Industrial Organization: Contemporary Theory & Practice Chapter 9: Vertical Relations.

Industrial Organization: Contemporary Theory & Practice

Chapter 9: Vertical Relations


Introduction• In any market, consumers have to decide

– what brand to buy• lots of intrabrand competition

– Mattel vs. Hasbro, Clarins vs. Estee Lauder– where to buy

• retailers specialize in carrying certain brands– toys; perfume; electronic goods

• For some goods there appear to be restrictions on what is sold where– Gas; Chevron retailer sells only Chevron gasoline– new cars; dealers sell only a few brands

• For others there are not– Many newspapers/magazines sold at same newstand– Department/discount stores carry many brands

• What explains these differences?


Upstream-downstream relations• The relationship between manufacturers and retailers is complex• Affects competition in the market-place

– exclusive dealing restricts competition• consumers have to travel to different outlets to compare brands

– non-restrictive supply increases competition• different manufacturers have to compete for retail space• retailers in much more direct competition

• So the chain from manufacturer to retailer is important– manufacturers typically not in direct contact with consumers

• exceptions: Dell and its imitators• How the manufacturer connects with the consumer—whether

through a retailer or not—is important


Manufacturer/retailer relations• Relations between manufacturers and retailers take many forms

– Profit sharing– Two-part tarrifs– manufacturer may want to have an input into

• marketing• required level of support services• Pricing, e.g., recommended retail price or resale price

maintenance (RPM)– Pricing agreements between firms cannot help but

look a bit like collusion» per se violation of anti-trust laws in the US» but recommended maximum prices might not be


Vertical restraints• The complexity of manufacturer/retailer relations inevitably leads to

formal contracts to sort out the rights and responsibilities of each party

• Just as inevitably, such contracts impose some restraints on each side. • While these restraints may look like restrictions on competition, they

may in fact be beneficial. They may improve efficiency – in pricing– In service provision– In preventing excessive duplication and proliferation of retail

outlets• The issue then becomes whether such potential efficiency gains will

be realized and if so, whether they will be large enough to overcome any creation of monopoly power


Vertical restraints and pricing Double Marginalization Issues: Monopoly manufacturer and monopoly retailer

Manufacturer makes suits that are sold through the retailer

Consumer demand for suits: P = 500 - Q/100

Suits cost $20 each to makeRetailer incurs additional cost of $40 per suit sold: space, labor etc.

The manufacturer sells the suits to the retailer at a price of r each


The examplePrice (P)

Quantity

500

50,000

Demand marginal revenue for the retailer is MR = 500 - Q/50

MR

25,000

marginal cost is r + 40

MCr+40

MC = MR gives r = 460 - Q/50

This is themanufacturer’s

deriveddemand

This is themanufacturer’s

deriveddemand

Price (r)

Quantity

Manufacturer’s demand

460

23,000

The manufacturer’s marginal revenue is MR = 460 - Q/25

MR

Marginal cost is $20

20 MC

MC = MR gives Q = 11,000

11,000

The suits are wholesaled at $240

240 The retailer’s MC is $280

280

He sells 11,000 suits

11,000

and prices them at $390 each

390

The manufacturer’sprofit is $2.42m

The manufacturer’sprofit is $2.42m

The retailer’sprofit is $1.21m

The retailer’sprofit is $1.21m


Vertical restraints We know from Chapter 8 that a merger of manufacturer and retailer improves on the foregoing outcome

Price

Quantity

500

50,000

marginal revenue for the merged firm is MR = 500 - Q/50

Demand

25,000

marginal cost is MC = $60

MC60

So MC = MR gives suit sales of 22,000

22,000

The suits are priced at $280 each280

Profit of the merged firm is $4.84 million

But is such a mergernecessary to achieve

these gains?


Royalty Schemes Royalty schemes may seem a better way to link the interests of the manufacturer and the retailer. But these too have problems. Under one possible royalty contract the manufacturer sells at cost c = $20 to the dealer and then receives a fraction of the retailer’s revenuesThe retailer’s marginal revenue is: = (1 - )(500Q -2 Q/100)

Equating marginal revenue with the marginal cost of 20 + 40 = 60 yields the retailer’s profit maximizing output of

Q* = 25,000 - 30001 -

This is less than 22,000 for all positive values of , i.e., for any scheme under which the manufacturer earns a profit.


