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EC930 Theory of

EC930 Theory of. Industrial Organisation. Vertical relationships. 2013-14, Spring Term. Vertical relationships. Most industries involve a chain of production, e.g. ¾ Inputs: energy, raw materials, components ¾ Manufacturing of finished product ¾ Distribution and retailing.

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EC930 Theory of

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  1. EC930 Theory of Industrial Organisation Vertical relationships 2013-14, Spring Term

  2. Vertical relationships Most industries involve a chain of production, e.g. ¾ Inputs: energy, raw materials, components¾ Manufacturing of finished product¾ Distribution and retailing Vertical integration ¾ All stages are undertaken by a single firm Vertical separation ¾ Stages are undertaken by separate firms ¾ Transactions (contracts) take place between the firms 2

  3. Outline 1. Vertical restraints -- terminology 2. Intra-brand competition ¾ Double marginalisation -- why merger/vertical restraints good for pricing¾ Service externalities – merger/vertical restraints good for service provision 3. Inter-brand competition -- vertical restraints to soften competition 4. Vertical foreclosure -- incentive to refuse to deal to soften competition 5. Vertical agreements in competition policy ¾ Policy • Appendix: Cases: beer, perfumes, car distribution • -- efficiency and market power balanced in policy and cases. Reading: Lecture notes 8, 8a Optional: Cabral Ch. 11 Tirolech 4 3

  4. 1. Vertical restraints Distinction between vertical integration and separationis not clear-cut ¾ Vertically-related firms under separate ownership oftenuse contracts to restrict one another’s behaviour Vertical restraints: e.g. ¾ Resale price maintenance (RPM)¾ Exclusivity clauses ¾ Non-linear pricing ¾ Franchising agreements 4

  5. Resale price maintenance (RPM) Manufacturer imposes conditions on price at whichretailer sells good to final consumers ¾ Pure RPM: manufacturer specifies a single retail price¾ Maximum RPM: retailer agrees not to sell above aspecified retail price ¾ Minimum RPM: retailer agrees not to sell below aspecified retail price Quantity forcing ¾ Similar to max. RPM, but instead specifies a minimumquantity to be sold 5

  6. Exclusivity clauses Exclusive distribution (ED) or territories ¾ Manufacturer appoints exclusive distributor within area¾ Exclusivity typically guaranteed by contract Selective distribution (SD) ¾ Retailer must satisfy minimum quality or service standards¾ Tends to restrict number of retailers, due to higher costs¾ Manufacturer also refuses to supply non-selective outlets Exclusive dealing ¾ Distributor agrees not to sell rival manufacturers’ products 6

  7. Non-linear pricing and franchising Two-part tariff or franchise fee ¾ Fixed (franchise) fee, independent of no. of units bought¾ Per-unit price ¾ Average price decreases with no. of units bought Equivalently: quantity discounts or progressive rebates Franchising agreements (e.g. McDonalds) ¾ Combine a number of vertical restrictions¾ Charge a franchise fee to extract profit 7

  8. Vertical vs. horizontal relationships Horizontal: products are substitutes ¾ Each firm would like the other to raise price Vertical: products are complements ¾ Reverses many of the usual inter-relationships¾ Each firm would like the other to reduce price • For given w, manufacturer would like distributor toreduce P, as increases demand ¾ Other actions of distributor may also affect demand • E.g. advertising and services provided to customers 8

  9. 2. Intra-brand competition Single manufacturer; one or more retailers Vertical externalities ¾ Double marginalisation¾ Service externalities Horizontal externalities ¾ Multiple retailers and service externalities Commitment problem in vertical contracting 9

  10. Pricing externality Problem arising when imperfect compn in both stagesE.g. one manufacturer (M) and one retailer (R) ¾ M sells product to R, charging uniform wholesale price w¾ R sells it to final consumers, setting retail price P Integrated firm ¾ Sets P such that gain from ↑P is exactly offset by ↓ demand,taking account of both wholesale and retail margins Vertical separation ¾ R takes account of loss of own profit margin¾ But ignores impact on M ¾ Result: P is too high, exceeds the monopoly price 10

  11. Model of double marginalisation Manufacturer M ¾ Sells product to R at wholesale price w¾ Marginal cost c Retailer R ¾ Sells product to final consumers at final price P¾ Has no marginal cost other than w Final demand Q = 1 - PDerive expressions for ¾ Punder vertical separation¾ Punder vertical integration 11

