooper et al. 2005; Vita 2000). To account for concern about the endogeneity of form, I use panel data methods as well as an instrumental variables (IV) strategy. The combination of the two approaches produces estimates robust to the presence of time invariant and time varying factors that simultaneously influence the choice of form and economic outcomes. After accounting for the endogeneity of form, I find that switching a station to a vertically separated form increases gasoline prices by amounts equal to 25%-45% of the average retail margin. These price effect estimates are slightly smaller in magnitude than the results in papers using statewide policy changes to identify the impact of organizational form (Barron and Umbeck 1984; Vita 2000). This difference makes sense given the distinct estimation strategies. In this paper, I identify the impact of form at marginal stations, where the refiner is fundamentally indifferent between forms. In contrast, using policy changes to identify the marginal effect of form conflates marginal stations with inframarginal ones, where a freely optimizing refiner would never choose to vertically separate. Thus, one might expect papers using policy changes to overstate the marginal impact of form while accurately estimating the consequences of adopting a law prohibiting a form. Similarly, estimates of the marginal effect of form will not necessarily accurately predict the consequences of a sweeping policy change. Interestingly, I do not find that vertical separation has a statistically significant impact on overall fuel sales. I interpret this as indicating that the high-powered incentives given to local agents at vertically separated stations induce greater effort to increase local demand. This can explain the apparently contradictory result of observing increased prices but not lower sales quantities. Moreover, it is consistent with past theoretical models of vertical separation in gasoline retailing (Slade 1996) as well as anecdotal impressions of refiners' organizational strategies (Kleit 2005). Overall, my paper contributes to two different literatures. First, it adds to a small but growing group of papers that disentangle the effect of form choice from the elements impacting the choice of form. The papers in this literature suggest that separation can have widely varying consequences. For example, Novak and Stem (2008) find that vertical separation induces a trade-off between initial performance and improvement in the automobile industry, while Forbes and Lederman (2010) show that vertically integrated regional airlines are better at minimizing delays and cancellations. In contrast, Kosova et al. (2013) find no observable difference in outcomes across organizational forms for hotels associated with a large brand owner. The different findings in our respective papers suggest that vertical separation induces local agents to exert effort in different ways in the two industries we examine. …