Royalty Schemes (cont.) As we have just seen, a royalty scheme based on the manufacturer’s selling at cost and then claiming some of the downstream revenues cannot replicate the integrated outcome There are other possible royalty contracts, though. One is to give the suits at no charge to the dealer and then again claim some of the downstream revenue

Now the retailer equates marginal revenue with a marginal cost of 40: = (1 - )(500Q - 2Q/100) = 40

Solving for Q yields : Q* = 25,000 - 20001 -

At = 1/3 or 33.33% this will equal 22,000

A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit . . . BUT

A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit . . . BUT


Royalty Schemes (cont) With output = 22,000, the retail price is again $280 so the retailer’s revenue is $280 x 22,000 = $6.16 million The manufacturer gets 1/3 of this so her royalty income is $2.053 millionthe manufacturer’s costs are $20 x 22,000 = $0.440 million

. This is less than the $2.42 million it earned under the non-integrated case. The manufacturer’s royalty scheme has duplicated the integrated outcome but at the cost of giving away even more profit to the retailer.

so her net profit from the royalty is $1.61 million.


Royalty Schemes (cont.) As a final scheme we consider the case in which the manufacturer sells at cost and then sets a royalty that is simply a fraction of of the retailer’s net profits

the retailer’s profit now is: R = (1 - )(500 - Q/100 - 20 - 40)Q

Notice that the factor 1- now affects both revenues and costs:

So marginal revenue is (1-)(500Q – 2Q/100) and marginal cost is (1-)(20+40).

This type of royalty scheme always works. The royalty rate is set bynegotiation to distribute aggregate profits of $4.84 million

This type of royalty scheme always works. The royalty rate is set bynegotiation to distribute aggregate profits of $4.84 million

Equating MR and MC yields the integrated output of Q = 22,000


Royalty Schemes (cont.)• Why are royalty schemes based on profits not more

widespread?– profits are easy to disguise

• misrepresent costs• incur additional discretionary costs: travel costs,

entertainment …..• suppose that retailing incurs fixed costs of F:

marketing, space costs ...• then the retailer can exaggerate F to negotiate a lower

royalty rate– revenues are more easily observable

• Are there other mechanisms that work?


Two-Part Pricing Manufacturer sells Q suits at a total charge of C(Q) = T + rQ

Set r equal to the manufacturer’s marginal cost of $20 per suit

The retailer’s profit is: R = (500 - Q/100 - 20 - 40)Q - T

The retailer’s marginal revenue is: MR = 500 – 2Q/100

The retailer’s marginal cost is: MC = 20 + 40 = 60

Equating MR and MC yields Q* = 22,000

Because the fixed charge does not affect marginal calculations, the retailer chooses the vertically integrated output and sells at the vertically integrated price

Because the fixed charge does not affect marginal calculations, the retailer chooses the vertically integrated output and sells at the vertically integrated price

Total profit is the vertically integrated profit of $4.84 million The manufacturer uses the fixed charge T to claim this profit


Two-part pricing (cont.)

the maximum the retailer will pay is $4.84m- $1.21m

Consider how the fixed charge T might be negotiated

If negotiations break down it is reasonable to suppose that the manufacturer and retailer revert to simple linear pricingProfit with a zero

fixed charge

Profit with a zerofixed charge

Profit with linearpricing


= $3.63m

the minimum the manufacturer will accept is $2.42m



There is scope for mutually beneficial negotiation over the fixed chargeThere is scope for mutually beneficial negotiation over the fixed charge


Two-Part Pricing (cont)• How common is a two-part pricing type of scheme?• When seen as a franchise agreement fairly

common– fixed charge represents a franchise fee giving the

retailer the right to sell the manufacturer’s product

– generates up-front profit for the manufacturer– so the manufacturer is willing to set a price per

unit near to (at) marginal cost


Resale Price Maintenance• Double marginalization means that the retailer sets too high

a retail price for the suits– what if the manufacturer imposes a price on the retailer?