  12. Pricing under vertical separation (1) R chooses P to maximise πR=(P−w)(1−P) ∂πR w)=0 FOC: = (1− 2P+ ∂P Corresponding output level: Q = ½ (1-w) 1−w (2) M chooses w to maximise πM=(w−c) 2 ∂πM 1 FOC: = 0 (1−2w+c)= ∂w 2 ⇒ w= ½(1+c)  Q = ¼ (1– c)  PS = ¼ (3+c) 11

  13. Pricing under vertical integration Choose P to maximise V = Π (P –c)(1−P) ∂πV FOC: +c)=0 = (1 − 2P ∂P ⇒ PM = ½ (1+c) Comparison ¾ We know that c < 1 (otherwise market will not exist)¾ PS = ¼ (3+c) = ½ {1 + ½(1+c)} > ½ (1+c) = PM Thus, under vertical separation ¾ PS is higher than monopoly price ¾ Total profit is lower V = (1-c)2/4 > M + R = 3(1-c)2/16 13

  14. Figure 1: Double marginalisation P, c Double marginalisation is bad for consumers *and* firms. The result holds for general demands… PS PM = w Demand c MR Q QS QM 14

  15. Overcoming double marginalisation Both firms and consumers better off with lower PSolutions ¾ Perfect competition downstream¾ Vertical integration: set PM ¾ Resale price maintenance: M sets max RPM at PM • Typically illegal • Recommended retail price (RRP) can have similar effect¾ Quantity forcing: M imposes QM ¾ 2-part tariff: M sets w = c, charge (lump sum) franchise fee • Problems if demand is uncertain or R has asym info 15

  16. Service externalities Demand may depend on services, S (as well as P) ¾ Advertising and promotional activities ¾ Pleasant surroundings (e.g. pubs) ¾ Information provided by sales staff, customer trials¾ Delivery speed and area covered ¾ After-sales services and warranties Key features ¾ Qdemanded is increasing in S ¾ S is provided and (typically) paid for by R ¾ When +ve margins, this benefits M as well as R 16

  17. Model of service provision Demand Q = Q (P, S); QP < 0, QS > 0 Service provision: S is provided by R; cost c'(S) > 0Both M and R have positive profit margins ¾ w - c > 0; P - w – c(S) > 0

  18. Model of service provision V chooses P to max V = {P-c -c(S)}Q(P, S) FOC: {w-c}QP(P, S) + (P-w-c(S)}QP(P, S) +Q(P, S) = 0 V chooses Sto max V= {P-c-c(S)}Q(P, S) FOC: {w-c}QS(P, S) + (P-w-c(S)}QS(P, S) – c’(S)Q(P, S) = 0 R chooses P to max R= {P-w - c(S)}Q(P, S) FOC: (P-w-c(S)}QP(P, S) +Q(P, S) = 0 R chooses S to max R= {P-w -c(S)}Q(P, S) FOC: (P-w-c(S)}QS(P, S) – c’(S)Q(P, S) = 0 ie, Retailer neither takes account of own price on manufacturer’s profit nor own choice of service provision on manufacturer’s profit.

  19. Model of service provision We can also think of marginal benefit of raising service provision as larger for the vertically integrated structure than the separated structure: Compare: {P-c-c(S)} VI raises service provision: both firms and customers benefit!  min. service standards ∂Q ∂c(S) and: { } P− w c(S) = Q ∂S ∂S marginal benefit of higher S marginal cost of = providing S 17

  20. Example (former exam question) A single retailer faces demand for its product, q, of q=1-p, where p is market price. The only cost of this retailer is the price of the product, which is provided by a single manufacturer. The manufacturer’s cost of production is c = q2/2. Find the equilibrium price, output, and profits of manufacturer and retailer if the manufacturer charges unit price, w, for the product. R: max (1-p)(p-w)  p* = (1+w)/2; q* = (1-w)/2 M: max wq* - q*2/2  ½ - w + ¼(1-w) = 0  w* = 3/5; p* = 4/5; q* = 1/5; PrR= 1/25; PrM = 1/10. Find equilibrium prices, output, and profits of both firms if the manufacturer charges a two-part tariff, (F, w) for the output. Does profit rise or fall? Note that w will be set at marginal cost or, equivalently, the retailer’s cost will be the Manufacturer’s cost. Hence: R: max (1-q)(q) – q2/2  q* = 1/3; p* = 2/3; PrR = 3/18; PrM = 3/18 (since entire surplus can be extracted through fixed fee)

