INDUSTRIAL ECONOMICS II Prof. Davide Vannoni Handout 7: Vertical Restraints Content of le ture and o!

"e tive# Introduction Vertical Integration the gains & possible anticompetitive effects Defining vertical restraints classification and examples The efficiency justification nti!competitive conse"uences

#ome real $orld examples $here the effects are contested Su$$e#ted readin$ Tirole% chapter &% but also chapter ' (especially sections ')* & ')&+ ,abral ch)'' ,hurch and -are ch).. /artin # ('00*+% Advanced Industrial Economics% 1 1lac2$ell% ch) '. Competition Commission (.333+ Report on #upermar2ets (4ood Retailing+ Dobson 5 and -aterson / ('006+ 7Vertical restraints and competition policy8% OFT Research Paper 9o) '. -aterson / ('00'+% 7Vertical Integration and Vertical Restraints8% Oxford Review of Economic Policy, vol) 0 no). ,lar2e% Davies and Driffield ('00:+% ch : for an extensive annotated listing of ;< cases (see Table :)' p)'.* for summary)+ #lade / ('00:+% 71eer and the tie: did divestiture of bre$er o$ned public houses lead to higher beer prices=8 Economic ournal% '3::
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%. Introdu tion In most real $orld mar2ets% the producer does not sell direct to final consumers they may produce only intermediate products% and?or may sell via a retailer) -e can thin2 of most products or services as the result of a vertical chain% e)g) a restaurant meal 4ull vertical integration occurs $henever successive stages of this chain are brought under single o$nership% e)g) a clothing manufacturer $ith its o$n retail shops% a car manufacturer $ith its o$n steel factories Vertical restraints are a milder form% in $hich a firm at one stage imposes restraints on its customers or suppliers in adjacent stages) 1elo$% I $ill tend to concentrate on the relationship bet$een manufacturers and retailers: a clothing manufacturer might o$n its o$n retail shops (vertical integration+% or it might impose restraints on the retailers concerning ho$ its clothing is sold in their shops) @"ually% it might impose restrictions on it textile suppliers The big "uestion: are vertical restraints (and vertical integration+ justified because they improve efficiency% or are they harmful to competition and consumer $elfare because they allo$ the firms to achieve and abuse mar2et po$er= This is highly contested territory)

&. 'ull Verti al Inte$ration There are t$o standard textboo2s explanations of $hy firms choose to be vertically integrated% each of $hich suggests that vertical integration is a Agood thingB from societyBs point of vie$) &.% Mini(i#e# tran#a tion# o#t#

This is the standard ,oase?-illiamson explanation of $hy firms choose to internalise exchanges $ithin the firm% rather than use mar2et transactions bet$een firms) The problems of transacting (i)e) contracting+ bet$een firms': unforeseen contingencies so many future possibilities that $riting them all into the contract $ould be too costly monitoring the contract may be costly enforcement costs (litigation+ $ill be high Civen that contracts are% necessarily% incomplete% there is al$ays the possibility of opportunistic behaviour (especially $ith specific assets)+ -here such costs of using the mar2et are high% it is best for the firm (and society+ if the activities are combined $ithin a single firm) #ee Tirole sections ')* and ')& for more discussion)+

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#ay% bet$een one firm underta2ing R&D and another% manufacturing% in some very high!tech mar2et) In principle% they could be separate firms% in practice% both activities are underta2en $ithin the same firm)

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Avoidan e of dou!le (ar$inali#ation )#u e##ive (ono*ol+

(ar,-u*#. This is the standard defence of vertical integration in the ID literature) T/e *ro!le(: $here one monopolist is selling to another monopolist% there is the possibility that each party adds its o$n mar2!up price is higher than needed for joint maximisation & the consumer loses out) (This is covered% slightly differently from the follo$ing% in Tirole in section &).).)+

A #i(*le (odel A##u(e0 ;pstream monopolist supplier of monopolist producer of 1 one unit of is re"uired for each unit of 1 supplies a do$nstream

The upstream monopolist incurs a constant marginal cost /, E , ) The do$nstream monopolist incurs no marginal cost% other than the input) Thus /,1 E 5

