Carlton & Perloff Chapter 12 Vertical Integration and Vertical Restrictions. I. VERTICAL INTEGRATION AND VERTICAL RESTRICTIONS A. Vertical Integration

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1 I. VERTICAL INTEGRATION AND VERTICAL RESTRICTIONS A. Vertical Integration Carlton & Perloff II. 1. Operating at successive stages of production a. downstream: towards final consumers b. upstream: towards inputs/raw materials B. Vertical Restrictions 1. Contracts between upstream and downstream firms that restricts actions C. Special cases of strategic behavior: choose that which is most profitable 1. Integrate vertically 2. Negotiate vertical restrictions 3. Rely on markets THE REASONS FOR AND AGAINST VERTICAL INTEGRATION A. Optimizing Behavior: weigh benefits and costs 1. Benefits: a. reducing costs b. eliminating externalities 2. Costs: a. transactions costs of acquisition or expansion b. higher internal production costs c. diseconomies of scope B. Integration to Lower Transactions Costs 1. General: high transactions costs promote opportunistic behavior a. costly to develop contract encompassing all contingencies b. vertical integration converts inter-firm monitoring into intra-firm monitoring (1) converts cooperative into boss-employee relations (2) downside: salaried employees less motivated than independent contractor 2. Specialized Assets a. Very limited number of uses: ripe for opportunistic behavior b. Specialized physical capital: use quasi-vertical integration (1) downstream firm owns specialized capital; upstream firm uses the specialized capital c. Specialized human capital d. site-specific capital (relocating costs promote opportunism) e. rivals may interfere with suppliers 3. Uncertainty: if quality hard to determine after production/construction, vertically integrate to determine quality 4. Transactions Involving Information a. difficult to write contract to insure maximum effort b. marketing surveyors can lie about extent of survey 5. Extensive Coordination a. high costs to coordinating networks that must mesh C. Integration to Assure Supply 1. Guarantee timely delivery and optimal quantity of critical inputs 2. Minimizing inventory costs D. Integration to Eliminate Externalities 1. Reputation generates externalities 12-1

2 a. good reputation confers benefits on others b. bad reputation confers costs on others E. Integration to Avoid Government Regulation 1. Price controls generally do not apply to intra-firm transactions 2. Price ceilings reduce quantity supplied a. get around quantity restriction by buying supplier 3. Intra-firm transaction exempt from taxes a. shift profits between tax jurisdictions F. Integration to Increase Monopoly Profits 1. Vertical Integration to Monopolize Another Industry a. Fixed-Proportions Production Function (1) Inputs must be used in given quantities (2) Since downstream firm has no choice, it cannot alter its input usage (3) Monopolist can extract all profits without integrating Carlton & Perloff 12-2

3 b. Variable-Proportions Production Function Carlton & Perloff III. IV. (1) Substitutes for input supplied by monopoly (2) Monopoly price alters input usage and raises MC of downstream firm (3) Supplier loses because: (a) reduced purchases of input (b) reduced sales of final product (4) Profit by integrating vertically 2. Price Discrimination a. By integrating vertically can prevent resale among markets b. Aluminum example (1) no substitutes in aircraft industry: charge higher price (2) substitutes for aluminum wire: charge lower price (a) wire makers could resell to aircraft industry (b) integrate into wire industry; pass lower costs along to wire buyers G. Integration to Eliminate Market Power 1. Avoid high prices of monopoly supplier a. buy out supplier b. build own production plant THE LIFE CYCLE OF A FIRM A. Relations change with age of industry 1. New industries: a. small scale b. no incentive for specialized suppliers to develop (no profit) c. new markets characterized by vertical integration 2. Mature industries a. large scale b. greater opportunity for specialization c. firm disintegrate 3. Declining industries a. same as new b. suppliers exiting industry VERTICAL RESTRICTIONS A. General 1. Manufacturers contract with distributors a. example of principal-agent b. principal cannot fully control agent 2. Contracts restrict behavior of distributors a. conditions in addition to wholesale price b. location, advertising, quotas, exclusivity, retail prices 3. Restrictions can have same impact as vertical integration 4. Why not integrate? a. Difficulty monitoring distant employees b. Manufacturers want lowest distribution costs B. Vertical Restrictions Used to Solve Problems in Distribution 1. Double Monopoly Markup a. The Loss from a Double Monopoly Markup 12-3

4 Carlton & Perloff (1) MR of downstream firm becomes D for upstream firm (2) upstream firm equates it MC with the curve that is marginal to the market MR curve (3) doubling the market reduces joint profits (4) buyers and sellers worse off (5) strong incentive to integrate b. Vertical Restrictions (1) manufacturer wants most efficient distribution system (a) competition in distribution is ideal (2) Options (a) set maximum retail price at single monopoly price (b) quantity forcing; set at single monopoly output (c) two-part pricing i) franchise fee set at monopoly profits ii) wholesale price at MC iii) get monopoly outcome if competition to become the sole distributor 2. Free Riding Among Distributors a. The Free Riding Problem (1) Problem occurs when extensive sales effort needed. (a) examples: showrooms, advertising, product training; trained sales staff; reputation (2) Any one distributor benefits from efforts of others and can avoid selling costs (3) Free riding results in insufficient sales effort b. Vertical Restrictions (1) exclusive territories (a) does introduce double monopoly problem (2) limited number of distributors (3) resale price maintenance (a) eliminates price competition (b) induces nonprice competition (4) advertising fees/cooperatives (5) favorable treatment for most efficient distributors (a) timely deliveries; better product selection 3. Free Riding by Manufacturers a. Some sales efforts benefit competitors (1) manufacturers that share distributors 12-4

5 Carlton & Perloff (a) free ride on promotions that increase traffic (b) manufactures may provide customer lists (2) manufacturers that share service/repair facilities b. Solution: exclusive dealing 4. Externalities Due to a Lack of Coordination Among Distributors a. Efficient sales effort requires coordination among distributors (1) efficient distribution of locations (2) efficient price distribution (a) discouraging search reduces transactions costs C. The Effects of Vertical Restrictions 1. Desirable Effects a. some restrictions reduce distribution expenses (1) benefits both buyers and sellers (2) lower costs and prices b. some promote inter-brand competition (1) lowers prices of all competitors c. relevant products (1) consumers often value services that come with the purchase (2) restrictions can promote these services 2. Ambiguous Effects a. May raise price to one group while lowering it to others (1) experienced versus new users of product (a) latter need instruction; information (showrooms) (b) former do not (c) making instruction available helps new users; harms experienced users b. Restrictions that result in price discrimination benefits one group while harming another 3. Undesirable Vertical Restrictions a. Restrictions that (1) facilitate the formation/maintenance of a cartel (2) reduce price competition (3) reduce entry D. Banning Vertical Restrictions 1. Often ineffective since firms will vertically integrate V. LEGAL STATUS UNDER ANTITRUST LAWS A. Nonprice Vertical Restrictions 1. governed by rule of reason B. Vertical Restrictions Involving Prices 1. Resale price maintenance 2. per se illegal VI. FRANCHISING A. Players 1. Franchisor: a. sells a proven method of doing business, or b. sells right to carry a product c. business-format franchisor: a total system of doing business (1) usually provides training and assistance 2. Franchisee: a. buys rights b. agrees to operate business according to contract c. pays fee plus a percentage of sales (1) sales easier to monitor than profits d. new franchises have much lower failure rate B. Franchises make franchisor and franchisee mutually interdependent 12-5

6 Carlton & Perloff VII. EMPIRICAL EVIDENCE 12-6