Nonprice Vertical Restraints

1. Nonprice Vertical Restraints Chapter 19: Nonprice Vertical Restraints

2. Introduction • Vertical Price Restraints are not the only kinds of vertical restrictions • Other common vertical restrictions include • Exclusive Dealing: Manufacturer restricts retailer’s abilityto buy and sell brands that compete with the manufacturer’s brand, e.g., Coca-Cola may restrain restaurants or other vendors from selling Pepsi products (Interbrand competition) • Exclusive Selling: Retailer restricts manufacturer from supplying other dealers, e.g., Lexus dealer obtains promise from Toyota not to authorize other Lexus dealers to sell in nearby locations (Intrabrand competition) Chapter 19: Nonprice Vertical Restraints

3. Exclusive Dealing • Exclusive Dealing as a way to deal with Free-Riding • Advertising and promotion by a manufacturer spills over to raise demand for similar products • Example: advertising Tylenol may raise demand not just for Tylenol but also for non-aspirin pain relievers in general • Pharmacist may respond to inquiries about pain relievers by substituting lower-cost non-aspirin pain reliever • Substitute costs less because it did not pay for advertising • Substitute manufacturer free-rides on the advertising of Tylenol • No manufacturer advertising and so no information provision could be the result—This is inefficient. • Exclusive dealing may solve this problem. • No spillovers if dealer sells no substitute products Chapter 19: Nonprice Vertical Restraints

4. Exclusive Dealing 2 • But exclusive dealing can compound monopoly problem • Assume two manufacturers and two retailers • Retailers (1 and 2) are spatially separated by distance M along a line • Consumers are spatially located around a circle at each retail location of radius r • Manufacturer’s (A and B) products located on circle at Given retail locations — A B A B Retailer 1Retailer 2 M – Chapter 19: Nonprice Vertical Restraints

5. Exclusive Dealing 3 • With No Exclusive Dealing, A and B compete at each location A A B B M Retailer 1 Retailer 2 • Substitutes never more than 2r apart • Interbrand Price competition is tough • Retailer 1’s price for B also constrained by availability of A at Retailer 2 M units away Chapter 19: Nonprice Vertical Restraints

6. Exclusive Dealing 4 • Exclusive Dealing, A and B at separate locations A B M Retailer 1Retailer 2 • Interbrand competition greatly reduced • Retailer 1’s price for A less constrained by availability of B at Retailer 2 because this is now • just M+ 4r units away • Both manufacturers and retailers can gain at expense of consumers Chapter 19: Nonprice Vertical Restraints

7. Exclusive Selling and Territories • Again, there is a free-riding issue • Service and Promotion may benefit other Sellers, especially nearby ones • Each dealer may try to “free ride” on service and promotion of other retailers with result that no services are provided • There is also a price externality • Price cuts by one dealer cut into profits of other dealers • Each dealer considers only the effect on her own profit Chapter 19: Nonprice Vertical Restraints

8. Exclusive Selling and Territories 2 • Exclusive Selling/Territories may solve these problems • With other dealers far away, each dealer can get the full benefits of her selling and promotional services • No free riding • Intrabrand price competition lowers double marginalization problem. Why should manufacturer’s want to reduce such competition? • Intrabrand price competition can intensify interbrand competition • (Assume no two-part tariffs)Retailers can only pay high wholesale price if they can pass it on at retail level • This requires some monopoly power on part of retailers • Movements in wholesale price now only partly reflected in retail price  Wholesale price competition less intense Chapter 19: Nonprice Vertical Restraints

9. Aftermarkets • The Kodak case • Kodak makes micrographic equipment for creating and viewing microfilm as well as office copiers. This is the Foremarket. • Kodak also has a network of technicians who maintain these machines pursuant to separate service and repair contracts • Other, independent service and repair companies compete with Kodak but both independent and Kodak service people rely on Kodak parts • The service and repair market is the Aftermarket. • After losing a big service contract to an independent Kodak initiated a new policy of refusing to supply parts to any independent service company, i.e. foreclosing them • Independents sued, but Kodak’s defense was that it could not leverage its power in the foremarket into power in the aftermarket because rational consumes would look ahead and if they foresaw a higher price in the aftermarket would reduce their willingness to pay in the foremarket Chapter 19: Nonprice Vertical Restraints