Price

Quantity

500

50,000

Demand

25,000

RPM280

11,000

390

set a maximum price of $280 per suit

the retailer will set this price

sales of suits increase to 22,000

22,000

60

aggregate profit is $4.84m

what wholesale price should the manufacturer set for the suits? must negotiate to redistribute the profits, e.g., a wholesale price of $240 will give all

the profit to the manufacturer


Retail Services (Advanced)• So far the retailer has been totally passive

– merely an intermediary between manufacturer and consumer• But retailers can do more than this

– provide additional services: marketing, consumer assistance• These services increase sales• This benefits manufacturers• But offering these services is costly

– provision by retailer related to retailer’s profit not manufacturer’s

• And both services and costs are hard for manufacturer to measure• How does the manufacturer encourage the efficient levels of service

provision by the retailer?


Retail services (cont.)

The provision of retail services increases demand

Price

Quantity (Q)D(s1)

D(s2)

Demand withretail services s1

Demand withretail services s1

Demand withretail services

s2 > s1


s2 > s1 But the provision of retail services is costly for the retailer: (s) per unit sold

$

Services (s)

(s)

What level of services will be provided by the retailer?

The retailer’s marginal cost is r+(s)

Suppose the wholesale price is r


Retail services (cont.) Efficiency is most likely if the retailer and manufacturer are vertically integrated

suppose that consumer demand is Q = 100s(500 - P)Price

Quantity (‘000)

500

50

Demand with

retail servicess = 1

Demand with

retail servicess = 1

100


s = 2


s = 2 assume that marginal costs for manufacture are cm and for the retailer are cr

the integrated firm’s profits areI = (P-cm-cr-(s))100s(500 - P)

Note: higher s (more service) raises demand


Retail services (cont.)I = (P- cm - cr - (s))100s(500 - P) Profit of the integrated firm:

The integrated firm sets P and s to maximize profits

I/P = 100s(500 - P) - 100s(P - cm - cr - (s)) = 0

Cancel the100s terms

Cancel the100s terms

500 - 2P + cm + cr + (s) = 0

P* = (500 + cm + cr + (s))/2

I/s = 100s(500 - P)(P - cm - cr - (s)) - 100s(500 - P)’(s) = 0

Cancel the100(500 - P)

terms


terms

(P - cm - cr - (s)) = s’(s) Substitute the first equation into the second and simplify

(500 - cm - cr)/2 - (s)/2 = s’(s)

(500 - cm - cr)/2 = (s)/2 + s’(s)

This equation givesthe efficient levelof retail services

This equation givesthe efficient levelof retail services



(500 - cm - cr)/2 = (s)/2 + s’(s)

The right hand side isincreasing in s

The right hand side isincreasing in s

$

s

(s)/2 + s’(s)

(500-cm-cr)/2

s*

Let c’m and c’r be new marginal costs

Let c’m and c’r be new marginal costs

Suppose that there is an increase in marginal costs,

apart from services, at either the manufacturing or retail level

(500-c’m-c’r)/2

ŝ

The rise in cost leads to a fall in the

optimal choice of s

from s* to ŝ

The rise in cost leads to a fall in the

optimal choice of s

from s* to ŝ

Initial manufacturing and retail costs

Initial manufacturing and retail costs


Retail services (cont.) Suppose for example that cm = $20, cr = $30 and (s) = 90s2

the equation (500 - cm - cr)/2 = (s)/2 + s(s) then gives

225 = 45s2 + s180s which gives: 225 = 225s2 s* = 1

P* = (500 + cm + cr + (s))/2

so P* = 275 + 45s2 P* = $320

And Q = 100s(500 - P) Q* = 18,000

It turns out that the integrated firm chooses the socially efficient level of retail services but sets price above marginal cost This provides our benchmark case

Aggregate profit is (320 - 50 - 90)x18,000 I = $3.24 million


Retail services (cont.) Suppose that retailer and manufacturer are independent The manufacturer sells its suits to the retailer at r per suit The retailer then sets retail price and service level to maximize profits

R = (P- r - cr - (s))100s(500 - P) Profit of the retailer is: The retailer sets P and s to maximize profits

R/P = 100s(500 - P) - 100s(P - r - cr - (s)) = 0Cancel the100s terms

Cancel the100s terms 500 - 2P + r + cr + (s) = 0

PR = (500 + r + cr + (s))/2

R/s = 100(500 - P)(P - r - cr - (s)) - 100s(500 - P)d(s)/ds = 0


terms


terms

(P - r - cr - (s)) = s(s)

which together gives: (500 - r - cr)/2 = (s)/2 + s(s)



