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ECONOMICS 3200MLecture 9

March 23, 2011

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Vertical Controls

Vertical restrictions

• Contracts instead of integration – transactions costs lower than costs of internalization

• Contractual restraints (prices, forms of behavior) to approximate outcomes form vertical integration at lower costs

• Upstream firm is monopolist selling to downstream firm(s) – has bargaining advantage

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Vertical Controls

Vertical restrictions

• Types of contracts:– Franchise fee – upstream firm charges downstream firm a fixed charge

plus a per unit price

– Resale price maintenance – upstream firms dictates selling price for downstream firm (price ceilings, price floors)

– Quantity fixing – upstream firm dictates amount to be bought by downstream firm (quantity forcing if quantity greater than free contracting quantity; quantity rationing if quantity lower)

– Exclusive territories

– Tie-in sales

– Royalty

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Vertical Controls

Vertical restrictions

• Chicago School: observed vertical restraints meant only to improve efficiency of real-world vertical relations and not exercise monopoly power – Address externality and free rider problems

– Store with reputation for stocking high quality products provides signal to consumers and thus helps overcome lemons/moral hazard problems

• If certain of these products available at discount store, reputation suffers and store no longer as valuable a signal of quality

• Consider case of Wal-Mart

• Cost advantages of vertical integration

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Vertical Controls

Vertical restrictions

• Consider case of double monopoly:– M charges R a per unit price of C and charges a franchise/license fee of

M [PM (C)]

– P = PM (C) and total profits = M [PM (C)]

– Quantity forcing: M requires R to buy Q1 units at P= PM (C)

– Resale price maintenance (RPM): M requires R to set a maximum price equal to PM (C)

• If demand at retail level depends upon services provided, R may provide sub-optimal level of services

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Vertical Controls

Vertical restrictions

• Case of services provided by downstream retailer(s):– Too high a price and sub-optimal level of services

– Franchise fee = single monopoly profit

– Quantity forcing sufficient to encourage R to charge correct price and provide optimal level of services

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Vertical Controls

Vertical restrictions

• Multiple inputs case – M sells product which is combined with another input (produced by competitive industry) to produce final product sold by monopolist– Franchise fee and unit price set at M’s MC(C) – no distortion in input use

– Tie-in with RPM – M sells both inputs to downstream firms, sets prices of both inputs so as to not distort relative prices and extract monopoly profits

– Royalty on number of units sold with input sold at MC

– If final product sold by competitive industry – franchise fee no longer works because profits = 0 for each of the downstream firms

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P

Q

D

MR

MC(C, C*)

Q1

P1

MC(PM, C*)

Q2

P2

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Vertical Controls

Vertical restrictions

• Intrabrand competition

• Downstream retailers are in competitive market

• Demand depends upon services (e.g., information about product) provided by retailers

• Provision of pre-sale information by one retailer to consumers who buys from retailer offering lowest price

• No incentive for any one retailer to provide information because unable to recover costs of doing so

• Contractual solutions:– RPM sufficient to guarantee price to cover costs of optimal level of

services – free rider problem still exists

– Exclusive territories

– M provides information and/or other services directly through retailers

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Vertical Controls

Vertical restrictions

• Interbrand competition

• Contractual solutions:– Exclusive dealing – exclusive territories may be necessary to get retailers

to accept exclusive dealing and M may have to provide promotional services (e.g. advertising)

– Limits returns to scale for downstream firms

– Increases search costs for consumers since retailers do not carry wide range of products – Internet may overcome this problem in part

– Contractual solution more likely if M can set up own distribution network (costs of internalization vs. costs of external transactions and price competition because of interbrand competition)

– Long-term contract to limit shelf space available for competing products – exclusive territories, promotional services provided by M, some sharing of monopoly profits

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Vertical Controls

• Market foreclosure

• Commercial practices (including mergers, acquisitions) to reduce buyers’ access to supplier(s) – upstream foreclosure; or reduce suppliers’ access to buyer(s) – downstream foreclosure– Exclusive dealing

– Tie-ins and/or products made incompatible with complementary products sold by other firms

• Tie-ins pervasive: shoes, gloves come in pairs; cars with engines; land with homes

• Tie-ins to protect investments in reputation, minimize problems with product liability – repair/maintenance services to product

• Entry barrier if entrant has to offer both products

– One-stop shopping – single source of supply of entire range of products (savings on search and transactions costs, reputation)

