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Industrial Organization

Industrial Organization. Vertical Issues. Vertical Structure. So far: firms sell directly to consumers In many cases:. c. Manufacturer (Upstream). P w. Retailer/Distributor (Downstream). P R. Demand: q=f(P R ). Vertical Structure. Why vertical separation? Efficiency:

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Industrial Organization

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  1. Industrial Organization Vertical Issues

  2. Vertical Structure • So far: firms sell directly to consumers • In many cases: c Manufacturer (Upstream) Pw Retailer/Distributor (Downstream) PR Demand: q=f(PR)

  3. Vertical Structure • Why vertical separation? • Efficiency: • Upstream unit can specialize in manufacturing • Downstream unit can specialize in retailing • Illegal/unfeasible

  4. Vertical Structure • Why not Vertical Separation? • Manufacturer does not control all variables directly (e.g. promotion, quality, service, price) • Inefficiencies: • If both upstream and downstream firms have some market power, solution is inefficient (double marginalization) • Contract costs, monitoring, negotiation • Opportunistic behavior (e.g. free riding by retailers)

  5. Vertical Structure • Why not Vertical Separation? • Retailer’s objectives not aligned with manufacturer’s • Other: • Assure supply • Hold up problem (supplier market power) • Price discriminate (e.g. aluminum) • Eliminate competitors?

  6. Vertical Structure • Suppose q=1-Pr • With Vertical Integration (VI):

  7. Vertical Structure • Suppose q=1-Pr • With Vertical Integration (VI):

  8. Vertical Structure • Vertical integration $ PVI Dr (Demand) C MRr Q QVI

  9. Double Marginalization • Vertical separation inefficient if market power at both levels: • Case 1: Retailer has no market power. Pr=Pw. Wholesaler’s profit maximization problem becomes the VI problem • Case 2: Wholesaler has no market power. Pw=c. Retailer’s profit maximization problem becomes the VI problem. • Case 3: Neither has market power. Then competitive solution Pr=c regardless of VI or vertical separation (VS)

  10. Double Marginalization • Set up • Wholesaler (upstream): • Retailer (downstream): Wholesale price Retail price Retailer’s only cost

  11. Double Marginalization Two-stage game: Retailer (2nd stage) Wholesaler (1st stage)

  12. Double Marginalization • Plug pw back into retailer’s solution: • We want to compare VI and VS:

  13. Double Marginalization $ A B Pr D C Pw=PVI Pw=Cr Dr (Demand) G F E Cw Dr MRw MRr=Dw Q QVS QVI

  14. Solutions to Double Marginalization • Franchise fees: • Upstream firm sets pw=c • Downstream sets pr=pvi • Upstream firm charges franchise fee • Resale Price Maintenance (RPM) • Upstream firm forces downstream firm to charge the VI price • Quantity is set at the VI level

  15. Franchise Fee • Franchise fee: PVIBEG (or slightly less) $ A B PVI Demand G E Pw=Cw=Cr MRw=MRr Q QVI

  16. Franchise Fee • Retail price and quantity correspond to VI solution • Downstream unit generates zero profit (or some portion of industry profit) • Total welfare increases • Examples: • McDonald’s, Starbucks

  17. Resale Price Maintenance $ • Downstream firm sells at PVI • Upstream firm sets Pw between cand PVI • Profits are split based on Pw location Πr Πw RPM=PVI Pw c Demand MR Q QVI

  18. Agency and Efficiency Problems of Separation (and solutions) • Competition among retailers can result in too little investment • Service, promotion, quality, are public goods • Sharing the market may mean less investment (or none at all) Manufacturer (Upstream) Pw D1 D2 Demand: q=f(PR)

  19. Agency and Efficiency Problems • Opportunistic behavior: • Downstream firm can use upstream’s investment in other activities (e.g. selling more profitable brands) • Upstream firm under-invests because it anticipates free riding by downstream firm

  20. Agency and Efficiency Problems: Solutions • Exclusive Distribution: downstream firm can only sell upstream’s products (not those of the competition) • Exclusive Territories: downstream firm is granted a monopoly within a predetermined geographic region (not allowed to sell anywhere else) • For retailers operating in a fixed location: guaranteed radius • Resale price maintenance: all downstream firms are supposed to sell at same (minimum) price

  21. Exclusive Distribution • Key: Downstream unit must make sure demand is big enough • Solves incentive problem: • Upstream firm’s investments are protected: equipment, training, etc • Objectives are aligned: downstream firm focuses effort on upstream firm’s products only • Upstream firm increases investments: • This decreases distribution costs (better equipment, training, etc.) • Enhanced consumer demand

  22. Exclusive Territories • Aligned incentives: • Quality of service is no longer a public good • Demand level is guaranteed: this provides larger investment incentives for distributor • May enhance consumer surplus: • Better service quality stimulates demand • Wider selection of products: • With no exclusive territories there can be under-provision of products

  23. Example: US Brewing Industry D2

  24. VI and VR: anticompetitive concerns

  25. What is (or may be) wrong with VR? • Antitrust authorites may not like these contracts: • RPM: related to price fixing in horizontal competition; overall market power is enhanced? Consumers face higher prices? • Exclusive territories: may increase downstream firm’s market power by reducing intrabrand competition • Exclusive distribution: • May exclude smaller downstream firms • Force use of less efficient channels

  26. Anticompetitive Behavior? • However: positive effects too • More efficient downstream firms in the presence of exclusive dealing (lower costs from higher upstream investment) • More investment and quality in the presence of exclusive territories • Maximum RPM eliminates double marginalization, minimumprovides incentives for downstream unit • Enhanced provision of services (increased consumer welfare) [with both ET and ED]

  27. A note on RPM • Maximum RPM • Avoid DM problem • Concern: retailers may think this is unfair (insufficient margins), e.g. MacDonald’s dollar menu • Minimum RPM (more problematic, looks as price fixing) • Avoid free riding problem • Concern: consumers facing higher prices (although possibly better services and larger quantities)

  28. A note on RPM • Maximum RPM • Avoid DM problem • Concern: retailers may think this is unfair (insufficient margins), e.g. MacDonald’s dollar menu • Minimum RPM (more problematic, looks as price fixing) • Avoid free riding problem • Concern: consumers facing higher prices (although possibly better services and quantity)

  29. Some evidence on RPM • Minimum RPM • In 1911 it was determined this practice is per se illegal (as if it were price fixing) • In 2007, the century-old ruling was overturned to “rule of reason” • Oct 2009: Maryland enacts per se illegality of RPM • Natural experiment (Bailey and Leonard, 2010): nearby Virginia stays rule of reason, Maryland goes to per se illegality

  30. Some evidence on RPM • If RPM effect is “bad”, we would expect Maryland prices to fall (or Virginia prices to remain high) • Of course, this evidence would not be conclusive (if found) since we do not know about service levels (and quantities sold). • Exercise: look at (newly released) video game prices before and after the ban in both treatment and control states

  31. What is (or may be) wrong with VI? • The main concerns are: • Foreclosure • Raising rivals’ costs

  32. Relevant Readings • Empirics: • Lafontaine and Slade, 2008 (vertical restraints) • Lafontaine and Slade, 2007 (vertical integration) • Bailey and Leonard, 2010 • Rojas, 2012 • Theory: • Rey and Tirole 2008

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