ECONOMICS 3200M Lecture 9 March 23, 2011

1. ECONOMICS 3200MLecture 9March 23, 2011

2. Vertical Controls Vertical restrictions • Contracts instead of integration – transactions costs lower than costs of internalization • Contractual restraints (prices, forms of behavior) to approximate outcomes form vertical integration at lower costs • Upstream firm is monopolist selling to downstream firm(s) – has bargaining advantage

3. Vertical Controls Vertical restrictions • Types of contracts: • Franchise fee – upstream firm charges downstream firm a fixed charge plus a per unit price • Resale price maintenance – upstream firms dictates selling price for downstream firm (price ceilings, price floors) • Quantity fixing – upstream firm dictates amount to be bought by downstream firm (quantity forcing if quantity greater than free contracting quantity; quantity rationing if quantity lower) • Exclusive territories • Tie-in sales • Royalty

4. Vertical Controls Vertical restrictions • Chicago School: observed vertical restraints meant only to improve efficiency of real-world vertical relations and not exercise monopoly power • Address externality and free rider problems • Store with reputation for stocking high quality products provides signal to consumers and thus helps overcome lemons/moral hazard problems • If certain of these products available at discount store, reputation suffers and store no longer as valuable a signal of quality • Consider case of Wal-Mart • Cost advantages of vertical integration

5. Vertical Controls Vertical restrictions • Consider case of double monopoly: • M charges R a per unit price of C and charges a franchise/license fee of M [PM (C)] • P = PM (C) and total profits = M [PM (C)] • Quantity forcing: M requires R to buy Q1 units at P= PM (C) • Resale price maintenance (RPM): M requires R to set a maximum price equal to PM (C) • If demand at retail level depends upon services provided, R may provide sub-optimal level of services

6. Vertical Controls Vertical restrictions • Case of services provided by downstream retailer(s): • Too high a price and sub-optimal level of services • Franchise fee = single monopoly profit • Quantity forcing sufficient to encourage R to charge correct price and provide optimal level of services

7. Vertical Controls Vertical restrictions • Multiple inputs case – M sells product which is combined with another input (produced by competitive industry) to produce final product sold by monopolist • Franchise fee and unit price set at M’s MC(C) – no distortion in input use • Tie-in with RPM – M sells both inputs to downstream firms, sets prices of both inputs so as to not distort relative prices and extract monopoly profits • Royalty on number of units sold with input sold at MC • If final product sold by competitive industry – franchise fee no longer works because profits = 0 for each of the downstream firms

8. P P2 P1 MC(PM, C*) MC(C, C*) D MR Q Q2 Q1

9. Vertical Controls Vertical restrictions • Intrabrand competition • Downstream retailers are in competitive market • Demand depends upon services (e.g., information about product) provided by retailers • Provision of pre-sale information by one retailer to consumers who buys from retailer offering lowest price • No incentive for any one retailer to provide information because unable to recover costs of doing so • Contractual solutions: • RPM sufficient to guarantee price to cover costs of optimal level of services – free rider problem still exists • Exclusive territories • M provides information and/or other services directly through retailers

10. Vertical Controls Vertical restrictions • Interbrand competition • Contractual solutions: • Exclusive dealing – exclusive territories may be necessary to get retailers to accept exclusive dealing and M may have to provide promotional services (e.g. advertising) • Limits returns to scale for downstream firms • Increases search costs for consumers since retailers do not carry wide range of products – Internet may overcome this problem in part • Contractual solution more likely if M can set up own distribution network (costs of internalization vs. costs of external transactions and price competition because of interbrand competition) • Long-term contract to limit shelf space available for competing products – exclusive territories, promotional services provided by M, some sharing of monopoly profits

11. Vertical Controls • Market foreclosure • Commercial practices (including mergers, acquisitions) to reduce buyers’ access to supplier(s) – upstream foreclosure; or reduce suppliers’ access to buyer(s) – downstream foreclosure • Exclusive dealing • Tie-ins and/or products made incompatible with complementary products sold by other firms • Tie-ins pervasive: shoes, gloves come in pairs; cars with engines; land with homes • Tie-ins to protect investments in reputation, minimize problems with product liability – repair/maintenance services to product • Entry barrier if entrant has to offer both products • One-stop shopping – single source of supply of entire range of products (savings on search and transactions costs, reputation) • Acquisitions

