Quantitative assessment of vertical restraints

Brasilia, may 2010

Lorenzo Ciari

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Plan of the talk

i. Rationale for vertical restraints •  Solving double marginalization issues •  Solving externalities •  Foreclosure

ii. Quantitative assessment of vertical restraints •  Informal/Semi-formal analysis •  Regression analysis/Natural Experiments •  Structural modeling •  Event studies

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Introduction A formal quantitative analysis of the effects of vertical

restraints or integration is both a complex task and one where the set of tools available for empirical analysis is modest.

There have been, however, some interesting attempts at empirical estimation of the effects of vertical integration, that we are going to explore.

Yet, before investigating the critical techniques, a presentation is needed of the main elements of theoretical literature that justify the use of vertical restraints: mainly to solve double marginalization and externality issues (plus, of course anticompetitive purposes)

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Vertical restraints and vertical integration

We look at the incentives that motivate vertical restraints. The ultimate vertical restraint is of course vertical integration. So, we are going to look at the incentives for vertical restraints in relation with the incentives for vertically integrating.

A first motive for vertical integration is related to the possibility to reduce transaction costs and to deal with contractual incompleteness.

A second motivation is related to the existence of double marginalization.

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Vertical Issues: Double marginalization

The principle states that an independent retailer will have the incentive to raise prices compared with the retail price charged by a vertically integrated firm.

This comes from the fact that a vertically integrated firms maximizes joint profits, while in a manufacturer-retailer structure, each party will set its own monopoly mark-up, thus leading to a further increase in price and reduction of quantity.

The result is higher prices and lower quantities at the retail level under a non-integrated structure.

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Other vertical externalities There might be also vertical service externalities. The vertical externalities can arise because the benefits

of retailers’ services or sales effort accrue not only to the retailer itself but also to the manufacturer.

Its products will experience an increase in sales, but the cost is borne only by the retailer. This implies that the retailer will choose a level of service which is low for the manufacturers, the vertical chain as a whole, and often also for the consumers

Another potential incentive for vertical integration lies in the existence of horizontal externalities. These occur because of actions taken at a given stage of the vertical chain, but whose effects are felt by all players.

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Horizontal externalities The classic example is that of a bookstore that

promotes a book only to see the customers buy it online. This business stealing effect is an example of negative

horizontal externality. In practice, if investments in service by one retailer also benefit its competitors, this results in retailers being discouraged from investing in promotional activities – practice which can hurt both consumers and manufacturers.

On the other hand, retailers may benefit more than the manufacturer from unilateral price decreases (they steal profits from competitors, but manufacturers’ profits is unchanged).

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Horizontal externalities (2) In summary, the effect of horizontal externalities on

retailer pricing and service provision suggests that both retailer pricing and retailer service may be too low relative to that a manufacturer would prefer.

The net effect of horizontal and vertical externalities generated by the provision of services appears to unambiguously result in insufficient services. Yet in term of prices, the two effects might cancel out leaving an ambiguous net result.

In terms of consumer welfare, the effect depends on the weight given to prices and services. In a VI context, you might have higher services, higher prices.

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Solving double marginalization Beyond integration, firms facing externalities and

divergent incentives might solve their problems with specific contract clauses: •  Resale price maintenance ceiling •  Two part tariff •  Intra-brand downstream competition

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RPM ceiling

By setting a maximum price for retailers, the upstream firm can stop retailers from increasing prices further away from the optimum. Hence it works to the benefit of manufacturers and of consumers.

RPM thus provides a central illustration of a general proposition that vertical restraints con sometimes be good for both profits and also consumer welfare.

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Two-part tariffs Two-part tariffs are pricing systems whereby the

upstream firm sets a fixed payment and an additional price per unit purchased.

By setting the per-unit payment equal to the marginal cost of the firm upstream and the fixed payment to the downstream firm’s gross profit, this payment structure allows the upstream firm to maximize total industry profits and recover most of the generated rent with the fixed fee to the downstream firm.

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Intra-brand competition downstream

If there is strong intra-brand competition downstream, there will be no need to solve the double marginalization problem since the individual firms downstream cannot extract supra-competitive margin by exercising market power to increase downstream prices and therefore reduce the manufacturers’ sales.

