The economics of
vertical restraints
Patrick Rey (IDEI, Toulouse)
CargeseMay 7, 2004
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OutlineOutline
• Introduction
• Inter-firm agreements– Intrabrand coordination– Interbrand competition
• Market power: foreclosure
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IntroductionIntroduction
• What are vertical restraints?
– Revenue sharing: other than a simple “linear price”• Non linear tariffs (two-part tariffs, rebates, menus of tariffs, … ) • Royalties (on sales, total sales, profit)• Commissions
– Obligations (restrictions on behaviour)• Service specification (upstream/downstream, national/local advertising, …)• Quantity forcing, quotas• Exclusivity: exclusive dealing, exclusive territories (active/passive sales)• Resale price maintenance – RPM (price ceiling/floor, recommended prices, …)• Bundling, mixed bundling, full-line forcing
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IntroductionIntroduction
• Questions
– Positive economics: Motivation?
– Normative economics: Competition policy (allow, encourage, forbid, …)?
• Two aspects
– Inter-firm agreements• Vertical coordination (intrabrand)• Strategic effects (interbrand, « short-term »)
– Abuse of market power: foreclosure (entry/exit, « long-term »)
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Intrabrand vertical coordinationIntrabrand vertical coordination• Prices Spengler (1950)
– double marginalisation
w > c => p > pM
– solutions• RPM (ceiling), sales quotas (min.)
• two-part tariffs
• intrabrand competition
– private and social objectives coincidewhat is good for the firm
is good for consumers
P
R
unit cost c
Consumers
wholesale price w
retail price p
q = D(p)
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Intrabrand vertical coordinationIntrabrand vertical coordination• other dimensions
– risk-sharing Rey-Tirole (1986)• local shocks on retail cost/demand• bias towards ET / retail competition
– retail services • excessive price, insufficient effort• solutions:
– RPM (ceiling) + sales quotas (min.)– two-part tariffs– not intrabrand competition
• Private and social interests may diverge– marginal / infra-marginal consumers
Spence (1975) Comanor (1985), Caillaud-Rey (1987)
– more congruence if free-ridingMathewson-Winter (1984)
P
R
unit cost c
Consumers
wholesale price w
retail price p
retail services e
q = D(p,e)
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Interbrand competitionInterbrand competition• “competition-dampening”
– Exclusive territories: strategic delegationBonanno-Vickers (1988), Rey-Stiglitz (1985, 1988)
• ET reduce intrabrand competition• retail prices respond to increases in
rival wholesale prices• higher wholesale (and retail) prices
→ clear conflict between private/social interests
– More generally: strategic commitmentCaillaud-Jullien-Picard (1990), Caillaud-Rey (1994)
P2P1
R1 R2
Consumers
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• RPM and interlocking relationships Rey-Vergé (2003)
Note: consumer goods
Manufacturer AManufacturer A
RetailerRetailer 1 1 Retailer 2Retailer 2
ConsumersConsumers
A-1A-1 B-1B-1 B-2B-2A-2A-2
Interbrand competitionInterbrand competition
Manufacturer BManufacturer B
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– Competition in two-part tariffs: p < pM
• Manufacturer i recovers retail profits → sensitive to retail margins on rival brand
max (pi – c – γ)Di + (pj – wj – γ)Dj
• w > c to maintain « high » retail prices in spite of retail competition→ i does not take into account the upstream margin on rival brand: p < pM
– Two-part tariffs + RPM: p = pM
• No need for w > c to maintain high retail prices• But if wj = c, manufacturer i becomes sensitive to the full margin on rival brand
→ p < pM
– Note: the Galland bill
Interbrand competitionInterbrand competition
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• Collusion: improving market transparency
Example: RPM Jullien-Rey (2003)allows for more uniform prices in spite of variations in local
conditions of supply and demand
• Facilitates the detection of deviations• But inefficient rigidity
→ can/will be used when enhances collusion substantially→ negative impact on consumers and efficiency
Interbrand competitionInterbrand competition
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• Supposes an “essential facility”
– Essential– Controlled by a dominant firm– No “objective” reason to deny access
• Traditional concern (leveraging market power)
Dominant firm – denies /limits access to some potential users, – to extend its market power from the monopolized segment to the
complementary segment
ForeclosureForeclosure
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• Vertical / horizontal foreclosure
monopoly market A, competitive market B
upstream/downstream complementary
ForeclosureForeclosure
C
M
C M C C
A BA
B
Terminal RR 1912, Commercial Solvents 1973
Infrastructure: stadiums, ports, airports, tunnels, RR,
electricity grid, local loop, Computer reservations syst.
Patents
IBM CPU - peripherals
United shoe, Chicken Delight, Tetrapak
Server OS / PC OS / applications
Aftermarkets (Volvo, Renault, Kodak)
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• Vertical foreclosure– vertical integration +
• refusal to deal • incompatibility • high wholesale prices • tie-ins, ...
– no vertical integration but• exclusive dealing• price discrimination, ...
• Horizontal foreclosure– tying,– access,– incompatibility
PracticesPractices
M C
M
M
C
C
M
C
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• Structural– common ownership of bottleneck (Terminal RR)– break up + line of business restrictions (AT&T)
• Regulation of access price– no discrimination among external clients (CAB 1984, Sabena / Saphir)– no discrimination between external and internal clients:– transparency, accounting separation (“chinese walls”)– price linkage: ECPR
access charge = final price - (marginal cost on competitive segment)example: local loop resale
• Open access (common carrier)
• Regulation of wholesale quantities (Eurotunnel).