12. Information • For consumers • Availability and prices • Search costs – local monopolies • Quality and other characteristics • Reliability – Jetsgo and provision of services • About consumers • Preferences, reservation prices • Demand curve – position, shape (price elasticity) • For rivals • Competitive advantages – cost structures, differentiation • Strategies – technology, product development, capacity, geographic expansion • Strategic responses • Market interaction a game with asymmetric and incomplete information

13. Information • Quality • Lemons' model: • Ex ante, consumers expect quality uniformly distributed: S  [0, 1] • Ex ante, expected quality is 0.5 – maximum price consumers willing to pay (P* = expected S) equals expected quality level – P* = 0.5 • Unit costs depend upon quality: C(S) = S • Qualities S  [0.5+, 1] will not be supplied • P – C < 0 for qualities in this range • New feasible set: S  [0, 0.5], with expected quality = 0.25 • Maximum price consumers willing to pay: P* = 0.25 • Market degenerates to S=0 • Rational consumers and producers expect only lemons to be supplied (moral hazard for producers), so only lemons supplied and P*=0

14. Information • Possible solutions to Lemons’ problem • Full warranties provided by producers • Producer compensates buyer in full if quality differs from advertised quality or service not provided • Quality must be able to be evaluated at low cost and high degree of reliability ex post by consumers • Credibility of warranty depends upon reputation of producer/provider of warranty (Amex provides money back guarantees to card holders for products purchased with the card) • Firms with long history more credible than start-ups – first-mover advantage; entry barrier • 3rd party providers

15. Information • Possible solutions to Lemons’ problem • Moral hazard problem if performance (quality) depends upon use by consumers • Adverse selection – case of insurance • Deductibles, co-insurance • Less than full warranty • Warranty applies subject to certain conditions regarding use of product • Consumers may infer this as signal of low quality • Advertising • Investment as signal of quality only if quality can be evaluated at low cost and high degree of reliability ex post by consumers • Brand names

16. Information • Classification of products according to ex ante/ex post information of consumers re. quality • Search products: quality know ex ante • Experience products: quality unknown ex ante (at least prior to 1st time consumption/use), but known ex post after purchase and use • Credence products: quality unknown ex ante and unknown ex post even after purchase and use – services • Importance of reputation

17. Information • Experience products – no warranties • One-time purchase – e.g.., restaurants in foreign cities • Assume two possible qualities – SL, SH – with corresponding unit costs CL < CH and consumers’ willingness to pay PL < PH • Assume: PH – CH > PL - CL • Consumers imperfectly informed (non-rational expectations), buy one unit ( no repeat purchases) • Assume: U(SH, PH) > U(SL, PL) • Incentive for producers to claim high quality product even though low quality: PH – CL > PH – CH • Lemons’ model

18. Information • Experience products – no warranties • Repeat purchase – some informed customers, e.g.., restaurants in foreign cities again • Assume some consumers informed of quality because of past purchases •  informed • If producer’s quality is SH : H = PH – CH per unit and all consumers buy • If producer’s quality is SL : L = (1-  )(PH – CL ) per unit and only uninformed consumers buy • Monopolist supplies SH if H > L •  PH > CH – (1- ) CL • Sufficiently high price for high quality product, large proportion of informed consumers, small unit cost differential

19. Information • Experience products – reputation, brand names • Repeat purchase – repeated games • Two-period game • Price in pd. 1 is P1 : PH > P1 > PL (a priori probability that quality is SH is X) • If monopolist produces SH : H = (P1 – CH) + (PH – CH) • If monopolist produces SL : L = (P1 – CL) + (PL – CL) • Assume: PL – CL = 0 • H - L = (PH – CH) – (CH - CL) • Future return from goodwill less cost disadvantage • Two-period game: fixed end-point, Prisoners dilemma – no incentive to build goodwill (brand name) • Warranty

20. Information • Repeat purchase – repeated games • In multi-period game with uncertain end-point or infinite number of periods, incentive to build up goodwill and greater return on goodwill • Low introductory offer in period 1 to attract customers to high quality product • Reputation • Alternatively, firm invests in advertising in period 1 – commitment to demonstrate credibility • Only high quality supplier can invest in advertising and earn return on investment • Leverage brand name into other products/geographic markets • Overcomes entry barriers • Examples: Armani into perfumes, glasses; Marriott into different categories of hotels; Sony into different consumer electronic products; Donald Trump into different city real estate markets