– Acquisitions

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Information

• For consumers– Availability and prices

• Search costs – local monopolies

– Quality and other characteristics

– Reliability – Jetsgo and provision of services

• About consumers– Preferences, reservation prices

– Demand curve – position, shape (price elasticity)

• For rivals– Competitive advantages – cost structures, differentiation

– Strategies – technology, product development, capacity, geographic expansion

– Strategic responses

– Market interaction a game with asymmetric and incomplete information

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Information

• Quality• Lemons' model:

– Ex ante, consumers expect quality uniformly distributed: S [0, 1]

– Ex ante, expected quality is 0.5 – maximum price consumers willing to pay (P* = expected S) equals expected quality level – P* = 0.5

– Unit costs depend upon quality: C(S) = S– Qualities S [0.5+, 1] will not be supplied

• P – C < 0 for qualities in this range

– New feasible set: S [0, 0.5], with expected quality = 0.25– Maximum price consumers willing to pay: P* = 0.25– Market degenerates to S=0– Rational consumers and producers expect only lemons to be

supplied (moral hazard for producers), so only lemons supplied and P*=0

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Information

• Possible solutions to Lemons’ problem• Full warranties provided by producers

– Producer compensates buyer in full if quality differs from advertised quality or service not provided

– Quality must be able to be evaluated at low cost and high degree of reliability ex post by consumers

– Credibility of warranty depends upon reputation of producer/provider of warranty (Amex provides money back guarantees to card holders for products purchased with the card)

• Firms with long history more credible than start-ups – first-mover advantage; entry barrier

• 3rd party providers

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Information

• Possible solutions to Lemons’ problem

• Moral hazard problem if performance (quality) depends upon use by consumers – Adverse selection – case of insurance

• Deductibles, co-insurance

– Less than full warranty• Warranty applies subject to certain conditions regarding use of

product

• Consumers may infer this as signal of low quality

• Advertising– Investment as signal of quality only if quality can be evaluated at

low cost and high degree of reliability ex post by consumers

– Brand names

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Information

• Classification of products according to ex ante/ex post information of consumers re. quality– Search products: quality know ex ante

– Experience products: quality unknown ex ante (at least prior to 1st time consumption/use), but known ex post after purchase and use

– Credence products: quality unknown ex ante and unknown ex post even after purchase and use – services

– Importance of reputation

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Information

• Experience products – no warranties

• One-time purchase – e.g.., restaurants in foreign cities– Assume two possible qualities – SL, SH – with corresponding unit

costs CL < CH and consumers’ willingness to pay PL < PH

– Assume: PH – CH > PL - CL

– Consumers imperfectly informed (non-rational expectations), buy one unit ( no repeat purchases)

– Assume: U(SH, PH) > U(SL, PL)

– Incentive for producers to claim high quality product even though low quality: PH – CL > PH – CH

– Lemons’ model

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Information

• Experience products – no warranties

• Repeat purchase – some informed customers, e.g.., restaurants in foreign cities again– Assume some consumers informed of quality because of past

purchases informed

– If producer’s quality is SH : H = PH – CH per unit and all consumers buy

– If producer’s quality is SL : L = (1- )(PH – CL ) per unit and only uninformed consumers buy

– Monopolist supplies SH if H > L PH > CH – (1- ) CL

• Sufficiently high price for high quality product, large proportion of informed consumers, small unit cost differential

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Information

• Experience products – reputation, brand names

• Repeat purchase – repeated games– Two-period game

– Price in pd. 1 is P1 : PH > P1 > PL (a priori probability that quality is SH is X)

– If monopolist produces SH : H = (P1 – CH) + (PH – CH)

– If monopolist produces SL : L = (P1 – CL) + (PL – CL)

– Assume: PL – CL = 0

H - L = (PH – CH) – (CH - CL)

• Future return from goodwill less cost disadvantage

– Two-period game: fixed end-point, Prisoners dilemma – no incentive to build goodwill (brand name)

– Warranty

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Information

• Repeat purchase – repeated games– In multi-period game with uncertain end-point or infinite number

of periods, incentive to build up goodwill and greater return on goodwill

– Low introductory offer in period 1 to attract customers to high quality product

– Reputation – Alternatively, firm invests in advertising in period 1 –

commitment to demonstrate credibility• Only high quality supplier can invest in advertising and earn return on

investment

– Leverage brand name into other products/geographic markets• Overcomes entry barriers• Examples: Armani into perfumes, glasses; Marriott into different

categories of hotels; Sony into different consumer electronic products; Donald Trump into different city real estate markets

