Vertical Restraints Advanced Industrial Organization 1 · Otherwise case-by-case analysis (Standard Oil (1911), Colgate (1919)) ... New rules towards agreements between ﬁrms (art.81)

VERTICAL RESTRAINTSAdvanced Industrial Organization 1

THIBAUD VERGÉ

CREST-LEI

ENSAE and Master APE (2009-10)

THIBAUD VERGÉ ( CREST-LEI ) Vertical Restraints Advanced IO 1 1 / 52

Introduction

Outline

1 Introduction

2 Vertical Coordination

3 Inter-brand Competition

4 Exclusivity and Foreclosure

5 Conclusions


Introduction Types of Restrictions

Tariffs

Non-linear tariffsTwo-part tariffs (T (q) = F + wq)

Quantity rebates

RoyaltiesFinal cost of a good depends not only on the quantity bought, but alsoon:

quantity actually sold;possibly on the turnover (maybe including that realized on the saleof other goods).


Introduction Types of Restrictions

Limiting the parties’ rights

Resale Price Maintenance (RPM) and quotasFinal price chosen by the producer

Variants: Price floor, price ceiling, recommended retail price, . . .Quantity sold fixed by a manufacturer

Variants: minimal quantity, quotas (rationing).

Tie-in salesFixed proportions (bundling)Full-line Forcing

Exclusivity ClausesExclusive territoriesExclusive or selective distribution


Introduction Competition Law

U.S. Competition Law

From the Sherman Act (1890) to Bush Sr.Sherman Act (1890)

Section 1: Restriction to competitionSection 2: Abuse of dominant position

Dr. Miles (1911), resale price maintenance becomes per se illegal.Otherwise case-by-case analysis (Standard Oil (1911), Colgate(1919))White Motors (1963): “the legality of territorial and customerlimitations should be determined only after a trial.”Schwinn (1967): all types of vertical restraints become per seillegal.Softening and back to case-by-case after GTE Sylvania (1977)Reagan and Bush Sr.: “laissez-faire” (Chicago School)



U.S. Competition Law

Recent EvolutionMore active enforcement“Rule of reason” (case-by-case analysis)Robert Pitofsky (FTC Chairman, 1996):“The Commission of the 1990s has tried to strike a middle groundbetween what many people believe was an excessively activeenforcement in the 1960s and the minimalist enforcement of the1980s. (...) The Commission investigates and is prepared toenforce the law against RPM agreements, some carefully selectednon-price vertical restrictions (...).”Recent Cases: Toys R Us, Microsoft, LePage v. 3M, Orbitz, . . .



European Competition Law

Multiple objectivesMore recent legal framework (Treaty of Rome (1957),implementation rules (1962, recently revised))Two objectives

Promote competitionCommon Market

Very strict against practices preventing or restricting parallelimports (Peugeot (2005), Nintendo (2003), Volkswagen (2001),Opel (2001), . . . )Very formal and bureaucratic approach until the recent reforms

New rules towards agreements between firms (art.81) came intoforce in May 2004Discussion about abuses of dominant position (art. 82)



European Competition Law

Main FeaturesResale Price Maintenance: black listMore lenient approach for non-price restrictions

Exclusive territories can be used in franchise contracts (Pronuptia(1987))But will be banned if it leads to restrictions of parallel imports(Grundig - Consten (1964, 1966))

Individual or block (category) exemptions (insurance contracts, cardistribution sector, . . . )

The mode of distribution is an essential elementFranchise agreements 6= exclusive or selective distribution

Recent cases: Michelin, Microsoft, The Coca-Cola Company


Vertical Coordination

Outline

1 Introduction




5 Conclusions


Vertical Coordination Double Marginalization

Successive monopolies

Basic frameworkOne producer selling through one retailerConstant marginal costs of production (c ≥ 0) and distribution(γ = 0)Demand D (p) = 1− p

The “game”Formally, we look for the subgame perfect Nash equilibrium of thefollowing game:

1 The producer sets the wholesale price w2 The retailer sets the retail price p



Retail price as a function of w

Which p for any given w?

maxp

(p − w) D (p)⇔ p = p (w) =1 + w

2

Equilibrium wholesale price w

maxw

(w − c) D (p (w))⇔ w = w =1 + c

2

Thereforew = 1+c

2 , p = 3+c4 , D = 1−c

4

ΠP = (1−c)2

8 , ΠD = (1−c)2

16 , S = (1−c)2

32 , W = 7(1−c)2

32



Comparing with the integrated structure

Maximizing the integrated structure’s profit

maxp

(p − c) D (p)⇔ p = pm =1 + c

2

Comparisonpm < p

ΠI = (1−c)2

4 > ΠP + ΠD = 3(1−c)2

16 ,

WI > W

General resultVertical integration eliminates the double marginalization problem.



