Lecture 5 The Economics of Vertical Agreements/Restraints Frances Ruane (Frances.Ruane@esri.ie) Department of Economics Trinity College Dublin
Introduction Horizontal Agreements (Substitutes) Vertical Agreements (Complements) Upstream Firm (e.g. manufacturer) Downstream Firm (e.g. distributor/dealer) Market Power Exists (Second Best World) Upstream and/or Downstream Power? Motivations? Welfare Effects? Starting point: Independence vs Integration
Vertical Relationships: Spectrum Unconditional Sale (Linear Pricing) Upstream Downstream Vertical Integration Impact of VI Competitive Competitive No effect Competitive Monopolist No effect Monopolist Competitive No effect Monopolist Monopolist Positive welfare effect
Welfare Change with VI Monopolist wholesaler Competitive retailers Pr
Welfare Change with VI Competitive Wholesalers Monopolist Retailers
Welfare Change with VI Upstream and Downstream Monopolists
Vertical Restraints: Spectrum Unconditional Sale Independent Ownership Vertical Integration (Linear Pricing) (Restraints on Pricing/Distribution) Resale Price Maintenance/Vertical Price Fixing Exclusive Selling/Distribution/Territory Exclusive Purchasing/Dealing Tying, Bundling and/or Price Discrimination Impact of Vertical Restraints can be (+) or (-) for consumers
Vertical Restraints: Advantages Welfare Increasing Arguments Aligning (Welfare Increasing) Incentives of Upstream and Downstream Firms Reducing Bargaining/Distribution Costs Eliminating Successive Monopolies (Vertical Integration/Merger) Preventing Excessive Entry (Welfare Increasing) Price Discrimination
Vertical Restraints: Disadvantages Welfare Decreasing Arguments Facilitation of Collusion Upstream Level and/or (more recently) Downstream Level Foreclosure Excluding Established Firms and/or Entry Deterrence (Welfare Decreasing) Price Discrimination
Sector without any VI
Sector with Significant VI
Variety of Vertical Restraints 1. Resale Price Maintenance (Vertical Price Fixing) 2. Exclusive Distribution/Selling/Territories (Selective Distribution, Franchising) 3. Exclusive Purchasing/Dealing 4. Tying, Bundling and/or Price Discrimination
1. Resale Price Maintenance (RPM) Motivations? (Useful starting point) Effects on Welfare? (End point) Maximum RPM - Price Ceiling Minimum RPM - Price Floor Recommended RPM Fixed RPM (Vertical Price Fixing)
Maximum RPM ( ~ Vertical Integration) Welfare Increasing Arguments Curbing Dealer Monopoly Power Product Promotion: Upstream Firm => Potentially Same outturn as Vertical Integration => Zero or Positive Welfare changes
Minimum RPM: Overview Motivations? Downstream Collusion: Dealers Cartel Upstream Collusion: Manufacturers Cartel Sales Increasing Services, Product Promotion, Quality Certification: Downstream Firms Bad Motivations Bad Effects Good Motivations Good Effects?
Min RPM and Dealers Cartel Potential Substitute for Horizontal Price Fixing P = Pm > MC Manufacturer enforces Min RPM - Dealers Gain Possible features : Lack of Good Substitutes, High Dealer (Net) Mark-up, Entry Barriers, Declining Market Share of Relevant Manufacturer(s)
Min RPM and Manufacturers Cartel Reduces incentive for Upstream firms to cut price Difficult to detect Possible Features: Homogenous Product, Relatively Unimportant Point-of-Sale Services, Low Dealer (Net) Mark-up, Declining Market Share (or Total Sales) of Manufacturers
Min RPM and Dealer Point-of- Sale Services Demonstration & Point-of-Sale Information Quality Certification Impractical to Charge Directly For Services Min RPM Can Deter Free-Riding / loss leaders Possible features: Complex Product, Service Competition, Unilateral, High Dealer Gross Mark-up & Low Dealer Net Mark-up
Min RPM: Welfare Diagram 1 P Impact of Min RPM on Welfare (c = price to competitive dealers) p 2 p p 2 2 P 1 : Price without Min RPM P 2 : Price with Min RPM p 1 c D 1 D 2 Q
2. Exclusive Distribution/Selling (Degree of Intervention in Dealer Competition) Min RPM Exclusive Distribution Vertical Integration Specific Geographic Market
Exclusive Distribution/Selling: Overview Motivations? Facilitate Collusion Among Dealers of Different Manufacturers Bolster Collusion Among Manufacturers Dampens Intrabrand Competition Foreclosure at the Downstream Level Product Promotion: Downstream Firms
Exclusive Distribution and Collusion Among Dealers Direct Manufacturer Collusion Difficult (e.g Price Cut Difficult to Detect at Upstream Level) Side- Payments to Manufacturer(s) Necessary Dampens Intrabrand Competition Foreclosure at the Downstream Level Possible features High Dealer Concentration, Side-Payments, Entry Barriers
Exclusive Distribution and Dealer Services Demonstration & Point-of-Sale Information Complex Product(s) Impractical to Charge Directly For Pre- Sales Services Regional Advertising Quality Control
3. Exclusive Purchasing/Dealing: Motivations? Overview Foreclosure (of Distribution Outlets) Manufacturers Cartel & Market Division Dampens Interbrand Competition Sales Increasing Services/Product Promotion: Upstream Firms Bad Motivations ~ Bad Effects? (Excessive entry possibility?)
Exclusive Dealing: Foreclosure Possible features Excessively Long Contracts Restricted Number of (Efficient) Distribution Outlets Entry Barriers at Both Levels Dominant Upstream Firm
Exclusive Dealing: Market Division Possible features Excessively Long Contracts No Switching Encouraged/Tolerated Non-Overlapping Geographical Areas
Exclusive Dealing & Manufacturer Services Product Promotion: Upstream Firm Investments in Downstream Firm (e.g. Equipment, Training,... ) Upstream Firm s Product Innovation Upstream Firm s Product Reputation Limits Conflicts of Interest Protects Upstream Firm s Property Rights
4. Tying, Bundling and/or Price Definition Motivations? Discrimination Protecting The Tying Product s Reputation (i.e. quality control) Extension of Monopoly Power (Leverage) Foreclosure (Producers of the Tied Product) Pricing Tactic (Price Discrimination)
Price Discrimination Central Issue: Effect on Welfare First, Second, Third Degree Market Segmentation Indicators 1. Change in Total Output? 2. Allocation of Output Among Different Consumers? Importance of Correct Counterfactual
Tying: Leverage (Extension of Monopoly) Vertical Merger/Integration & Extensions of Monopoly Power? Fixed Proportions Technology: No Variable Proportions Technology: Yes? (P in general)
Tying (Pricing Tactic) Example: Maximum Values to Theatres Movie A Movie B Fox Theatre York Theatre $100 $70 $60 $80 Suppose Cost of Movie A = $125 Cost of Movie B = $135
Vertical Agreements Emerge from potential to explore upstream downstream differences when there is monopoly power Judgement depends on case made for justifying agreements Case by case basis Welfare impact determined by market effects