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 (cont.) • But exclusivedealing 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 A B A B Retailer 1 Retailer 2 M – Manufacturer’s (A and B) products located on circle Given retail location Chapter 19: Nonprice Vertical Restraints

5. Exclusive Dealing (cont.) • With No Exclusive Dealing, A and B compete at each location A B A 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 (cont.) • Exclusive Dealing, A and B at separate locations A B M Retailer 1 Retailer 2 • Interbrand competition greatly reduced • Retailer 1’s price for A less constrained by availability of B at Retailer 2 because this is now 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 (cont.) • 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. Franchising and Divisionalization • Why Are There So Many Franchisees? Why do Firms Operate Many Different Divisions? • Recall the Merger Paradox: In a Cournot or quantity competition setting, 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

10. Franchising and Divisionalization (cont.) • 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

11. Franchising and Divisionalization (cont.) • 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

12. Franchising and Divisionalization (cont.) • 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: • So, solving for industry output Q and price P, we have: and Chapter 19: Nonprice Vertical Restraints

13. Franchising and Divisionalization (cont.) • 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

14. Franchising and Divisionalization (cont.) • 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

15. Franchising and Divisionalization (cont.) • 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