Vertical relationships and double marginalization

Idea:If they are externalities (+ or -), «coordination» is necessary

Vertical integration:Looked at more favorably by competition authorities than verticalrestraints.

Some ambiguous results:Short term benefit (lower prices)Long term barriers to entry?Foreclosure, predation?



Using vertical restraints to solve the doublemarginalization problem

Type of restraintsFranchise contract (or two-part tariff)Resale price maintenanceQuotas



Franchising contract

Two-part tariffT (q) = F + wqLeads to the maximization of the joint profit

The producer offers the tariffLow wholesale price w = c and maximal fixed fee F = Πm

ΠP = Πm, ΠD = 0

The retailer offers the tariffLow wholesale price w = c but minimal fixed fee F = 0ΠP = 0, ΠD = Πm



Resale price maintenance

The producer chooses w and pThen w = p = pm

And we thus have ΠP = Πm, ΠD = 0

In reality we often observePrice floors: p ≥ p, but would not solve the problem hereHowever a price ceiling (or maximum RPM, p ≤ p = pm) wouldwork.Minimal quantities

(q ≥ p = qm) would also solve the problem



Vertical restraints as solutions to the doublemarginalization problem

Vertical restraintsAllow perfect coordination within the vertical structure (withoutintegration)Increase profit and consumer surplus (and thus total welfare)Different types of restraints lead to the same result

LimitationDemand and/or cost uncertaintyBetter informed retailers (e.g. local demand conditions)Competition between identical retailers


Vertical Coordination Retail Services

Services offered by the retailer

ServicesInformation or advice to consumers. . .Reducing waiting time at the check-out, delivery, . . .After-sales services, hotline, . . .

Adapting the basic frameworkThe retailer exerts an effort s . . .. . . that increases the demand D(p, s)

Effort is costly: φ(s) per unit (of effort)



Linear tariff vs. Two-part tariff

Pricing and effort decisions

maxp,s

(p − w − φ(s)) D (p, s) =⇒

{(p − w − φ(s))∂D

∂p + D(p, s) = 0(p − w − φ(s))∂D

∂s = φ′(s)D(p, s)

Linear tariffThe producer chooses w > cThe vertical structure’s profit is therefore not maximized

Two-part tariffIf w = c, the retailer chooses the retail price and the level of effortthat maximize the joint profit.The fixed fee can then be used to share that profit.



Other types of vertical restraints

How is it possible to replicate vertical integration?RPM does not suffice since the retailer chooses the optimal levelof effort only when w = cMonitoring (imposing) the level of effort cannot work with lineartariffs onlyHowever setting the quantity to be sold generates the “monopoly”profit.



Quantity forcing

The producerforces the retailer to sell at least: qm = D (pm, sm)

sets a wholesale price equals to: wm = pm − φ (sm)

The retailer

max (p − pm + φ (sm)− φ(s)) D(p, s) s.t. D (p, s) ≥ qm

⇔ max (p − φ(s)) s.t. D (p, s) = qm

⇔ D (p, s) = qm and φ′(s)∂D∂p

+∂D∂s

= 0

Chooses the retail price and effort level that would be chosen by avertically integrated structure: p = pm et s = sm



Welfare effect

Consumer surplusThis time the impact on consumer surplus is ambiguousThe vertically integrated structure takes into account the effect ofa change in price or service level on the marginal consumerBut the consumer surplus depends on the average effect of achange in price and retail servicesIn general, marginal 6= average, when consumers areheterogenous

ConclusionEliminating double marginalization increases profit but does notnecessarily increase total welfare.



Intra-brand competition

Competition alone does not sufficeIntra-brand competition eliminates the retail marginBut the effort levels are not optimal (from the point of view of thevertical structure)

SolutionsRPM (here minimum RPM - price floors - suffices) leads to jointprofit maximizationBut two-part tariffs don’t.

They could however be combined with territorial exclusivity



The “free-rider” problem

“Free-Riding”Example: pre-purchase consumer information / adviceProblem: A customer might come to get some advice and then goand buy from a cheaper rivalConsequences: without “guarantee”, retailers are not willing tooffer pre-purchase advice to consumers (prisoner’s dilemma).Joint-profit is not maximized.

