The Economics of Vertical

Agreements/Restraints

Frances Ruane (Frances.Ruane@esri.ie)

Department of Economics

Trinity College Dublin

Lecture 5

Introduction

• Horizontal Agreements (Substitutes)

• Vertical Agreements (Complements)

– Upstream Firm (e.g. manufacturer)

– Downstream Firm (e.g. distributor/dealer)

• Market Power Exists (Second Best World)

• Upstream and/or Downstream Power?

• Motivations? Welfare Effects?

• Starting point: Independence vs Integration

Vertical Relationships: Spectrum

Unconditional Sale Vertical Integration

(Linear Pricing)

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

Pr

Monopolist wholesaler

Competitive retailers

Welfare Change with VI

Competitive Wholesalers

Monopolist Retailers

Welfare Change with VI

Upstream and Downstream

Monopolists

Vertical Restraints: Spectrum

Unconditional Sale Independent Ownership Vertical Integration

(Linear Pricing) (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

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)

• 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

• 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-of-

Sale Services

• 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

Q

c

p1

p2

D1

D2

Impact of Min RPM on Welfare

(c = price to competitive dealers)

P1: Price without Min RPM

P2: Price with Min RPM

p2

p2

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) “Side-

Payments” 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 Pre-

Sales Services

• Regional Advertising

• Quality Control

3. Exclusive Purchasing/Dealing:

Overview

• 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

• 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