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Intra-brand competition downstream (2)

The upstream firm, in case of downstream intra-brand competition, can get the integrated firm’s monopoly profit by setting the wholesale price equal to the price of the hypothetically integrated firm minus the downstream costs.

Doing so ensures that the upstream firm can get the downstream price to be just as the level that the vertically integrated firm would optimally chose.

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Addressing other externalities

Firms also use contractual means to address other types of misalignment in incentives: in setting the right level of services the manufacturer needs to take into account the vertical externalities between the manufacturer and the retailer, and the horizontal externalities across retailers.

We have already mentioned that when price is not the only determinant of the demand, a producer will want to elicit the right level of services (e.g. promotional services by downstream firms.)

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Addressing other externalities (2)

In setting the right level of services the manufacturer must take into account both the vertical externalities with its retailers as well as the horizontal externalities among retailers (e.g. free-riding on promotions)

There are a number of common practices that can address these problems, that are worth being discussed.

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Territorial restrictions Territorial restrictions are usually used to reduce

intra-brand competition downstream. By granting exclusive territorial rights to a retailer,

the manufacturer can ensure that retailers in different areas do not free ride on each other investment, so that arbitrage opportunities are eliminated.

Indeed, it is exactly the horizontal pricing externality which the competition authorities usually fight very hard to protect, because it results in low prices for consumers.

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Resale price maintenance: minimum price

Restricting retailers’ price competition is another way to induce them to provide the adequate level of services.

In the EU, resale price maintenance is treated as an hardcore pricing restriction that is illegal unless the parties bring forward substantial claims of eff ic iencies such that there is ‘ rebuttable presumption of illegality’.

RPM may on occasion be a device for horizontal price fixing with negative consequences for consumers.

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Exclusive dealing There are many valid substantial reasons that an

upstream firm may want this kind of agreement: for instance, it may be the desire to protect their own investments in advertising and quality by preventing competitors to steer customers toward lower-priced alternatives.

Thus excusive dealing may solve externalities. Although on the other hand it might also provide a mechanism for foreclosure.

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Tying and Bundling Tying and bundling are also ways in which a

manufacturer can condition the decisions of retailers downstream.

There is a large literature and discussion on the incentives to do bundling (I am sure you saw it with Paolo)

It can be motivated by quality concerns, transaction cost savings, economies of scale and scope. So, it can have a positive effect for retailers through lower prices.

However, it can be conceived as a way to foreclose rivals, soften competition with a detrimental effects for consumers.

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Refusal to deal In practices of refusal to deal, the goal of

protecting the incentives of innovation and large upfront investments is balanced against the benefits that an access to the input would generate through a more intense competition downstream.

From a competition policy perspective, a refusal to deal is unlikely to be regarded as a problematic action unless the upstream firm has some degree of market power; one important source of upstream market power may arise from the fact that a firm operates an essential facility.

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Measuring the effects of vertical restraints

The theoretical effects of vertical restraints are ambiguous, hence for assessing a specific case, empirical analysis is often a better choice.

Unfortunately, since the different effects are difficult to identify and to measure, this kind of effect-based analysis is particularly difficult.

Most common empirical strategies used to determine such effects are: regression analysis (particularly fixed-effects one), natural experiments, and event studies.

Most are ex-post analysis (crucial point)

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Informal and semi-formal analysis of incentives

A back-of-the-envelope analysis of a firm’s incentives to foreclose access should consider:

•  the potential returns in the downstream market •  the cost of foreclosing access, upstream.

Assuming constant margins, a rough calculation would check whether: ΔProfit(upstream) = Margin(u)*ΔVolume(u) ? > ΔProfit(downstream) = Margin(ds)*ΔVolume(ds)

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the TomTom – TeleAtlas case In 2008 the European Commission investigated

the TomTom-TeleAtlas merger, involving an upstream digital map database provider (TeleAtlas) and a downstream producer of personal navigation devices (TomTom).

The EC had to evaluate the plausibility of a foreclosure story.

Under a total foreclosure strategy the vertically integrated firm will lose profits upstream by stopping to sell to the direct competitors in the downstream market.

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TomTom – TeleAtlas (2) Downstream rivals would face higher costs

because they would have to buy from a rival upstream supplier which not anymore constrained by competition in the upstream market.

