![Page 1: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/1.jpg)
Vertical Relations and Restraints
• Many transactions take place between two firms, rather than between a firm and consumers
• Key differences in these types of transactions:– Demand for an intermediate good being sold by an
upstream company to a downstream company is derived from the demand curve the downstream company faces.
– The buyers of the intermediate good, the downstream companies, compete with one another.
![Page 2: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/2.jpg)
Types of Vertical Relationships/Restraints
• Relationships– Franchise– Licensed/authorized dealer– Agent
• Restraints– Exclusive territories– Royalty agreements– Resale price maintenance
![Page 3: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/3.jpg)
Double Marginalization
• Assume there is an upstream firm, the manufacturer of the product, and a downstream firm that sells the product in a retail outlet.
• Assume retailers have no costs, just buy the product and then resell it costlessly.
• Also assume that the marginal cost of manufacturing the product is constant, c.
• Consumer demand for the product is P = a - bQ.
![Page 4: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/4.jpg)
Double Marginalization, con’t
• If the manufacturer and retailer were an integrated company, the firm would set MR=MC to maximize profit: a-2bq = c or q = (a-c)/2bPrice = a - b*(a-c)/2b = (a+c)/2Profit = [ (a+c)/2 - c ]*(a-c)/2b = (a-c)2/4b
![Page 5: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/5.jpg)
a
(a+c)/2
c
MR Demand
(a-c)/2b
Monopoly Solution
![Page 6: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/6.jpg)
Double Marginalization, con’t
• If the manufacturer and retailer are separate companies:– Assume that the price the retailer pays the
manufacturer is r.– To maximize profit, the retailer sets r = MR:
a-2bq = r or q = (a-r)/2bPrice = a - b(a-r)/2b = (a+r)/2Profit = [ (a+r)/2 - r ]*(a-r)/2b = (a-r)2/4b
![Page 7: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/7.jpg)
Double Marginalization, con’t
• Thus the retailer’s demand for the manufacturer’s product is q = (a-r)/2b.
• The inverse demand curve for the manufacturer is thus r = a-2bq.– Note that this is the same as the retailer’s
marginal revenue curve.
• So the manufacturer’s MR curve = a - 4bq.
![Page 8: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/8.jpg)
Double Marginalization, con’t
• Setting MR=MC: a - 4bq = c, or q = (a-c)/4b Price = a - 2b (a-c)/4b = (a+c)/2
(Be sure to use the manufacturer’s demand curve to get price, not the consumer’s demand curve)
Profit = [(a+c)/2 - c]*(a-c)4b = (a-c)2/8b
• The retailer pays (a+c)2 and sells (a-c)/4b at P = a-b*(a-c)/4b = (3a+c)/4.
![Page 9: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/9.jpg)
Double Marginalizationa
(3a+c)/4
(a+c)/2
c
MR for retailer Demand
(a-c)/2b
MR for manufacturer
![Page 10: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/10.jpg)
Double Marginalization, con’t
• Double Marginalization: both firms mark the price up above their own costs.
• Both cosumers and firms are better off if the two firms act in concert to maximize joint profits.
![Page 11: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/11.jpg)
Double Marginalizationa
(3a+c)/4
(a+c)/2
c
MR for retailer Demand
(a-c)/2b
MR for manufacturer
![Page 12: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/12.jpg)
Vertical Restraints as a Response to Double Marginalization
• Two-part tariff: Fixed cost of F to sell the good, then goods sold to retailer at marginal cost.– Retailer sets MR = MC, so the joint profit maximizing
quantity is sold.
– F can be set so that both the manufacturer and the retailer share profits.
– Classic franchise arrangement.
• Royalty arrangement: Goods sold to retailer at MC, manufacturer gets percentage of profits.
![Page 13: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/13.jpg)
Level of Competition
• To understand vertical relations and restraints, need to distinguish between two levels of competition:– Intra-Brand competition: competition between
two different retailers of the same brand of the product.
– Inter-Brand competition: competition between two different manufacturers/retailers with different brands the same or similar product.
![Page 14: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/14.jpg)
Retail Services
• Retailers can invest in advertising, customer service, consumer education, all of which enhance consumer willingness to pay.
• Positive externalities from these services (to other retailers as well as to the manufacturer), thus the services generally will be underprovided.
• Vertical restraints can ensure the optimal level of services.
![Page 15: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/15.jpg)
Vertical Agreements to Ensure Provision of Services
• Could specify contractually what services should be provided, but determining the right level of services is hard and monitoring the level of services is very difficult.
• Classic example of the principal-agent problem: the manufacturer is the principal, the retailer is the agent.
• Solution: Align the agent's payoff function with the principle's payoff function.
![Page 16: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/16.jpg)
The Principal-Agent Problem
• Assume Q = (A-P)s where s is the service level, then P = A - Q/s.
• Assume the cost of s is increasing (diminishing marginal returns to service).
• To maximize joint profits, there is an optimal level of service and an optimal price to the consumer.
• On his own, the retailer will set price is too high (due to double marginalization) and the service too low (due to free riding).
![Page 17: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/17.jpg)
Possible Solutions to the P-A Problem
• Resale Price Maintenance: Establish a minimum price that the retailer can set.– Retailers cannot use price to increase consumer
demand, so they must increase service to compete with other retailers.
– Works for some services, although not for advertising.
• Exclusive territories: Designate one retailer for a certain area.– Retailer gets all the benefits from services provided.
![Page 18: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/18.jpg)
Manufacturer Competition
• Vertical restraints can help manufacturers compete against rivals.– Slotting allowances: fixed fee paid to retailers to obtain
shelf space. Two-part tariff in reverse.
– Exclusive dealing: if the manufacturer provides services (e.g., training) to retailer which could benefit other manufacturers.
![Page 19: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/19.jpg)
Pro-competitive Effects of Vertical Restraints
• Exclusivity: gain economies of scale, lower distribution costs, achieve optimal level of services.
• Resale price maintenance: achieve optimal level of services.
• Royalty and franchise agreements: overcome double marginalization.
![Page 20: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/20.jpg)
Anit-competitive Effects of Vertical Restraints
• Exclusivity: facilitate collusion, foreclose markets to competitors.
• Resale price maintenance: facilitate collusion.
• Royalty and franchise agreements: foreclose markets to competitors.
![Page 21: Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types](https://reader036.vdocument.in/reader036/viewer/2022062511/5518c785550346b31f8b5877/html5/thumbnails/21.jpg)
Antitrust and Vertical Restraints
• Exclusivity.– Evaluated under rule of reason: do they harm
welfare/consumers overall. Takes into account differences between intra- and inter-brand competition.
• Resale price maintenance.– Per se illegal.
• Royalty and franchise agreements.– Some limits on these agreements, evaluated under rule
of reason.