1/at *ri e 2ill A /ar$e 34

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 1efore $e can ans$er% $e need to 2no$ the demand curve for from 1) To derive this $e first note that 1 $ill maximise his profits by setting /R1 E /,1 E 5 #o $hatever price is set by % this becomes 1Bs marginal cost% and this $ill be e"uated to 1Bs marginal revenue) In other $ords% firm 1Bs /R curve becomes Bs derived demand curve% (see figure (a+)+ 9o$ turn to figure (b+ to see $hat this implies for Bs optimal price) Fe $ill set his o$n /R E /, % and this implies "uantity G H and price 5 H)

1/at i# 35# final *ri e4 1 sets his o$n marginal cost (5 + e"ual to his /R1% implying a price to final consumers of 51H) Thus% there is a double mar2!up) If A and 3 are inte$rated )i.e. a #in$le fir(.. In this case% it sets /R1 E , % $ith output GIH and price 5IH

Nu(eri al e6a(*le Iinear demand curve: Bs constant /, are .: TR1 E '3G1 G1.% and so #o /R1E/,1 means 51E '3 ! G1 /, E . /R1 E '3 ! .G1 '3 ! .G1 E 5 is: 5 E '3 ! . G In figure (b+% firm Thus G E .% 5 E 6% and 51 E '3 . E :% 1ut in t/e inte$rated a#e% /R E /,% i)e) Therefore G E &) 5 E 6% '3 .G E . E (5 .+)G E '6 sets /R E /, % i)e) '3 ! &G E . E (5 , +)G E : 1 E (51 ,1+)G E &

nd% since G EG1% the derived demand curve for

;nder vertical integration price is lo$er% "uantity is higher and both consumerBs surplus and producerBs surplus are higher $)r)t separation E6ten#ion#: a+ -hat happens if there is more than one firm at the do$nstream stage $here competition is on prices=

b+ -hat happens if there is more than one firm at the do$nstream stage $here competition is on "uantities= c+ Is vertical integration the only strategy to avoid double marginalisation= 9o% other strategies sort the same effect) ! Re#ale Pri e Maintenan e ! R5/ (the do$nstream firm cannot sell at a price higher than 6+ ! 7uantit+ fi6in$ (the do$nstream firm must buy & units or more+ ! 'ran /i#e fee! do$nstream firm is charged a t$o part tariff: 4 K . ") 5rofits of the do$nstream firm are '6! 4 $hile profits of the upstream firm are 4: they bargain over 4)

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Po##i!le /ar(ful effe t# of verti al inte$ration extract full monopoly profit $hen unintegrated

extension of mar2et po$er in cases $here each stage is unable to foreclosure of rivals (refusal to supply+ and?or to increase barriers to entry 4or more detail% see vertical restraints belo$)

8. Verti al Re#traint#0 definition and la##ifi ation # /e(e Vertical Restraint (VR+ is anything $hich restrains the freedom of resaleL invariably contractual% and can be seen as an alternative to full vertical integration 1eing similar to vertical integration% VR can usually be justified on efficiency terms (incl) avoidance of double marginalisation)+ 4or anti!competitive conse"uences% $e should loo2 for the possible impact on collusion% predatory possibilities and entry deterrence 1elo$% thin2 mainly in terms of the relationship bet$een manufacturers and retailers) This $ill focus our minds on a 2ey distinction ! bet$een intra!rand and inter!rand competition (T: 'J.!*+) U*#trea( U*#trea(% U*#trea(&

Do2n#trea(%

Do2n#trea(&

Do2n#trea(%

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la##ifi ation and no(en lature (ini(u( #ale# re9uire(ent: the manufacturer re"uires the retailer to sell at least a minimum "uantity (T:'J'+ re#ale *ri e (aintenan e the manufacturer insists retailer does not price belo$ some minimum (T: 'JJ+ $eo$ra*/i re#tri tion# on lo ation of #ale# a$ent: territorial re#tri tion#: the manufacturer bars the agent (retailer+ from selling outside his designated locality #ele tive di#tri!ution: the manufacturer limits $hich retailers can sell his product e6 lu#ive dealer#/i*: the manufacturer bars the retailer from selling rival manufacturersB products tie in #ale#; full line for in$; !undlin$: the manufacturer re"uires the consumer to purchase AbundlesB of his products