TomTom would enjoy: •  Reduction in costs by solving the double

marginalization •  Increase in rival’s cost by total foreclosure in

the input market. This is shown in the next slide’s graph.

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TomTom – TeleAtlas (3)

The change in downstream competition has ambiguous effects on net welfare, depending on the magnitude of the two shift effects (depending on market shares).

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TomTom – TeleAtlas (4) When integrating gains are small with respect to

the magnitude of the increase in costs, the outcome becomes unambiguously bad for consumers.

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TomTom – TeleAtlas (5) With the limited amount of non-confidential

information found in the Decision taken by the EC is possible to do a rough evaluation of the impact of the merger.

The upstream market for maps featured a yearly average of 10.8 mill. Maps, at an average price of 14.6 euro. TomTom rivals share of business was about [10-30%]. TA had gross margins of about 85%.

Thus total foreclosure would involve sacrificing [13,7-40] million of profits.

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TomTom – TeleAtlas (6) A simple calculation of the change in profits (where

subscript 0 is pre-merger and 1 post merger):

Supposing now that TomTom’s market share were 40% before and 45% after the foreclosure strategy, we see that the sales would go from q0=0.4 * 10.8 = 4.31 mill, to q1= 0.45 * 10.8 = 4.85 mill, with a growth of 0.53 mill customers.

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TomTom – TeleAtlas (7) TomTom reduction in marginal cost might be as

large as 0,85 * 14,6 = 12,4 euro. Further, assuming a 25% gross margin in the

downstream market, and knowing that the final average price pre merger was p0= 200 euro, and a p1= 187,6 euro, we can estimate the downstream profit as being:

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TomTom – TeleAtlas (last) Since the estimation of 19.5 mill. is within the

range of [13,7-40] mill. of profits that are estimated being lost upstream, the calculation does not make a clear case for or against an incentive to total foreclosure.

Nonetheless this type of preliminary calculation is can help us to explore which alternate assumptions would provide ground for concern.

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Regression analysis in vertical integration

As the first example of a regression analysis we consider the ARCO-Thrifty case, in the retail gasoline market, in California.

The case refers to the sale of Thrifty a chain of independent gas stations, to Arco, a large US company which is vertically integrated.

The sale occurred in 3/1997 because the boss of Thrifty, a 75 year old man, decided to retire (again on the issue of exogeneity).

60 days after the operation all the stations went under the control of Arco.

There was a rebranding of the stations. Then a part was operated directly by Arco, while another part was leased.

Hastings (2004) collected a panel data set of retail prices at the station level for 4 months in the LA and SD Metropolitan Statistical Areas.

The months were February, June, October and December 1997 (so before and after the merger)

Stations defined different local markets (Hastings takes a definition of one mile of distance in each direction)

The case provides a ‘nice’ natural experiment, as the sale was largely independent of market conditions so we have an exogenous change in the extent of vertical integration in local markets.

Regression analysis in vertical integration

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Thrifty-ARCO: methodology Additionally some specific markets can be clearly

identified which are unaffected from the merger. These markets provide a perfect ‘control’ sample.

Hastings (2004) exploits the natural experiment by using a ‘difference-in-differences’ technique.

This econometric tools allows to reach an identification of the effects of a given change in the market, by comparing the change in prices before and after the merger, in markets which were affected, with the change in markets that instead, were not affected, the latter being a ‘control’ group, able to clean-up for other effects that couldn’t otherwise be measured or identified.

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Descriptive analysis’ evidence

Retail prices at gas stations which competed with Thrifty had showed an increase, w.r.t. the prices in gas stations not directly competing: Thrifty competitors had prices 3% lower than the non-competing stations, before the merger; but they had prices 2% higher than the non-competing ones, after the merger.

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Thrifty-ARCO: the sample (ii)

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Thrifty-ARCO: the econometric model

Hastings provides – beyond the simple descriptive analysis just seen – a more complex econometric model to control for unobservable factors.

Hastings runs the following fixed-effect regression:

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Thrifty-ARCO: the econometric model (ii)

In the model, µ is a constant, α is a j-th station specific effect and δ is a city/quarter dummies, c is then the indicator of whether the station becomes a company operated station (not a licensed-dealer-operated station), z is an indicator of whether the company competes with an independent gas station and ξ is the error term.

