Economics of Management StrategyBEE3027

Miguel Fonseca

Lecture 8

Recap

• Whenever you…– … phone your mum, or switch on the light, or buy

health insurance…

• … you purchase a service or product from a chain of vertically related industries.

• We’ve looked at vertical integration in the context of firm boundaries.

Recap

• Today, we focus on the strategic aspect of vertical integration.

• We will start by looking at the potential for efficiency gains in a vertical merger.

• We will finish by looking at the potential for the welfare losses with vertical foreclosure.

Why should a firm acquire a supplier?

• If markets are efficient, firms will sell their output at marginal cost.

• That means that it is just as cheap to buy from an external supplier as producing in-house.

• Several problems do occur in the real world:– Incomplete contracts;– Hold-up;– Supplier market may not be perfectly competitive.

Double marginalisation

• Let’s consider the case of an upstream firm (supplier) producing an intermediate good, and a downstream firm (retailer) producing a consumer good.

• Demand for the final good is linear: P = a - bQ

• The marginal cost of producing a unit of the intermediate good is constant and equal to c.

• Let’s first consider if the two firms merge and act as a single company.

a

(a+c)/2

c

MR

(a-c)/2b

Monopoly Solution

Q

P

The case of separate companies

• Now let’s assume both firms are separate monopolies.

• Lets call the price the retailer pays the supplier for each unit be equal to r.

• The retailer will maximise profits: – Πr = (P- r)Q– Q* = (a-r)/2b, P*= (a+r)/2.

Double marginalisation (cont.)

• So the demand for the intermediate good is– Q = (a-r)/2b

• Inverting it as a function of the price of the intermediate good gives: r = a – 2bQ (note that this is the same as the retailer’s MR curve)

• So the supplier maximises her profits [Πs = (r-c)Q] with respect to Q:

• This gives Q = (a-c)/4b. r = (a+c)/2.

Double marginalisation (cont.)

• Recall the optimal output and price by retailer:Q* = (a-r)/2b, P*= (a+r)/2.

• Plugging r = (a+c)/2 into the equilibrium output and price of the retailer, we get: Q* = (a-c)/4b and P* = (3a+c)/4.

• Both the consumer surplus AND the sum of firms’ profits are lower with separate companies!

Double Marginalizationa

(3a+c)/4

(a+c)/2

c

MR for retailer

(a-c)/2b

MR for manufacturer

P

Q

Double marginalisation (cont.)

• How can this be tackled?

• Two-part tariff (franchising):– Supplier charges a Fixed fee F to sell the good to

retailer and sells each unit at marginal cost.– F should not affect retailer price, as the key

condition is that MR = MC.

• Royalty arrangement– Supplier sells goods at MC but earns a percentage

of profits.

Vertical Foreclosure

• Consider a market in which an upstream firm, U, produces an input at MC = 0.

• Each unit of input is costlessly converted into a homogenous unit of a final good by downstream firms D1 and D2.

• The final good is sold to consumers with demand function given by:P = a – bQ, Q =q1+q2

Vertical Foreclosure

Vertical Foreclosure

• Let’s also assume firms engage in Cournot competition.

• U sells input goods to D1 and D2 by proposing contract of the form (x, T), where – x is amount of input, and – T is payment for bundle.

Vertical Foreclosure

• There are two important cases to consider in this case:– Public contracts;– Secret contracts.

• Public contracts are those in which D1 knows contractual terms of D2 and vice-versa.

• Secret contracts are those in which neither firm knows what terms were offered to rival.

Vertical Foreclosure

• If contracts are public, the subgame-perfect equilibrium of this game is:– U offers to both D-firms– Both D-firms accept.

• Under this offer, both firms:– Make zero profits net of payment to U if all input is

turned into output and sold at monopoly price.

• If firms reject offer, they also make zero profit.

)2/,2/( mmq

Vertical Foreclosure

• If contracts are secret, it may not be possible for U to achieve monopoly profit.

• Suppose D2 accepts offer from U.

• If so, it is in U’s and D1’s to agree to a contract (x*,T*), such that .

• D2 anticipates this and rejects contract.

)2/,2/( mmq

2/* mqx

Vertical Foreclosure

• The only possible equilibrium is for U to offer contract , where firms make Cournot-Nash profits.

• In this contract, neither D-firm has an incentive to raise outputs.

• The solution for U to achieve maximum profit is to merge with one of the D-firms.

),( ccq

Vertical Foreclosure

Vertical Foreclosure

• Firm U-D1 sells monopoly quantity through its downstream subsidiary.

• Since it already captures full monopoly profits, it has no incentives to supply D2.

Vertical Restraints

• Let’s broaden our analysis further and consider two possibilities:– Intra-Brand competition: competition between two

different retailers of the same brand of the product.

– Inter-Brand competition: competition between two different manufacturers/retailers with different brands the same or similar product.

Vertical Restraints

• Retailers can invest in advertising, customer service, consumer education, all of which enhance consumer willingness to pay.

• Such investments benefit retailer but also its competitors and the manufacturer;– Thus the level of investment will be insufficient.

• Vertical restraints can ensure the optimal level of services.

Vertical Restraints

• Could specify contractually what services should be provided, – How does one determine the right level of services? How

does one monitoring the level of services?

• This is an example of the principal-agent problem: – the manufacturer is the principal, – the retailer is the agent.

• Solution: Align the agent's payoff function with the principle's payoff function.

The Principal-Agent Problem

• Assume Q = (A-P)s where s is the service level, then P = A - Q/s.– Assume the cost of s is increasing (diminishing marginal

returns to service).

• To maximize joint profits, there is an optimal level of service and an optimal price to the consumer.

• On his own, the retailer will set price is too high (due to double marginalization) and the service too low (due to free riding).

Possible Solutions to the P-A Problem

• Resale Price Maintenance: Establish a minimum price that the retailer can set.– Retailers cannot use price to increase consumer

demand, so they must increase service to compete with other retailers.

– Works for some services, although not for advertising.

• Exclusive territories: Designate one retailer for a certain area.– Retailer gets all the benefits from services provided.

Manufacturer Competition

• Vertical restraints can help manufacturers compete against rivals.

– Slotting allowances: fixed fee paid to retailers to obtain shelf space. Two-part tariff in reverse.

– Exclusive dealing: if the manufacturer provides services (e.g., training) to retailer which could benefit other manufacturers.

Pro-competitive Effects of Vertical Restraints

• Exclusivity: gain economies of scale, lower distribution costs, achieve optimal level of services.

• Resale price maintenance: achieve optimal level of services.

• Royalty and franchise agreements: overcome double marginalization.

Anti-competitive Effects of Vertical Restraints

• Exclusivity: facilitate collusion, foreclose markets to competitors.

• Resale price maintenance: facilitate collusion.

• Royalty and franchise agreements: foreclose markets to competitors.

Antitrust and Vertical Restraints

• Exclusivity.– Evaluated under rule of reason: do they harm

welfare/consumers overall. Takes into account differences between intra- and inter-brand competition.

• Resale price maintenance.– Per se illegal.

• Royalty and franchise agreements.– Some limits on these agreements, evaluated under

rule of reason.