(500 - r - cr)/2 = (s)/2 + s(s)

$

s

(s)/2 + s(s)

(500-cm-cr)/2

s*

This is the retailer’schoice of s at

wholesale price r

This is the retailer’schoice of s at

wholesale price r(500- r - cr)/2

The efficientchoice of s

The efficientchoice of s

The manufacturer willset the suit price at greater

than marginal cost:r > cm

sr

The retailer provides toolow a level of support

services


Retail services (cont.)• The only way that the manufacturer makes profit is by

setting wholesale price greater than cost• This squeezes the profit margin of the retailer• The retailer marks up the wholesale price• but also the retailer cuts back on support services

– takes account only of the impact on his own profits– ignores the beneficial external effect on the

manufacturer• Can we get the vertically integrated outcome without

integration?– royalty– two-part tariff– RPM


Retail services (cont.)• As before, royalty on retailer’s profit could work

– suits provided at cost so no distortion in service provision

• But problems of monitoring retailer’s profits are now even more severe

– Retailer can exaggerate cost of service provision

• What about a two-part tariff?

– manufacturer sets a charge C(Q) = T + r.Q with r = cm

R = (P- cm - cr - (s))100s(500 - P) - T Profit of the retailer is:

Maximizing with respect to P and s gives the integrated outcome!The manufacturer and retailer then bargain over the franchise fee

A two-part tariff achieves the efficient level of service provisionA two-part tariff achieves the efficient level of service provision


Retail services (cont.)• What about RPM?

– The manufacturer could impose a retail price of P*

– But to make a profit he must set a unit price of r > cm

– This squeezes the retailer’s profit margin

– So the retailer reduces the service level

• RPM does not work

• What happens if the retail sector is competitive?


A Competitive Retail Sector• Suppose the retail sector is competitive

– large number of identical retailers

– each buys suits from the manufacturer at r and incurs service costs per unit of (s) plus marginal costs cr

– competition in retailing drives retail price to PC = r + cr + (s)

– competition also drives retailers to provide the level of services most desired by consumers subject to retailers breaking even

– so each retailer sets price at marginal cost

– and chooses the service level that maximizes consumer surplus


Competitive retail services (cont.) Demand is Q = 100s(500 - P)

suppose the service level for each firm is s1

Price

Quantity (‘000)

500

50s1


s1


s1

50s2


s2


s2

competition gives P1 = r+cr+(s1)

r+cr+(s1)

consumer surplus is shaded area

Now increase service level to s2

price rises to P2 = r+cr+(s2)r+cr+(s2) there is both a gain and a

loss in consumer surplus

Gain inconsumersurplus

Gain inconsumersurplus

Loss ofconsumersurplus

Loss ofconsumersurplus

these have to be balanced in the choice of s


Competitive retail services (cont.) Demand is Q = 100s(500 - P) and P = r + (s)

Price

Quantity (‘000)

500

50s1

P = r+cr+(s)

Consumer surplus is CS = (500 - P)

Height ofthe triangle

Height ofthe triangle

Q

x Q/2

Multiplied by half thebase of the triangle

Multiplied by half thebase of the triangle

= 50s(500 - P)2

= 50s(500- r-cr-(s))2

To maximize CS with respect to s:CS/s = 50(500-r-cr-(s))2

-100s(500-r-cr-(s))(s) = 0

so 500 - r - cr - (s) = 2s(s)

(500 - r - cr)/2 = (s)/2 + s(s)

This equation givesthe competitive level

of retail services

This equation givesthe competitive level

of retail services

Cancel the common term50(500 - r - cr - (s))

Cancel the common term50(500 - r - cr - (s))


Competitive retail services (cont.)(500 - r - cr)/2 = (s)/2 + s(s)

$

s

(s)/2 + s(s)

(500 - cm - cr)/2

s*

This is the efficientchoice of s

This is the efficientchoice of s

(500 - r - cr)/2

For the manufacturerto make a profitrequires r > cm

For the manufacturerto make a profitrequires r > cm

sC

This is the competitivechoice of s given a

wholesale cost r

This is the competitivechoice of s given a

wholesale cost r

Retail competition gives too low a level of support

services


Competitive retail services (cont.)• Why the low provision of retail services?