  21. R may spend S to shift demand to q = 2-p. What is the maximum R will be willing to spend under the two pricing arrangements, (a) and (b)? Compare your answers. R: if spends S, then under (a) behaves as: max (2-p)(p-w)  2 – 2p + w = 0  p* = (2+w)/2; q* = (2-w)/2 M: max wq* - q*2/2  1-w+1/2 (1-w/2) = 0  w* = 6/5; p* = 8/5; q* = 2/5; PrR= 4/25 gross of S

  22. Multiple retailers & horizontal externalities manufacturer M retailers R1 R2 R3 … Multiple retailers of the same manufacturer’s product ¾ May be located in different geographical areas ¾ E.g. retailers of books, electronic equipment, cars 19

  23. Externalities between retailers Price competition between retailers (intra-brand) ¾ Good for M as reduces retailer margins and ↑ sales:helps overcome double marginalisation Service provision ¾ Services provided by one retailer may benefit other retailers • E.g. test drive car at showroom, then buy on Internet ¾ Positive externality between retailers (as well as on M) • Free-riding further undermines service provision • Greater competition in retailing makes this worse¾ Bad for manufacturer (and customers) 20

  24. Overcoming service externalities Service provision will be too low, for 2 reasons ¾ Positive externality on manufacturer ¾ Positive externalities between retailers • Both tend to reduce S, lowering manufacturer’s Π andconsumer welfare Possible remedies (1) Integration • Between M and R • Between different R’s (2) Contractual restraints 21

  25. Integration to overcome service extys Integration between M and R ¾ Internalise pricing externality: ↓P¾ Internalise service externalities: ↑S ¾ Possible disadvantage if retailer is “closer to the market” • R is better informed about consumer demand; integrationmay weaken this Integration between retailers ¾ Internalises service externalities between firms: ↑S¾ But reduces competition between retailers: ↑P • Likely to worsen double marginalisation problem¾ May not be permitted by competition authorities 22

  26. Vertical restraints and service provision Selective distribution: M specifies min service standards ¾ But M may be less well informed than R about Q(S)¾ Monitoring difficulties Exclusive distribution: M appoints exclusive retailer ¾ Reduces spillovers between retailers ¾ But does not reduce vertical externality between R and M¾ Loses benefit of P competition between retailers RPM: M specifies a (minimum) retail price ¾ Retailers then compete by offering higher quality services • But reduces benefits of price competition between retailers • Levi Strauss in jeans (1970s, US). Price falls when abandon RPM 23

  27. What do we observe? Often we see a combination of vertical restraintsE.g. car distribution (1992: CR3 = 55%) – MMC UK * Selective distribution: dealers must meet various displayand service standards with excl. distn, encourages investment in services * Exclusive distribution: dealers are awarded exclusive territories restricts intra-brand competition and prevents efficient dealers’ expanding. • Exclusive dealing: dealers cannot sell cars of other marques • since search costs low, gain to CRs from effective selling of single make outweighs loss. • * RRP (like RPM) (though note -- may prolong life of inefficient dealers!) ¾ Quantity-forcing techniques: sales targets and bonuses 24

  28. What do we observe? 1992 – vertical restraints have both efficiency and market power effect, but profits don’t appear excessive. While prices higher than in rest of Europe, don’t seem excessive… Note main concern is with dealer incentives. 2000 – revisits case as UK retail prices rise to 10% above continental prices. Eliminates sanctions if RRP undercut, but allows selective and exclusive distribution. This modified by 2002 EU ruling against selective and exclusive distribution if used together. Clearly, efficiency still weighed against market power… 24

  29. Commitment in vertical contracting Suppose ¾ Single manufacturer M ¾ Many potential retailers, Ri, in the territory Manufacturer auctions exclusive franchise ¾ Competition between Ri’s → M extracts Π (franchise fee)¾ Contracts with single retailer R1 But can M commit not to supply R2, etc.? ¾ No: it would be profitable ex post to supply additional retailers¾ Foreseeing this, R1 will not pay Π for franchise Due to commitment problem, M cannot exploit its market power 25

  30. Modelling commitment problem Hart & Tirole (1990), Rey & Tirole (2003) Manufacturer M ¾ Produces good at marginal cost c M Two retailers, R1 and R2 ¾ Compete in final goods market, inverse demand P = 1 - Q R1 R 2 ¾ Must acquire good from M¾ No further downstream costs FINAL DEMAND 26

  31. Model as two-stage game Stage 1: Contracting ¾ M offers each retailer Ri a contract (Ti, qi) ¾Ri accepts or rejects contract; if accepts pays Ti and receives qi Stage 2: Retail competition ¾ Ri brings qi to market¾ Price clears market Look at two cases a) Observable contracts b) Unobservable contracts 27