SolutionsVertical restraints are thus needed to restore vertical coordinationExclusive territories or RPM can be used as they eliminateintra-brand competition (and thus the free-riding problem)Combined with two-part tariffs to solve the double marginalizationproblem


Inter-brand Competition

Outline

1 Introduction




5 Conclusions


Inter-brand Competition Softening Inter-brand Competition

Rey and Stiglitz (Rand Journal of Economics, 1995)

Consommateurs

Fonctions de demande: q1=D1(p1,p2) et q2=D2(p1,p2)

w1

Distributeur 2

Coût γ

Distributeur 1

Coût γ

Producteur 2

Coût c

Producteur 1

Coût c

w2

p1 p2



Rey and Stiglitz (1995)

Strategic Use of Vertical RestraintsInteractions between vertical structuresUse of restraints as a commitment device to appear lessaggressive (e.g. reducing competitive pressure)Assigning exclusive territories

Eliminates intra-brand competitionBut also reduces inter-brand competition

Impact of intra-brand competitionThe strong competition between retailers eliminates retail marginsRetail price = wholesale price + retailing costIntra-brand competition: equivalent to a situation where the twoproducers sell directly to consumers




In the absence of any kind of restraintpi − c − γ

pi=

1εii (p1,p2)

, where εii (p1,p2) = − pi

Di

∂Di

∂pi

Exclusive territoriesProducer 1 assigns exclusive territories to its retailersRetailers selling product 2 still compete, therefore p2 = w2 + γ.Retailers selling product 1thus sell at pr

1 (p2; w1) such that:

pr1 (p2; w1)− w1 − γ

pr1 (p2; w1)

=1

ε11(pr

1 (p2; w1) ,p2)




Competition between producersThe demand faced (perceived) by producer 2 is now:

Dr2 (w1,w2) = D2 (pr

1 (w2 + γ; w1) ,w2 + γ)

The elasticity of the perceived demand with respect to (w.r.t.) w2thus writes as:

εr22 (w1,w2) = ε22 (pr

1 (p2; w1) ,p2) + λ12ε21 (pr1 (p2; w1) ,p2)

whereλ12 is the elasticity of the best response function pr

1 (p2; w1) w.r.t. p2ε21 is the elasticity of substitution of demand D2 w.r.t. p1




(Reasonable) AssumptionsProducts are imperfect substitutes so that ε21 < 0An increase in w2 (and thus in p2) reduces the competitivepressure on product 1, thus λ12 > 0

Conclusionsεr

22 < ε22

Producer 2 is thus less aggressiveMaking producer 1 less aggressive too

⇒Wholesale prices and thus retail prices are higher inequilibrium




Some RemarksRequires retailers to have some freedom (to set prices)

Resale price maintenance would have the same effect asintra-brand competition

Commitment must be credible

Non-linear tariffs should be expected to have a more limited impactthan territorial restrictions (observability)

Not linked to the fact that producers make the offers

Slotting allowances (see Shaffer (Rand Journal of Economics,1991))


Inter-brand Competition Collusion

Resale Price Maintenance (RPM) and collusion

Informal arguments against RPMU.S. Supreme Court (Business Electronics, 1988):“There was support for the proposition that vertical price restraintsreduce intra-brand competition because they facilitate cartelization”

Mathewson and Winter (Review of Industrial Organization, 1998):“If wholesale prices are not easily observed by each cartel member,cartel stability would suffer because members would have difficultydistinguishing changes in retail prices that were caused by cost changesfrom cheating the cartel. Resale price maintenance can enhance thecartel stability by eliminating retail price variation”


Inter-brand Competition Collusion

Jullien and Rey (Rand Journal of Economics, 2007)

In the absence of RPMRetail prices reflect wholesale prices but also shocks on (local)demand or retailing costsMore difficult to identify deviations from the collusive path and thusto sustain a collusive outcome

Resale Price MaintenanceUniform retail pricesDeviations are now easily detected and thus collusion is facilitatedNot necessarily optimal since prices do not adjust following a localshockOverall ambiguous effect on consumer (and thus total) surplus,although more likely to be negative


Inter-brand Competition Interlocking Relationships

Rey and Vergé (Journal of Industrial Economics,forthcoming)

ConsommateursFonctions de demande: i≠h=A,B et j≠k=1,2: qij=Dij(pij,phj,pik,phk)