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Information

• Labor markets– Information re. safety, promotion (future earnings) opportunities,

employment stability– Reputation of employers

• Role of regulation – experience and credence products– Certification to practice a profession– Standards – environment, product quality, safety, workplace– Liability laws, other laws – securities, environment, tort, banking,

transportation safety

• Outsourcing– Transactions costs– Information re. quality, reliability – ISO certification– Reputation of outsourcer – e.g. Celestica

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Information

• Government regulation– Consumers uninformed re. monitoring, enforcement,

scope of regulations/laws

– Moral hazard potential – consumers/financial institutions overestimate scope of regulations/laws

• Safety

• Deposit insurance

• Bankruptcy of companies engaged in travel industry

• Workplace safety

• Risky investments – case of sub-prime loans

• Too big to fail

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Brand Names

Signals a substitute for complete and perfect information

• Educational attainment (MBA, CFA, CA, etc.); institution at which degree received (reputation of institution)

• Track record, experience – reputation • Venture capitalists invest in grade A

management and grade B business plan but not in grade A business plan and grade B management

• Appearance, behaviour

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Brand Names

• Brand names a signal for quality – quality difficult to measure without repeated use of product; brand name developed over time provides some assurance to consumers about quality of product

• Developing a brand name • Consumers willing to pay price premium for

established brand name products– Travel abroad, willing to purchase brands recognized

from home (hotels, consumer goods, financial institutions, entertainment)

– Example of products from China

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Brand Names

• Brand names, warranties, money back guarantees– Quality, reliability – consumers willing to pay price premium– Value of brand name – BMW, Coca Cola, Disney, Coach,

Trump, Dell, Google, Apple, Starbucks, Nokia, Microsoft, Zara, H&M, Harrods, Prada, Sony, Toyota, GE, HSBC, IBM, McKinsey, Goldman Sachs, Ikea, Sotheby’s, etc.

– Transferable to other markets? – geographic, product– Warranties a form of insurance – conditions attached to ensure

consumers do not abuse products (moral hazard)

• Reputations, brand names valuable (value does not show up on balance sheet unless company acquired and goodwill is recorded – but goodwill and reputations can be destroyed)

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Advertising

• Informational vs. persuasive– Price, product characteristics, availability (distribution channels)

• Search, experience, credence• Mutual fund companies advertising performance of their funds, types

of funds during RRSP season• Advertising prices lower average prices for consumers• For most professional services, advertising prices usually not

permitted by regulatory bodies – required to ensure ethical behavior

– Image, quality• Search, experience, credence

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Advertising

• Objective to increase demand and profits (economic and accounting): increase sales at current prices or sell current volume at higher prices

– MB (marginal benefit) of advertising vs. MC (marginal cost): investment decision must take into account competitors’ behavior and longer-term impacts on reputation and brand names

– MB increases if company able to expand product line to capitalize on reputation (e.g. Nike moving into athletic clothing)

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Advertising

• Sales/marketing– Segmentation of customers

• Individuals – income, ethnicity, age, education, etc., strategies of rivals

• Firms – size, location, alternative sources of supply, strategies of rivals

• Targeted advertising vs. click through ads• Attitudinal data, behavioral characteristics

– Advertising strategies and budgets – different media– Social networks – use of Twitter – Trade shows

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Advertising

• Sales/marketing– Internal sales force vs. independent sales agents – exclusive

arrangements• Technical skills – pharmaceutical companies (basis for competitive

advantage), aircraft manufacturers

– Internet sites – importance in age of Google searches, click through ads

– Distribution channels – commission overrides, promotional budgets

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Advertising

• Profit maximization and advertising– P = P(Q, A) inverse demand function with demand depending

upon quantum of advertising expenditures • Past advertising expenditures – investment; capital stock

• Possibility of depreciation of stock of advertising – rate of depreciation may vary with media

– Profit function: P(Q, A)Q – C(Q) – A

– Profit maximization conditions:• MR=MC

• QP/ Q + P = C/ Q

• Q P/ A = 1 A/PQ = A/• However, different media for reaching consumers; relative

importance of informational vs. persuasive advertising

• Prisoners’ dilemma

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Advertising

• Marketing/sales/advertising as entry barriers– Example of pharmaceutical companies (big pharma) and control of

distribution channel – doctors for prescription medicines

– Sunk cost for incumbents

– Increase entry costs

• Legal restrictions on false or misleading advertising