  32. Case (a): observable contracts Contract (Ti, qi) is observed by both Ri and RjThen M can extract entire monopoly profitE.g. ¾ M offers Ri quantity qi = ½Qm (½ monopoly output)for fixed payment Ti = ½πm (½ monopoly profit) ¾ R1 and R2 each accept the contract ¾ Outcome: monopoly price in final market 28

  33. Case (b): Unobservable contracts Ri observes (Ti, qi) but not (Tj, qj) Suppose M offers R1 contract q1 = ½Qm and T1 = ½πm ¾ What is Π-max’ing contract for M and R2, given q1? ¾ Choose q2 according to R2’s reaction function: q2 > ½Qm¾ Anticipating this, R1 refuses contract Problem: Lack of commitment power undermines M’sability to extract monopoly Π ¾ Worsens as number of potential retailers increases¾ Or when retailers are closer substitutes 29

  34. Restoring market power Vertical integration: merger between M-R1 ¾ Eliminates incentive to deal with R2 Vertical restraints ¾ Exclusive distribution: commit to dealing with R1 only¾ Most-favoured customer (MFC) clause: commit to match any offer made to Rj ¾ Market-wide RPM: Price floor of Pm Capacity constraint at Qm ¾ Must be publicly observable Repeated game: reputation 30

  35. 3. Inter-brand competition Multiple manufacturers: M1, M2, etc. ¾ Competing vertical chains M1 M 2 Vertical restraints may be used to affect competition between manufacturers R1 R 2 ¾ Insight from principal-agent models (delegation) ¾ M wants to soften competition in final market FINAL DEMAND ¾ Extract higher Π through franchise fee 31

  36. Vertical restraints to soften competition Two-part tariff ¾ M1 sets w > c to ↑P1 charged by R1 ¾ Softens competition in final market: R2 also ↑P2 ¾ Higher profits in retail market, extract via franchise fee Exclusive territories ¾ Weakens intra-brand competition → higher retail P1¾ Again, R2 increases P2 → higher profits ¾ Commitment: contract is visible and not easily renegotiated NB: Not robust to nature of final market competition ¾ Strategic complements vs. strategic substitutes RPM may facilitate collusion: ↓P more transparent 32

  37. 4. Vertical foreclosure Suppose manufacturer M has market power Would it want to leverage this power into retailing? ¾ Integrate with R1 and refuse to supply other R’s(or only at higher prices) Control over retailing may be used to foreclose entryto other manufacturers (or increase entry cost) Would this be rational? ¾ Chicago view: no ¾ Post-Chicago view: perhaps, but not straightforward 33

  38. Chicago critique of foreclosure Chicago School: Bork (1978), Posner (1976) “One monopoly profit” argument ¾ There is a single final market and therefore only onemonopoly profit to be reaped ¾ An upstream monopolist can already earn monopoly Π • E.g. competitive retailing sector; contracting ¾ Cannot ↑Π by extending market power to related market¾ Only benefit of vertical integration is from efficiencies • E.g. pricing & service externalities • Transaction costs, security of supply, etc. 34

  39. Let there be an incumbent supplier upstream, hoping to foreclose a second supplier, which can supply the input at marginal cost, c, to the buyer. Hence, with the entrant, the Buyer earns entire welfare triangle above c. To induce the buyer to sign an exclusive contract with the incumbent seller, the seller would have to offer the buyer compensation = surplus = blue + green. In exchange for exclusivity, the incumbent can charge monopoly price to buyer, pM and so earn the blue area. This is less than the payment to exclude , so can never pay to purchase exclusivity from buyer. £ pM MC = c Demand Q MR Vertical Foreclosure: Chicago Argument that Efficiencies must be present

  40. Ordover, Saloner & Salop (1990, 1992) Does foreclosure pay? What are its effects on firms/consumers? Baseline: Vertical separation ¾ Bertrand competition between M1 & M2 in supplying R’s¾ Good supplied at marginal cost: w = c ¾ No double marginalisation problem • And hence no pricing efficiency from integration 36

  41. Vertical integration with 2 manufacturers 2 upstream firms, M1 and M2 ¾ Homogeneous good¾ Marginal cost c M1 M2 Suppose M1 and R1 merge R1 R2 ¾ Integrated M1-R1 = F1 Would F1 refuse to supply R2? FINAL DEMAND ¾ If so, M2 gains monopoly power over R2: ↑w ¾ Weakening R2’s ability to compete in final market 35