Distributeur 2

Coût γ

Distributeur 1

Coût γ

Producteur B

Coût c

Producteur A

Coût c

(wA1 ,FA1)(wA2,FA2) (wB1,FB1)

(wB2,FB2)

(pA1,pB1) (pA2,pB2)



One Common Retailer

Bernheim and Whinston (Rand Journal of Economics, 1985)Retail prices chosen by the (common) retailer:(

pMi (wA,wB)

)i=A,B

= arg max(pA,pB)

∑i=A,B

(pi − wi − γ) Di (pA,pB)

Denote by πMA+B (wA,wB) the corresponding profit, and by

qMA (wA,wB) and qM

B (wA,wB) the quantities soldSelling the two products the retailer thus earns:

πR(A,B) = πMA+B (wA,wB)− FA − FB

By selling product i only, it obtains:

πR(i) = πMi (wi)− Fi , où: πM

i (wi) = maxpi

[(pi − wi − γ) Di (pi , ∅)]



One Common Retailer

EquilibriumThe maximal fixed fee the retailer is ready to pay to sell product Ais thus:

πR(A,B) = piR(B)⇐⇒ F A = πMA+B (wA,wB)− πM

B (wB)

In equilibrium, we must thus have:

w∗A = arg maxw

[(pM

A (w ,w∗B)− c − γ)

qMA (w ,w∗B)

+(

pMB (w ,w∗B)− c − γ

)qM

B (w ,w∗B)− πMB (w∗B)− F ∗B

]



One Common Retailer

EquilibriumThe rent left to the retailer cannot be directly affected by aproducerTherefore the best a manufacturer can do is to set its wholesaleprice so as to maximize the industry profit (taking the retailers’decisions into accountIf w∗B = c, it is optimal for retailer A to generate the monopolyprices setting w∗A = c

Equilibrium with a common agentUnique equilibrium (wholesale prices) w∗A = w∗B = c, leading tomonopoly prices and (industry) profit



Rey and Vergé (forthcoming)

ConsommateursFonctions de demande: i≠h=A,B et j≠k=1,2: qij=Dij(pij,phj,pik,phk)

Distributeur 2

Coût γ

Distributeur 1

Coût γ

Producteur B

Coût c

Producteur A

Coût c

(wA1 ,FA1)(wA2,FA2) (wB1,FB1)

(wB2,FB2)

(pA1,pB1) (pA2,pB2)



Intrinsic Double Comment Agency

Timing1 Producers offer two-part tariffs

(wij ,Fij

)and when possible,

impose the retail price pij .2 Retailers (simultaneously) accept or reject the offers3 Two possibilities:

All offers have been accepted: retailers compete in prices on thefinal marketOne of the offers has been rejected: all profits are equal to 0.

RemarkResults extend to more realistic framework as long as the following conditions aremet:

Retailers do not have market power

A producer cannot exclude the rival from one of the markets



Intrinsic Double Comment Agency

Retail EquilibriumEach retailer j = 1,2 chooses the retail prices pAj and pBj thatmaximize its profit:

πj =(pAj − wAj − γ

)DAj (p) +

(pBj − wBj − γ

)DBj (p)− FAj − FBj .

For any vector of wholesale prices w, we denote by

pr (w) = (prA1 (w) ,pr

B1 (w) ,prA2 (w) ,pr

B2 (w))

the equilibrium retail prices and by Drij (w) = Dij (pr (w)) the

corresponding quantities



In the absence of RPM

Producer’s maximization programEach producer i maximizes its profit (under constraints):

maxwi1,wi2,Fi1,Fi2

(wi1 − c)Dri1(w) + Fi1 + (wi2 − c)Dr

i2(w) + Fi2,

s.t . : (pri1 (w)− wi1 − γ)Dr

i1 (w)− Fi1 + (prj1 (w)− wj1 − γ)Dr

j1 (w)− Fj1 ≥ 0

(pri2 (w)− wi2 − γ)Dr

i2 (w)− Fi2 + (prj2 (w)− wj2 − γ)Dr

j2 (w)− Fj2 ≥ 0

In equilibrium the constraint are necessarily binding and theprogram rewrites as:

maxwi1,wi2

Πri (w) ≡

∑j=1,2

(pr

ij (w)− c − γ)

Drij (w) + (pr

hj (w)− whj − γ)Drhj (w) .