– increased services has three effects• higher retail demand and increased consumer surplus• higher retail prices and reduced consumer surplus• higher wholesale demand and increased profits to the

manufacturer– the competitive retailers ignore the third effect

• it is an externality that does not affect them directly• Can the manufacturer correct this?

– two-part tariff C = T + rQ• for this to be efficient r = cm

• but then competition between retailers destroys their profits• so T = 0 and the manufacturer makes no profit


Competitive retail services (cont.)• What about RPM?• This is a possibility but it is complicated

– require retailers to sell at P = P*• Sell to the retailers at a wholesale price r such that

• margin over cost P* - r - cr

• equals cost of optimal level of services (s*)– In our example

• set RPM = P* = $320• set r so that r = P* - cr - (s*) = 320 - 30 - 90 = $200 • competition in retailing results in s* = 1 as required

• But does the manufacturer have the necessary information?– manufacturer may not know cost of service provision– cost especially difficult to know since retailers are not identical


Further Aspects of RPM • Manufacturing and retailing are complementary

– separate operation is inefficient

– contractual arrangements can improve efficiency

– RPM is one such arrangement

• but it is controversial

• generally treated as in violation of anti-trust laws

– should re-examine this view

– RPM may offer benefits

• to prevent free-riding on support services of some retailers

• to help cope with variable demand


RPM & Customer Service • Many services are informational

– choice of high-tech equipment– fashion clothing– wine

• These services are costly– no obligation on consumer to buy from particular

retailer– discount stores can free-ride on retailer’s services– so retailers cut back on services– manufacturers lose out

• RPM potentially offers a correction– freeze price discounting– gives retailers who provide services an edge


RPM and Variable Demand• Another justification for RPM has been recently suggested

– to cope with variable demand and competitive retailing– retailer facing uncertain demand has to balance

• how to meet demand when demand is strong• how to avoid unwanted inventory when demand is weak

– monopoly retailer behaves differently from competitive• monopolist throws away inventory when demand is weak to

avoid excessive price fall• competitive retailer will sell it

– believes that he is small enough not to affect the price• retailing competition causes sharp price cuts if demand is weak

– reduces the profit of the manufacturer– makes competitive firms reluctant to hold inventory


RPM and variable demand• RPM can correct this

– in periods of low demand retailers act just like an integrated firm

• throw away excess inventory

• do not dump it on the market

• An example


RPM and variable demand illustrated Suppose that demand is high, DH with probability 1/2

Price

Quantity

DH

And that demand is low, DL with probability 1/2

DL

Marginal costs are assumed constant at c

c MC

Integrated firm has to choose in each period

stage 1: how much to produce

stage 2: knowing demand - how much to sell

since costs are sunk: maximize revenue


RPM and variable demand illustrated

Price

Quantity

DH

DL

c MC

an integrated firm will not produce more than QUpper

MRH

QUpper

and will not produce less than QLower

QLower

MC = MR withhigh demand

MC = MR withhigh demand

MC = MR withlow demand

MC = MR withlow demand

the integrated firm will produce Q*

Q*

How is Q*determined

MRL



Price

Quantity

DH

c MC

if demand is high the firm sells Q* at price PMax: MR = MR*H

MRH

if demand is low selling Q* is excessive

the firm maximizes revenue by selling Q*L at price PMin: MR = 0

Q*

PMax

Q*L

PMin

MR*H

expected marginal revenue is:

DL

MRL

MR*H/2 + 0 = MR*H/2

Q* is such that expected MR = MC so MR*H/2 = c

Revenue withlow demand

Revenue withlow demand

Revenue withhigh demand


Expected profit is

I = PMaxQ*/2 + PMinQ*L/2 - cQ*



Price

Quantity

DH

c MC

if demand is high the retail firms sell Q* at price PMax: MR = MR*H

MRH

Q*

PMax

DL

MRL

Suppose thatretailing iscompetitive



if demand is low each firm will sell more so long as price is positive

so, if demand is low competitive retailers keep selling until they sell the total quantity QL at which price is zero

QL

revenue is therefore zero in low demand periods if competitive firms stock Q*

Will competitive retailers stock the optimal amount Q*? What will happen if they do?


