Vertical Relations and Restraints

1. Vertical Relations and Restraints • Many transactions take place between two firms, rather than between a firm and consumers • Key differences in these types of transactions: • Demand for an intermediate good being sold by an upstream company to a downstream company is derived from the demand curve the downstream company faces. • The buyers of the intermediate good, the downstream companies, compete with one another.

2. Types of Vertical Relationships/Restraints • Relationships • Franchise • Licensed/authorized dealer • Agent • Restraints • Exclusive territories • Royalty agreements • Resale price maintenance

3. Double Marginalization • Assume there is an upstream firm, the manufacturer of the product, and a downstream firm that sells the product in a retail outlet. • Assume retailers have no costs, just buy the product and then resell it costlessly. • Also assume that the marginal cost of manufacturing the product is constant, c. • Consumer demand for the product is P = a - bQ.

4. Double Marginalization, con’t • If the manufacturer and retailer were an integrated company, the firm would set MR=MC to maximize profit: • a-2bq = c or q = (a-c)/2b • Price = a - b*(a-c)/2b = (a+c)/2 • Profit = [ (a+c)/2 - c ]*(a-c)/2b = (a-c)2/4b

5. a (a+c)/2 c Demand MR (a-c)/2b Monopoly Solution

6. Double Marginalization, con’t • If the manufacturer and retailer are separate companies: • Assume that the price the retailer pays the manufacturer is r. • To maximize profit, the retailer sets r = MR: • a-2bq = r or q = (a-r)/2b • Price = a - b(a-r)/2b = (a+r)/2 • Profit = [ (a+r)/2 - r ]*(a-r)/2b = (a-r)2/4b

7. Double Marginalization, con’t • Thus the retailer’s demand for the manufacturer’s product is q = (a-r)/2b. • The inverse demand curve for the manufacturer is thus r = a-2bq. • Note that this is the same as the retailer’s marginal revenue curve. • So the manufacturer’s MR curve = a - 4bq.

8. Double Marginalization, con’t • Setting MR=MC: • a - 4bq = c, or q = (a-c)/4b • Price = a - 2b (a-c)/4b = (a+c)/2 (Be sure to use the manufacturer’s demand curve to get price, not the consumer’s demand curve) • Profit = [(a+c)/2 - c]*(a-c)4b = (a-c)2/8b • The retailer pays (a+c)2 and sells (a-c)/4b at P = a-b*(a-c)/4b = (3a+c)/4.

9. a (3a+c)/4 (a+c)/2 c MR for manufacturer Demand MR for retailer (a-c)/2b Double Marginalization

10. Double Marginalization, con’t • Double Marginalization: both firms mark the price up above their own costs. • Both cosumers and firms are better off if the two firms act in concert to maximize joint profits.

11. a (3a+c)/4 (a+c)/2 c MR for manufacturer Demand MR for retailer (a-c)/2b Double Marginalization

12. Vertical Restraints as a Response to Double Marginalization • Two-part tariff: Fixed cost of F to sell the good, then goods sold to retailer at marginal cost. • Retailer sets MR = MC, so the joint profit maximizing quantity is sold. • F can be set so that both the manufacturer and the retailer share profits. • Classic franchise arrangement. • Royalty arrangement: Goods sold to retailer at MC, manufacturer gets percentage of profits.

13. Level of Competition • To understand vertical relations and restraints, need to distinguish between two levels of competition: • 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.

14. Retail Services • Retailers can invest in advertising, customer service, consumer education, all of which enhance consumer willingness to pay. • Positive externalities from these services (to other retailers as well as to the manufacturer), thus the services generally will be underprovided. • Vertical restraints can ensure the optimal level of services.

15. Vertical Agreements to Ensure Provision of Services • Could specify contractually what services should be provided, but determining the right level of services is hard and monitoring the level of services is very difficult. • Classic 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.

16. 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).

17. 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.

18. 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.

19. 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.

20. Anit-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.

21. 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.