RemediesRemedies
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Vertical foreclosureVertical foreclosure
Chicago school critique
Posner (1976), Bork (1978), Posner-Easterbrook (1981)
“Only one profit”: how can bottleneck owner earn more than one profit?”
• M charges – Wholesale price w
– Franchise fee F
• Downstream competition– Retail price p(w) = pm
– Profits recovered through F
C
M
C
Demand
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• Response to the critiqueResponse to the critique
– Incentive: restore, rather than extend market powerUpstream monopolist cannot exercise monopoly power without excluding
Hart-Tirole (1990), O’Brien-Shaffer (1992), McAfee-Schwartz (1994), Rey-Vergé (2004), ..., Rey-Tirole (2003) « A Primer on foreclosure »
– Analogies• Patent: multiplication of licenses• Franchising: multiplication of franchises.
Vertical foreclosureVertical foreclosure
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• Model
Vertical foreclosureVertical foreclosure
M
C1 C2 Cn
unit cost cu
1 unit of input required
for 1 unit of output
unit cost cd
Consumers
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• Example (“Cournot” downstream competition)
– Framework• M offers wholesale contracts (e.g., two-part tariffs: Ti(qi) = Fi + wiqi)• each competitor Ci orders its quantity qi and pays accordingly Ti(qi) • each competitor Ci set its price pi
→ downstream competition analogous to “Cournot”
Kreps-Scheinkman: pi = P(q1 + … + qn)
– If wholesale tariffs are “public”: monopoly outcome• Monopolistic franchise contract w = cu, F = πm
• Oligopolistic franchise contract w: pC(w+cd) = pm, F = πC(w+cd)
Vertical foreclosureVertical foreclosure
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• Secret contracting: OpportunismHart-Tirole (1990)
When dealing with a competitor C, M has an incentive to free-ride on the sales of the other competitors
πM + πi ~ (P(qi +Σj≠iqj) - cu – cd)qi (+ Σj≠i (Tj - cuqj))
→ it is optimal for each competitor C to order and for M to supply a quantity that is the “best reaction” to the others’ production
levels→ Cournot outcome (quantity competition)→ as number of competitors increases, price goes down to cost
(competitive pricing, no market power)
Vertical foreclosureVertical foreclosure
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• Variant: Bertrand downstream competitionO’Brien-Shaffer (1992)
When dealing with one competitor Ci, M still has an incentive to free-ride on the downstream margins of the other competitors
πM + πi ~ ( pi - cu )Di + Σj≠i(wi – cu)Dj
→ It is optimal for M and each competitor C to agree on a price that is the “best reaction” to the others’ prices
→ Bertrand outcome (price competition)
Issue: which conjecture? Passive, wary beliefs McAfee-Schwartz (1994), Rey-Vergé (2004)
Vertical foreclosureVertical foreclosure
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• Foreclosure: restoring market power– reputation, transparency
reduce scope for opportunism– vertical integration
no incentive to free-ride on its own subsidiary– exclusive contracts
eliminates downstream competition– nondiscrimination laws (!)
eliminates opportunism– RPM, …
• Remarks– Incentive for foreclosure stronger
• the more competitive the downstream industry,• the less competitive the upstream industry
– Some competition upstream generates some access.
Vertical foreclosureVertical foreclosure
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• Comment: who’s “upstream”?
Vertical foreclosureVertical foreclosure
Bottleneck is upstream
M
C1 C2
Clients
C1 C2
M
Clients
Illustration : US gas reform (pipelines)
Bottleneck is downstream
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• Efficiency defenses
– Benefits from vertical integration
– Maintaining upstream reputation
– Cost of increasing capacity
– Investment and innovation• Regulation of access = regulation of rate of return• Where does the market power come from?
– historical reasons / legal monopolies (port, airport, ...)– scale economies (Otter Tail, Hecht, ...)– network externalities (WorldComMCI, Open Network Provision directive, ...)– investment / innovation
Vertical foreclosureVertical foreclosure
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Horizontal foreclosureHorizontal foreclosure
• Chicago school critique
Complement goods
→ competition in the B market • makes A good more attractive
• raises profit for M
→ M has no incentive to
reduce competition in B market
M C
Demand
q = D(pA+pB)
A B
C
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• Response to the critique
Two lines of arguments:
– Non complementsa second source of monopoly power does not devalue M's monopolized product A
– Complementsentry in the adjacent market B may facilitate entry in the monopolized market A
Horizontal foreclosureHorizontal foreclosure
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Independent goods: Whinston (1990)
• Assumption: commitment to sell A and B only as a bundle→ M becomes a very aggressive competitor if C enters B market
• Conclusions– tie-in costly if C enters/stays in market,– tie-in tends to discourage entry (commitment to being aggressive)– tie-in may be profitable if deters entry,– (because of Chicago school reason) does not work if A and B complements.
Horizontal foreclosureHorizontal foreclosure
BA
M M, C
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• Complements: protecting home market– Choi-Stefanadis (2001)
• Initially, M monopolist in both A and B• In each market, C can invest I
– enters with probability ½ – if enters, gets profit π
• Without tying, C enters (in both markets) if ½ π = π/2 ≥ I• With tying, C must succeed in both markets:
→enters only if ¼ π = π/4 ≥ I
– Carlton-Waldman (2002)• Sequential entry in B, then in A• Scale economies
Horizontal foreclosureHorizontal foreclosure
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• Efficiency reasons for tie-ins– Prevention of inefficient input substitution
illustration: durable good maintenance
– Protection of reputationSignal of quality for a durable good (profit made on complementary good)
– Price discrimination / metering of demand• IBM cards, Chicken Delight• aftermarkets
Horizontal foreclosureHorizontal foreclosure