Revenue sharing and vertical control in the video rental industry

Revenue sharing contracts, in which retailers pay a royalty on sales to the ir suppliers, are now widely used in the video rental industry. We show tha t revenue sharing is valuable in vertically separated industries in which d emand is either stochastic (unpredictable) or variable (e.g., systematicall y declining), downstream inventory is chosen before demand is realized and downstream firms engage in intrabrand competition. Unlike two-part tariffs. revenue sharing achieves the first best outcome by softening retail price competition without distorting retailers' inventory decisions. Our theories are also consistent with trends in prices and availability following retai lers' adoption of revenue sharing contracts.