21. Information • Labor markets • Information re. safety, promotion (future earnings) opportunities, employment stability • Reputation of employers • Role of regulation – experience and credence products • Certification to practice a profession • Standards – environment, product quality, safety, workplace • Liability laws, other laws – securities, environment, tort, banking, transportation safety • Outsourcing • Transactions costs • Information re. quality, reliability – ISO certification • Reputation of outsourcer – e.g. Celestica

22. Information • Government regulation • Consumers uninformed re. monitoring, enforcement, scope of regulations/laws • Moral hazard potential – consumers/financial institutions overestimate scope of regulations/laws • Safety • Deposit insurance • Bankruptcy of companies engaged in travel industry • Workplace safety • Risky investments – case of sub-prime loans • Too big to fail

23. Brand Names Signals a substitute for complete and perfect information • Educational attainment (MBA, CFA, CA, etc.); institution at which degree received (reputation of institution) • Track record, experience – reputation • Venture capitalists invest in grade A management and grade B business plan but not in grade A business plan and grade B management • Appearance, behaviour

24. Brand Names • Brand names a signal for quality – quality difficult to measure without repeated use of product; brand name developed over time provides some assurance to consumers about quality of product • Developing a brand name • Consumers willing to pay price premium for established brand name products • Travel abroad, willing to purchase brands recognized from home (hotels, consumer goods, financial institutions, entertainment) • Example of products from China

25. Brand Names • Brand names, warranties, money back guarantees • Quality, reliability – consumers willing to pay price premium • Value of brand name – BMW, Coca Cola, Disney, Coach, Trump, Dell, Google, Apple, Starbucks, Nokia, Microsoft, Zara, H&M, Harrods, Prada, Sony, Toyota, GE, HSBC, IBM, McKinsey, Goldman Sachs, Ikea, Sotheby’s, etc. • Transferable to other markets? – geographic, product • Warranties a form of insurance – conditions attached to ensure consumers do not abuse products (moral hazard) • Reputations, brand names valuable (value does not show up on balance sheet unless company acquired and goodwill is recorded – but goodwill and reputations can be destroyed)

26. Advertising • Informational vs. persuasive • Price, product characteristics, availability (distribution channels) • Search, experience, credence • Mutual fund companies advertising performance of their funds, types of funds during RRSP season • Advertising prices  lower average prices for consumers • For most professional services, advertising prices usually not permitted by regulatory bodies – required to ensure ethical behavior • Image, quality • Search, experience, credence

27. Advertising • Objective to increase demand and profits (economic and accounting): increase sales at current prices or sell current volume at higher prices • MB (marginal benefit) of advertising vs. MC (marginal cost): investment decision must take into account competitors’ behavior and longer-term impacts on reputation and brand names • MB increases if company able to expand product line to capitalize on reputation (e.g. Nike moving into athletic clothing)

28. Advertising • Sales/marketing • Segmentation of customers • Individuals – income, ethnicity, age, education, etc., strategies of rivals • Firms – size, location, alternative sources of supply, strategies of rivals • Targeted advertising vs. click through ads • Attitudinal data, behavioral characteristics • Advertising strategies and budgets – different media • Social networks – use of Twitter • Trade shows

29. Advertising • Sales/marketing • Internal sales force vs. independent sales agents – exclusive arrangements • Technical skills – pharmaceutical companies (basis for competitive advantage), aircraft manufacturers • Internet sites – importance in age of Google searches, click through ads • Distribution channels – commission overrides, promotional budgets

30. Advertising • Profit maximization and advertising • P = P(Q, A)  inverse demand function with demand depending upon quantum of advertising expenditures • Past advertising expenditures – investment; capital stock • Possibility of depreciation of stock of advertising – rate of depreciation may vary with media • Profit function: P(Q, A)Q – C(Q) – A • Profit maximization conditions: • MR=MC • QP/ Q + P = C/ Q • Q P/ A = 1  A/PQ = A/ • However, different media for reaching consumers; relative importance of informational vs. persuasive advertising • Prisoners’ dilemma

31. Advertising • Marketing/sales/advertising as entry barriers • Example of pharmaceutical companies (big pharma) and control of distribution channel – doctors for prescription medicines • Sunk cost for incumbents • Increase entry costs • Legal restrictions on false or misleading advertising