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Effi ien + defen e# of VR !ote that, in these four cases, "Rs will ultimately #enefit the consumer as well as the manufacturer$ I. Mini(i#e# tran#a tion# o#t# lso% $ithout the vertical lin2% there is the possibility of: Ahold!upB this is $here one party should ma2e a specific investment (e)g) specific training% location or display facilities+% but fears that the other $ill then act opportunistically) If so% there may be underinvestment) lac2 of coordination: e)g) on advertising and sales promotion T/e #olution: long!term contracts% or simultaneous commitment (exchange of hostages+ A**ro*riate VR#: exclusivity and price guaranteesL selective distribution II. Avoidan e of dou!le (ar$inali#ation T/e #olution: restrict ability of retailer to charge high priceL or change incentives of retailer to ensure that they donBt $ant to price too high) A**ro*riate VR#: maximum retail priceL "uantity forcingL or t$o part pricing scheme% often in the form of a franchise agreement (T: 'J3!' and 'J6!J+) #ee above)

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III. To #e ure #uffi ient retailer inve#t(ent<effort This is the free rider problem on the retailer side (T: ':.!*+ T/e *ro!le(: applies to cases $here retailers need AeffortB (advertising% sho$rooms% training% "uality control+ to sell the product properly) The danger is that some retailers (discounters=+ $ill cut out on these expenditures in order to price lo$% relying on other retailers to provide these T/e #olution: selective distribution% or force retailers to compete on "uality not price (R5/+ A**ro*riate VR#: selective distribution% exclusive territories% R5/) These encourage intrabrand competition but not interbrand) IV. Avoidan e of free ridin$ !+ ot/er (anufa turer# This is the free rider problem on the manufacturer side T/e *ro!le(: applies to cases $here one manufacturer provides advertising% training% or a list of customers% $hich retailers can also use to sell products of rival manufacturers) Therefore% danger that manufacturers underprovide such services) T/e #olution: again% loo2 for property rights solutions% but this time for the manufacturer A**ro*riate VR#: various types of exclusivity% price guarantees% selective distribution)

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Mar,et *o2er effe t# of VR In these four cases, "Rs will harm the consumer as well as rivals$ They tend to occur where some de%ree of mar&et power '#ut not full monopoly( already exists I. To #often inde*endent *ri e o(*etition

This is $here unilateral price competition is too fierce% so firms loo2 for non!collusive solutions T/e #olution: delegate retail price setting to someone $ith less incentive to cut priceL reduce manufacturerBs o$n perceived elasticity A**ro*riate VR#: any $hich reduce interbrand competition (exclusivity for manufacturers% different from exclusivity for retailers+ II. To #u#tain ollu#ion T/e #olution: leadershipL ma2ing price more transparentL change incentives a$ay from price cutting A**ro*riate VR#: common selling agency% R5/% exclusive territories for producers (mutual forbearance+L most favoured customersL meet the competition

#imilar% but has more to do $ith $ays of securing coordinated pricing

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III. 'ore lo#ure and *redation (T: ':>!6 and '0*!:+ T/e #olution: reduce profitability of entry A**ro*riate VR#: exclusive purchasing limits potential

distribution chainL minimum sales targetsL loyalty rebates etc) ma2e small scale entry difficult as retailers need to sell more of existing products to get discountsL tie in sales & full line forcing can exclude competitors $ho can only offer a restricted range of products IV. Pri e di# ri(ination in general% price discrimination is only possible if arbitrage (bet$een retailers+ is prevented T/e #olution: prevent resale e)g) parallel imports A**ro*riate VR#: any $hich reduce intrabrand competition% such as exclusive territories and sales targets

T/ree a#e #tudie# fro( C/ur / = 1are ) /a*ter &&. case study ..)' (pp) 60>!6+ <oda2 case (p) J3&+ exclusive supply in petrol case study ..). (pp) 60:!J3.+ /icrosoft

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DI CR /# TD III;#TR T@ DD;1I@ / RCI9 II# TID9 (a+ deriving the demand curve for

/R1ED

D1 G

(b+ double marginalisation $ith successive monopoly 51 5 D1 ,

G H

/R

/R1ED

(c+ the integrated firm

5IH

, /R1 GIH '>