Lecture 5
The Economics of Vertical
Agreements/Restraints
Frances Ruane ([email protected])
Department of Economics
Trinity College Dublin
Introduction
• Horizontal Agreements (Substitutes)
• Vertical Agreements (Complements)
– Upstream Firm (e.g. manufacturer)
– Downstream Firm (e.g. distributor/dealer)
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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)
Vertical Integration
Impact of VI
Upstream
Downstream
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
(Linear Pricing)
Independent Ownership
Vertical Integration
(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
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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)
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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
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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-ofSale Services
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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)
p2
p2
p2
P1: Price without Min RPM
P2: Price with Min RPM
p1
c
D2
D1
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) “SidePayments” 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 PreSales Services
• Regional Advertising
• Quality Control
3. Exclusive Purchasing/Dealing:
Overview
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Motivations?
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
Discrimination
• Definition
• Motivations?
• 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
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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
$100
$70
York
Theatre
$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