Lecture 11 Vertical Relations

7/30/2019 Lecture 11 Vertical Relations

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Tore Nilssen Strategic Competition Lecture 11 Slide 1

Vertical relations

Products are sold through retailers.How does this affect market performance?

pw wholesale price

p retail priceDemand: q =D(p)

Contracts producer-retailer

One extreme:vertical integration producer and retailer act as if they are one firm

The other extreme:linear price total price is T(q) =pwq

p

pw

c

Producer

Retailer


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Two-part tarifftotal price is T(q) =A +pwqprice per unit decreasing in q quantity discountA franchise fee

Resale price maintenanceProducer determines the retail price.Variations: price ceiling, price floor.

Exclusive dealingRetailer is not allowed to carry competing producersproducts.(inter-brand competition)

Exclusive territories

Retailer has the sole right to sell the producers productswithin a specified area.(intra-brand competition)

Arguments for vertical integration

incentives for relationship-specific investments we focus here on other arguments


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Vertical externalities

Double marginalizationIf both producer and retailer are monopolists, then quantitysold is less than if they were integrated.

pw > c pm(pw) >p

m(c)

Example:D(p) = 1 p, c < 1

(i) No integrationThe retailer solves:

maxp r= (p pw)(1 p)

21 wpp +=

21 wpq =

The producer solves:

( )2

1max wwp

p

pcp

w

=

21 cpw+

= 4

1,4

3 cqcp

=+

=

Total profit:( ) ( )

( )222

116

3

16

1

8

1c

ccrpni =

+

=+=


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(ii) IntegrationThe integrated firm solves:

maxp i = (p c)(1 p)

2

1,

4

3

2

1 cq

ccp

=

+

=

4

12

Both the two firms and society would gain from anintegration.

Alternatives to full integration

(a) two-part tariffT(q) =A +pwq

The producer can set:pw = c,( )

4

12

cA

=

Interpretation: Sell the whole business to the retailer for a

price equal to monopoly profit the retailer becomes theresidual claimant.

But:- risk-sharing: what if D(p) is uncertain and the retailer is

risk averse?- asymmetric information aboutD(p)


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(b) resale price maintenanceProducer restricts retail price:ppm,sets wholesale price:pw = p

m.

But again: risk sharing

Other externalities

- retailer serviceThe retailer may, by putting in promotion effort, increasethe demand for the product. But some of the increase indemand will benefit the producer.

Two-part tariff still works (but: risk sharing?)

Resale-price maintenance is not sufficient:The producer would want to control the service level,too.

- input substitutionTie-in: producer sells both inputs to the retailer.


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A horizontal externality

Several retailers.

One retailers advertising effort benefits also the otherretailers.

The producer needs to encourage such efforts in orderhimself to benefit from this externality.

Two-part tariff withpw < c

Retailer power

What if the retailer has the bargaining power?Example: recent changes in the Norwegian grocery industry.Gabrielsen & Srgard, Scand J Econ 1999


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Vertical foreclosure

A firm has control over the production of a product orservice that is an essential input for producers in apotentially competitive industry. The competition in thisindustry can be altered by the firm by denying or limitingaccess to the input.

Essential facility- bottleneck- network industries: firms need access to network to

deliver product or service telecom: AT&T, Telenorpower: Statnett shipping: harbours railway: Eurotunnel

- outside network industries: firms are at a disadvantagewithout access computer reservation systems for airlines cooperatives: ski lifts, newspapers, ATMs distribution of goods: retailing chains (food

stores, pharmacies, book stores, pubs)

Horizontal foreclosure: bundling, tying- complement products with one firm having (near)

monopoly in one of the markets- Microsoft

Windows/internet browser Windows/media player


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The Chicago School

Theres only one monopoly profitto be had. Vertical integration and vertical foreclosure cannot be

harmful.

If there is a problem, it is that there is no competitionupstream.

The foreclosure doctrine

The upstream firm does indeed have incentives to favourone downstream firm, such as a downstream subsidiary.

Upstreammonopolist

Downstream

subsidiary

Downstream

competitor


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A reconciliation: the role of commitment

Having contracted with one downstream firm, theupstream firm has incentives to contract further withother downstream firms, even though these firms in turnwill compete with the first firm and decrease its profit.

The first downstream firm realizes this and is less willingto sign a contract. This reduces the upstream firms

profit.

The upstream firm will be looking for ways to get aroundthis problem. Vertical foreclosure

Analogue: The durable-good monopolist. (RonaldCoase)

Model

U

D1 D2

Consumersp = P(q)


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Timing

Stage 1: Firm Uoffers firmsD1 andD2 tariffs T1() and

T2() for purchase of the intermediary good. EachDi thenorders a quantity qi and pays Ti(qi).

Stage 2: FirmsD1 andD2 transform intermediate good intofinal good and sell at pricep = P(q1 + q2).

Define: Qm = arg maxq {[P(q) c)]q}

pm = P(Qm), m = (pm c)Qm

Observable contracts

Firm Uoffers (qi, Ti) = (Qm

/2,pm

Qm

/2) to each downstreamfirm. They both accept and sell in total monopoly quantityat monopoly price. No rationale for foreclosure.

But can firm Ucommit to these contracts?

IfUandD2 agree on (q2, T2) = (Qm/2,pmQm/2), thenfirms UandD

1would want to sign a contract that

maximizes their joint profit given the U/D2 contract, witha quantity q1 given by:

q1 = arg maxq {[P(Qm/2 + q) c)]q} > Qm/2.

Anticipating this, firmD2 would turn down the (Qm/2,pmQm/2) offer.


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Secret contracts

Passive beliefs: If a firm receives an unexpected offer, itdoes not revise its beliefs about the offer made to its rival.

Consider a candidate equilibrium in which firmDj isoffered a quantity qj. Whatever firmDi is offered, it stillbelieves that firmDj is offeredqj.

Firm Uoffers firmDi a quantity qi so that the joint profitforU/Di is maximized, given the offer ofqj to firmDj:

qi = arg maxq {[P(q + qj) c]q}

This is the same problem as the one facing a Cournotduopolist.

q1= q2 = q

C

the Cournot quantity

The profit of the upstream firm:

U= 2C< m

The upstream firm suffers from its inability to commit. The problem becomes more severe the larger the number

of downstream firms.

The more competitive the downstream industry, the moreinterested is the upstream bottleneck owner inforeclosure in order to retain profit.


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Why does the upstream firm foreclose access?

- Not in order to extend its market power to thedownstream market, but rather in order to re-establishthe market power lost because of its inability to commit.

Downward integration

Firm Ubuys one of the downstream firms. It crediblyoffers the monopoly quantity Qm to its own affiliate andnothing to the other.

Bypass: Sometimes, there is an alternative supplieravailable to the non-integrated firm, so that the foreclosingfirm can be bypassed. Still, if the alternative supplier is less

efficient for example, has higher production costs c > cforeclosure with bypass is inefficient.

Exclusive dealing

By entering an exclusive-dealing contract withD1, firmUcommits itself not to supply toD2.

A substitute for vertical integration.

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Lecture 11 Vertical Relations