RPM and variable demand If competitive retailers stock Q*, their expected net revenue is thus:

PMaxQ*/2 + 0 = PMaxQ*/2 Since competitive firms just break even, this means that the manufacturer can charge a wholesale price PW such that:

PWQ* = PMaxQ*/2 which gives PW = PMax/2

The manufacturer’s profit is then:

= (PMax/2 - c)Q*

This is much less than the integrated profit: the competitive retailers sell too much in low demand periods An RPM agreement can fix this



Price

Quantity

DH

c MC

the integrated firm never sells at a price below PMin

MRH

Q*

PMax

Q*L

PMin

MR*H

DL

MRL

so set a minimum RPM of PMin

In high demand periods Q* is sold at price PMax

In low demand periods the RPM agreement ensures that only Q*L is sold Expected revenue to the retailers is PMaxQ*/2 + PMinQ*L/2


RPM and variable demand Expected net revenues of retailers is

PMaxQ*/2 + PMinQ*L/2

So the manufacturer can charge a wholesale price PW such that:PWQ* = PMax.Q*/2 + PMinQ*L/2

which gives PW = PMax/2 + PMinQ*L/2Q*

The manufacturer’s profit is= PMaxQ*/2 + PMinQ*L/2 - cQ*

This is the same as the integrated profit

The RPM agreement has given the integrated outcome This can benefit consumers by encouraging retailers to stock products with variable demand that would otherwise not be stocked.


Exclusive Territories• Gives a retailer the sole right to sell a good in a particular

territory

• Prevents the manufacturer from opening too many outlets

• Encourages retailer to provide support services

– inhibits the ability of discount stores to free ride

• Allows the manufacturer to control entry to a market

• Usually see exclusive territories associated with franchise fee arrangements

• This kind of arrangement may enhance efficiency: remove double marginalization

• But it may also reduce efficiency


Exclusive dealing and competition

Supplier 1 Supplier 2

Retailers

Consumers

Suppose thatthere are several

retailers

Suppose there are2 suppliers of

competing products

Price competitionby the suppliersdrives price tomarginal cost

Price competitionby the suppliersdrives price tomarginal cost

Price competitionby the retailersdrives price tomarginal cost

Price competitionby the retailersdrives price tomarginal cost

What if the suppliersoffer an exclusive

territory?


Exclusive dealing and competition

Supplier 1 Supplier 2

Retailers

Consumers 1

Suppose the suppliersdivide retail into

two regions

And suppose thesuppliers give exclusive

territories to thesame retailers

Each lucky retaileris now a local

monopolist

Each lucky retaileris now a local

monopolist

Consumers 2


Exclusive Territories/Dealing• The potential for inefficiency is that this arrangement can create

local monopolies with the usual distortions• Exclusive dealing agreements whereby the retailer is constrained

to carry the brand of one manufacturer can are similar– advertising and promotion have public good qualities and can

lead to free-riding problems– brand-name manufacturer advertising creates demand not just

for that brand but for all such goods including generic types– retailer may make higher margins on the generic type and so

“suggest” that this is the one to buy• Exclusive dealing is intended to prevent this type of free-riding

but, as noted, can reduce price competition much like exclusive territories

• Exclusive dealing also increases possibility of foreclosure– Coca-Cola’s arrangements with bottlers


Franchising and DivisionalizationWhy Are There So Many Franchisees? Why do Firms Operate Different Divisions?

Recall the Merger Paradox. In a Cournot or quantity competition setting, the merger of two firms makes those firms worse off and remaining firms better off

Why? Because the two merged firms act as one. If there were originally 6 firms and two merge, these two firms are now one of five whereas they were two of six. That is, the merged firms now constitute just one-fifth of the independent decision making units instead of one-third.

This is the intuition behind divisionalization. By operating different divisions or franchises, a single firm avoids the problem raised by the merger paradox

But with each firm doing this, the industry becomes populated with many divisions and franchises—perhaps more than is consistent with either joint profit maximization or efficiency

Industrial Organization: Contemporary Theory & Practice Chapter 9: Vertical Relations.

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Transcript of Industrial Organization: Contemporary Theory & Practice Chapter 9: Vertical Relations.