The fixed effects control for potential omitted variable that determine prices and they turn out to be quite important in the regression, so they show that there are many unobserved determinants of the price at local level.

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The econometric model results

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Thrifty-ARCO: results The estimates in column 3 suggest that there is an

increase by 5 per cent in gasoline prices when there is no longer an independent retailer in the market. There is no additionally statistically significant effect of becoming a fully integrated company-operated gas station compared with becoming a dealer with a contractual relationship with the upstream company.

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Peculiar aspects of the analysis One area of particular concern arises from the fact

that the merger results in a change of an unbranded product into a branded one, that may cause a price rise.

To address this concern, Hastings breaks up the ‘branded’ gas stations in brand-awareness groups (high, mid, low).

The effect of the disappearance of a competitor is stronger on ‘low brand’ gas stations, thus indeed branding effect might have an important impact on a price raise, rather than just increase of market concentration.

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Vertical integration in the Cable TV market

Chipty (2001) looks at the vertical integration between programming and distribution services in cable TV, assessing whether vertical arrangements might result in higher prices but also in greater service provision.

The paper assess this argument with 2 specific methodologies: •  a reduced form regression of equilibrium outcomes •  a tailor made method to check if consumers sufficiently value the service provided to be better off in vertical integrated markets

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The Cable TV market in the U.S. The structure of the market is broadly:

•  Producer companies (e.g. Paramount, Universal) sell their media productions (e.g. movies, sit-com) •  Program service providers (e.g. HBO, AMC) use the productions to create channels and sell them to local cable system operators •  Cable system operators, usually enjoying local monopolies provide the consumers with different sets of channel packages.

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The Cable TV market in the U.S. Chipty wants to investigate the actual effect of

vertical integration on foreclosure. She proposes to study the way that observed market outcomes at the retail level vary across vertically integrated and non vertically integrated markets.

The databases she uses comprises 11039 cable franchise areas, operated by 1919 cable systems, which are in turn run by 340 cable system operators

The data provide info on ownership structure, channel capacity, the number of homes with access to cable, the cable system’s program offer , the price and the quantity of subscribers

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The descriptive data There are also demographic controls. Vertical integration occurs when the cable operator

owns any part of a program service that serves that franchise area.

The data show that on average, a cable system provider offer 15 ‘basic’ channels and about 3 ‘premium’ ones. A simple look at descriptive statistics show that:

Vertical integration with supplier of premium contents increases the supply of basic channels but reduces the supply of premium channels.

Vertical integration with basic content providers increase the content of channel packages of both premium and basic channels.

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The analysis The author runs a reduced-form regression of the

equilibrium outcome on demand and cost factors, and on a vertical integration dummy, to clean up spurious correlation effects.

Two proxies for quality are examined: the number of basic services and the number of premium services.

The results suggest that vertical integration with basic content providers significantly increases the number of basic channels and does not significantly affect the provision of premium content.

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The analysis (ii) On the other hand, vertical integration with

premium content providers reduces the number of both basic and premium channels in the packages: the premium-integrated operators carry less ‘competing’ premium channels and less basic ones.

Everything appears to fit a foreclosure story. But this is one element of the story, we need to look at prices.

Next the author use the reduced-form approach to study the prices.

Integration with premium content: •  sharply increases premium content prices •  sharply decreases basic content prices

Integration with basic content has the reverse effect, but with a much smaller magnitude.

Yet, the true effect on consumers depend on the relative value that they give to premium vs. basic channels.

The analysis (iii)

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Structural modelling the demand Structural modeling requires the specification of

structural equation of demand and supply. A particular problem with structural model in

vertical integration is that many of the factors that determine and motivate those contracts are not well captured by off the shelf models (e.g. it’s not easy to measure ‘sales effort’).

Chipty (2001) uses this technique to estimate two demand curves for the case: one for basic prices and one for premium ones, in order to assess the consumer surplus of the consumers.

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The structural model In setting up the model, the author uses

‘penetration rate’ as a proxy measuring quantity demanded.

The specification of the model also includes population variables affecting demand, the price of the service and the price of the complementary service (the premium or basic counterpart).