  42. The argument for foreclosure (by integration of D1 into U1) and exclusion of rivals… M1 M2 w↑ -- VI raises rival’s cost R1 R2 p↑ -- cost rise  price rise p↑ due to upwards- sloping reaction functions Bertrand competition between R1 and R2 in final market

  43. OSS analysis (1) Vertical foreclosure takes place in eqm as long as ¾Ri’s revenues are increasing in w • E.g. P competition between differentiated (final) goods:↑ P induces rival to ↑ P (strategic complements) Can (integrated) M1 resist temptation to compete fullyin supplying R2 (by undercutting M2’s price)? Integrated firm faces a trade-off between ¾ Gaining Π margin on sales to R2, and¾ Lowering wholesale cost to R2, w • ↓w strengthens R2 in downstream competition, loweringprofitability of (integrated) R1 37

  44. OSS analysis (2) How far should M1 compete in ↓w to R2? At high level of w ¾ Margin on sales to R2 exceeds gain to R1 ¾ Price charged to R2 may be below monopoly price At an intermediate w*, the two effects are balanced ¾ F1 has no incentive to undercut further in supplying R2¾ Critical point is higher than MC of inputs: w* > c¾ Difference reflects R1’s foregone profit: this is anopportunity cost that is added to MC 38

  45. OSS analysis (3) OSS also consider possibility of M2-R2 merger -> Bertrand competition between identical entities. Integrated firm F1 must continue to supply R2 to avoid giving M2 and R2 an incentive to merge ¾ Critical w above which combined profits of M2 & R2 ↑ ifthese firms merge ¾ Must hold w < w so that R2 does not bid for M2 and undoforeclosure effect of M1-R1 merger 39

  46. OSS comments Commenting on their paper, OSS write: “We have shown that … vertical foreclosure can lead to theraising of intermediate input prices and downstreamprices to the disadvantage of the unintegrateddownstream firm and of final consumers…. Vertical integration changes the incentives of the integratedupstream firm and therefore affects equilibriumoutcomes…. Although vertical integration does not invariably lead to higher prices and reduced welfare, we have demonstrateda mechanism by which these adverse results do obtain.” (OSS, AER 1992, p703) 40

  47. Summary: Vertical restraints and vertical mergers generally create efficiencies to the benefit of firms and consumers, in stark contrast to horizontal mergers. But they may also create market power to the detriment of consumers. Which effect dominates depends a great deal on the facts of the case, so each case should be treated on a case-by-case basis. That being said, certain vertical restraints are viewed as more likely to cause harm than others, such as RPM, and multiple restraints may be more of a problem than just one. While rule of reason is administratively expensive, in this case there are few set guidelines on prohibitions… 51

  48. 5. APPENDIX Policy towards vertical relationships Traditional view (US 1911 to 1970s) ¾ Naïve foreclosure view: vertical restraints and integrationforeclose markets to rivals and reduce competition ¾ Vertical merger prohibited even when large no. ofcompetitors (e.g. Brown Shoe 1962) Chicago School, e.g. Bork The Antitrust Paradox (1978) ¾ These arguments based on weak economic reasoning ¾ Resulted in a period of inaction on vertical restraints andmergers (Reagan/Bush era) Post-Chicago view: Modern IO and game theory ¾ Claims of anti-competitive effects may sometimes be valid ¾ More mixed approach to vertical restraints / mergers 41

  49. EU and UK competition policy regime Article 81 / Chapter I of CA98 ¾ Prohibits anticompetitive agreements between firms¾ Vertical agreements subject to rule of reason¾ Block exemptions for certain types of agreement¾ RPM generally prohibited Merger control ¾ UK Enterprise Act 2002: Merger can be prohibited or modified if results in significant lessening of competition ¾ EU Merger Regulation 1989/2003: Does mergersignificantly impede effective competition? ¾ Foreclosure may be a concern 42

  50. Treatment of vertical agreements UK: OFT Guidelines exclude vertical agreements fromChapter I Prohibition, unless ¾ Firm has (horizontal) market share > 25% ¾ Agreement fixes prices, shares mkt, or imposes min RPM¾ Or is part of a network of agreements which have anti-competitive effects EU: Generally exempt from Art. 81(1) Prohibition ¾ Block Exemptions for vertical agreements, R&D, techtransfer, and motor vehicle distribution & servicing ¾ Concern if (horizontal) market share > 30% ¾ Hardcore restrictions (e.g. price-fixing) prohibited 43

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