10. Aftermarkets 2 • The Kodak case (continued) • Kodak ultimately lost the case. • But the issue of using vertical restrictions and there ability of a firm to leverage foremarket power into the aftermarket remains • The logic of Kodak’s defense is clear. Foreward-looking consumers will incorporate the cost of expected repairs into their willingness to pay for a new machine. But this is not quite the same as saying price will equal marginal cost. • As Borenstein, Mackie-Mason, and Netz (2000) showed, there can be a “lock-in” effect that shields the firm from aftermarket competition • This lock-in gives rise to a potential for supra-competitive pricing Chapter 19: Nonprice Vertical Restraints

11. Aftermarkets 3 • Lock-in and aftermarket power • Two producers of machines • Marginal Cost of making and repairing a machine = 0 • Machine runs at most two periods • Consumers value machine services at $50 per period • Machine is • 100% reliable in 1st period • 50% breakdown chance in 2nd period • After 1 period of use, consumers are locked in to the technology of whatever brand they bought • If there is a breakdown in period 2, it is not worth buying a new machine • However, repair worthwhile if done at marginal cost • Expected value of a new machine at start of period 1 (before purchase) is $50 + 0.5($50) = $75 Chapter 19: Nonprice Vertical Restraints

12. Aftermarkets 4 • Repair would sell at marginal cost if repair was competitive • But aftermarket foreclosure prevents this • If a firm prevents any rival from repairing its machine, say by foreclosing parts supply then price of repairs can rise to (just under) $50, • For cohort of new customers who have not bought a machine, the machine is still valued at $75 • For those with a broken machine, paying the repair bill of $50 is now worthwhile even though it would not have been worth it ex ante • Of course, $50 is well above marginal cost • Such effects can also arise if some (not necessarily all) consumers are myopic Chapter 19: Nonprice Vertical Restraints

13. Public Policy • In the main, public policy toward nonprice vertical restrictions has been dominated by a rule of reason approach • In both Europe and North America, however, policy since the 1990’s has applied the rule of reason with a strong presumption that the restraint is justified • The basic argument is that since the restraint is a voluntary contract between an upstream and downstream firm, it must at least benefit these two parties and may benefit consumers, as well. • However, policy-makers are not yet ready for a per se legal approach Chapter 19: Nonprice Vertical Restraints

14. Franchising and Divisionalization • Why Are There So Many Franchisees? Why do Firms Operate Many Different Divisions? • Recall the Merger Paradox: • With Cournot or quantity , the merger of two firms makes those firms worse off and remaining firms better off • Why? Because the two merged firms act as one. If there were originally 6 firms and two merge, these two firms are now one of five whereas they were two of six. That is, the merged firms now constitute just one-fifth of the independent decision making units instead of one-third. Chapter 19: Nonprice Vertical Restraints

15. Franchising and Divisionalization 2 • This may be the logic behind franchising and divisionalization • By operating many independent divisions or franchises, firms may avoid the logic of the merger paradox • But with each firm doing this, the industry becomes populated with many divisions and franchises • Perhaps more than is consistent with either joint profit maximization or efficiency Chapter 19: Nonprice Vertical Restraints

16. Franchising and Divisionalization 3 • Assume demand P = A – BQ and Cournot competition – Firm j has divisions denoted by i, i = 1,2 – Profit of ith division of jth firm given by: –qijis output of ith division of jth firm; Q-ij is output of all other divisions of all industry firms; and c is marginal cost – Equating marginal revenue and marginal cost yields: Chapter 19: Nonprice Vertical Restraints

17. Franchising and Divisionalization 4 • Let n1 and n2 be the number of divisions at firms 1 and 2, respectively. Since all divisions are alike the , the optimal output of any division is: • Solving for industry output Q and price P, we have: and Chapter 19: Nonprice Vertical Restraints