System characteristics are used as identifying instruments: the results of the estimation are presented in the following slide.

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Demand estimates

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The structural model (reprise)

The results produce negative demand elasticities as predicted by the theory; also, price elasticity of basic cable is higher than that of premium cable services: intuitively premium consumers are more ‘inelastic’ than basic consumers.

The total consumer surplus is finally calculated as the sum of the surplus of the two different customer bases.

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The results In summary the author finds that vertical

integration increases consumer surplus and that this increase is larger when there is vertical integration with premium content providers, as shown in the table below. This contrasts with the previous results.

$/ month per consumer Unintegrated

Integration with basic services

Integration w/ premium services

Consumer Surplus $ 1.47 $ 1.69 $ 1.87

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Stock market event studies

Event studies focus on the implications that certain practices will have on the perceived profitability of the firms.

This method looks at the investor’s valuation of companies as approximated by the stock market valuation of the companies’ shares .

These studies can potentially be useful for a whole variety of applications, from merger evaluation to testing for market definition.

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Event studies and RPM Ippolito and Overstreet (1996) study the change in

the law on resale price maintenance, using a famous 1970’s case: Corning Glass Works .

The company sold household glass products to wholesalers, giving them presigned contracts that they had to give to retailers.

These contracts imposed price floors (RPM agreement)

They study the FTC’s announcement, on Oct. 8th, 1971 of a “price-fixing” challenge to Corning’s RPM policy.

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Event studies and RPM On Jan. 16th 1973 the FTC announces that the

Court (the FTC’s hearing examiner), has judged in favor of Corning’s.

On June 17th, 1973, the FTC issued an appeal decision (that reversed the previous administrative decision) later reconfirmed by the Court of Appeals, in 29, Jan 1975.

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Hypothesis testing The authors explain that the event study is able to

distinguish between a number of basic hypothesis: 1.  If RPM is a cartelization device at retail level, its prohibition leads to a manufacturers profits increase. It would increase the profits of all manufacturers. 2.  If RPM allows cartelization upstream, its prohibition would reduce manufacturers profits. 3.  If the practice was only trying to elicit services from retailers (this was the Corning’s view), the end of RPM would hurt the profits of both Corning ant its competitors that used RPM. Competitors that were not using RPM (e.g. Anchor Hocking) would have a 0/+ effect on profits.

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Hypothesis testing In reality, the prediction that the elimination of RPM on

competitors in the case where RPM induces promotional and sales effort is not so obvious.

For example it could be that promotional sales efforts to promote Corning glassware increase the total demand for glassware positively, affecting Anchor Hocking’s sales in the process. (AH is the major comp not using RPM)

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The estimation The authors estimate whether firms had an abnormal

return around the day of events that rules for or against resale price maintenance.

The model features the following regression:

Where, R(i,t) is the % return of each firm, R(m,t) is the % return of a portfolio of NYSE and ASE stocks and D(t) are the dummy variables (that take value 1 in the event window: crucial the definition).

Thus, the cumulative abnormal returns are: CAR = c(i)*Days in the event window.

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The results The regression results show a negative effect on

the valuation of the company after the FTC announcement of the investigation; the interim reversal had a very small positive effect. The FTC reversal and upholding of the case had again a negative effect.

The most significant result is a negative change of 12% in the 5 days window around the announcement of the FTC investigation.

The event study using Cornick stock data indicates that investors in the firm value RPM as having a positive impact on the profits.

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The interpretation However, such an observation is consistent with

either RPM acting to facilitate price fixing or simply solving the free-rider problem in service provision.

In order to attempt to discriminate between these stories we need to look at what happens to the expected profits of competitors.

In particular, the effect on Anchor Hocking was also negative. Again, the interpretation is ambiguous.

Another piece of evidence was used to claim that RPM was a device to keep a high level of services.

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The interpretation Namely, the fact that Corning increased

dramatically investment sin advertising after the prohibition (so advertising was a way to substitute for lower services downstream). And also the fact that AH did not change its commercial policy at all.

Bottom line: technique can be valid, based on strong assumptions about the ability of the stock market to foresee the impact of given practices.

Technical problems: the time window around the event, the use of CAPm.

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