In the absence of RPM

Competitive EquilibriumIn any equilibrium without resale price maintenance, retail pricesare below their monopoly level

For producers, using a comment agent is a way to eliminateinter-brand competition

However, in order to limit competitive pressures (from intra-brandcompetition), a producer (say A) should set wholesale pricesabove marginal cost

But in that case, the producer B does not internalize the retailmargin earned on producer A’s products and are thus tooaggressive

This leads to relatively competitive prices



Resale Price Maintenance

Multiple EquilibriaA producer’s profit no longer depends on its wholesale pricesBut its rival’s profit doTherefore wholesale prices affect the equilibrium retail prices andwe usually have co-existence of multiple equilibria

There exists an equilibrium with monopoly pricesThis equilibrium is such that the producers:

1 Set retail prices at their monopoly level2 Set wholesale prices equal to their marginal costs (i.e. wij = c)3 Use the fixed fees

(Fij)

to recover the monopoly profits



Equilibrium with Monopoly Prices

Producer’s programSuppose that producer B adopts this strategy. Producer A’s profitthus writes as: (with p =

(pA1,pM

B1,pA2,pMB2))

ΠA =∑

j=1,2

((pAj − c − γ

)DAj (p) +

(pM

Bj − c − γ)

DB1 (p)− FBj

).

This profit is equal to that of the vertically and horizontallyintegrated structure (up to a constant)It is thus optimal for the producer to set its retail prices at theirmonopoly levelThis equilibrium is the only one robust to the introduction of an(retailer) effort variable



Interlocking Relationships and Monopoly PricesEmpirical Evidence

See Bonnet, Dubois and Simioni (mimeo, 2005) and Bonnet andDubois (Rand Journal of Economics, forthcoming)

Bottled water in France

Individual consumption data, 1998-2001

Methodology à la Berry, Levinson and Pakes (Econometrica,1995)

Multinomial Nested Logit Demand

Test several specifications of the competition game

Best-fit: Two-part Tariffs with RPM



Interlocking Relationships and Monopoly PricesRecent French Antitrust Cases

Brown Goods (December 2005)Philips (e16m), Sony (e16m) and Panasonic (e2.4m) fined by theFrench competition authorities

“Recommended” retail prices to distributors and refusal to sell todistributors cutting prices

Perfumes (December 2005)L’Oréal, Chanel, Dior, Kenzo, Guerlain, Givenchy, . . .

Mariannaud, Séphora, . . .

Total fines: e45.4 million


Exclusivity and Foreclosure

Outline

1 Introduction




5 Conclusions


Exclusivity and Foreclosure Slotting Allowances

Slotting Allowances

Marx and Shaffer (RAND Journal of Economics, 2007)A producer selling through multiple (two) retailersRetailers have all the bargaining power (make offers)Three-part tariffs: Slotting allowances, conditional fixed fee andunit wholesale priceSlotting allowances are used by the “biggest” retailer to exclude itsrival

Miklós-Thal, Rey and Vergé (Journal of the European EconomicAssociation, forthcoming)

Similar model but with contingent contracts (an exclusivity offerand an non-exclusive offer)Slotting allowances are eliminate intra-brand competition but theproduct is sold by the two retailers


Conclusions

Outline

1 Introduction




5 Conclusions


Conclusions

Competition Policy and Vertical Restraints

No simple conclusionWhat matters is not the type of restraints but the context inwhich it is used

Improving vertical coordination cannot be the essential argumentto defend a particular restraint

Interactions between vertical structures (inter-brand competition)are the most important feature

Theoretical ConclusionsNo per se rule but case-by-case analysis


Conclusions


Intra- and inter-brand competitionMarket structure –and more specifically the extent of inter-brand competitionfrom other producers and distributors - is a crucial factor in the analysis of theeffects of vertical restraints

Vertical restraints are unlikely to harm economic efficiency when inter-brandcompetition is fierce

ConclusionCompetition authorities should focus on:

The extent of inter-brand competition

The role of alternative distribution systems (e.g. hard discount versus moreconventional channels)

Rather than on intra-brand competition


Conclusions


Final RemarksVertical restraints (especially price restraints) might haveanti-competitive effects even though there is strong inter-brandcompetition.

Beware of intricate relationships (i.e. when producers use commonretailers)

Effects based policies (i.e. coherent decisions based on thewelfare impact of a practice) rather than strict rules based on thetype of restraint


Documents

Vertical Restraints Advanced Industrial Organization 1 · Otherwise case-by-case analysis (Standard Oil (1911), Colgate (1919)) ... New rules towards agreements between ﬁrms (art.81)