18. Franchising and Divisionalization 5 • Given its optimal output, qij*, each division at each firm will earn profit • Firm 1’s total profit is: n1i,1 – Kn1 where K is the sunk cost of setting up each division. So Chapter 19: Nonprice Vertical Restraints

19. Franchising and Divisionalization 6 • Maximizing firm 1’s profit with respect to n1 and recognizing that by symmetry, each firm must have the same optimal number of divisions then yields: • Solving for the optimal number of divisions at any firm we have Chapter 19: Nonprice Vertical Restraints

20. Franchising and Divisionalization 7 • The implication is that the greater the potential for monopoly profit (A – c), the greater the incentive for firms to create more divisions. But – More independent divisions brings the industry profit down – Firms engaged in a prisoner’s dilemma gain in which each adds divisions to the detriment of joint industry profit – Depending on the nature of the sunk cost of creating a division, it is even possible that the total surplus may be reduced by excess divisionalization Chapter 19: Nonprice Vertical Restraints

21. Empirical Application: Exclusive Dealing in the Beer Industry • US beer market has three tiers • Brewers (Anheuser-Busch, Miller, Molson-Coors) sell to • Distributors who sell to • Retailers • It is common for brewers to adopt exclusive contracts and exclusive territories with distributors • Reasons for exclusive contracts • Foreclosure of rivals. If this is the motivation, exclusive contracts will become less likely as market grows because there will be room for lots of distributors and tying up one or a few will not keep out rivals • Protect advertising investment against free-riding. If this is the motivation, exclusive contract will become more likely as the national advertising level rises Chapter 19: Nonprice Vertical Restraints

22. Empirical Application: Exclusive Dealing in the Beer Industry 2 • Sass (2005) analyzes 381 beer distribution contracts 69 of which have an exclusive dealing arrangement • Uses probit estimation to determine how probability of an exclusive contract rises as a function of: • Market size as measured by: • Regional population, POP • Market share of distributor’s largest supplying brewery, MSD • Advertising as measured by • National Advertising of distributor’s main supplier, ADS • Presence of a ban on billboard advertising in the state, BAN • Years distributor has been owned by one family, YRS, which may indicate how experienced distributor is. Highly experienced distributors may not want to be restricted by an exclusive contract Chapter 19: Nonprice Vertical Restraints

23. Empirical Application: Exclusive Dealing in the Beer Industry 3 • Sass (2005) analyzes 381 beer distribution contracts 69 of which have an exclusive dealing arrangement. The results of his Probit estimation are shown below Explanatory Estimated Variable Coefficient t-statistic POP0.0001 (1.87) MSD 0.0079 (2.79) ADS -0.0017 (-2.10) BAN -0.0002 (-0.38) YRS-0.0095 (-2.12) Chapter 19: Nonprice Vertical Restraints

24. Empirical Application: Exclusive Dealing in the Beer Industry 4 • Interpretation of Sass (2005) results • Foreclosure not a likely motivation for exclusive beer contracts because these become more likely as market size grow • Protection of advertising against free-riding seems to be a more compelling explanation for exclusive contracts. • Such contracts more likely as advertising expense rises; and • Such contracts less likely if billboard advertising is banned • Experienced distributors with lots of specialized information about the local market like to be free to use that information as they see best and so such distributors are less likely to sign an exclusive contract Chapter 19: Nonprice Vertical Restraints

25. Empirical Application: Exclusive Dealing in the Beer Industry 5 • Sass (2005) then examines the effect of the exclusive contracts. He finds that • Exclusive contracts raise the wholesale price by about six percent and the retail price by about three percent • Despite these price increases, exclusive contracts also raise total sales volume for both the brewer’s own brand and its rivals by about 30 percent. • This again suggests that the exclusive contracts are being used to enhance the effectiveness of advertising. In so doing, they raise demand and thereby raise both price and output. • Profit to brewers, wholesalers, and retailers rises. Given sales increase, consumer surplus likely rises, too. Chapter 19: Nonprice Vertical Restraints