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The Economics of Vertical
Agreements/Restraints
Frances Ruane ([email protected])
Department of Economics
Trinity College Dublin
Lecture 5
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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
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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
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Welfare Change with VI
Pr
Monopolist wholesaler
Competitive retailers
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Welfare Change with VI
Competitive Wholesalers
Monopolist Retailers
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Welfare Change with VI
Upstream and Downstream
Monopolists
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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
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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
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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
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Sector without any VI
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Sector with Significant VI
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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
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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)
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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
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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?
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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)
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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
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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
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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
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2. Exclusive Distribution/Selling
(Degree of “Intervention” in Dealer
Competition)
Min RPM Exclusive Distribution Vertical Integration
Specific Geographic Market
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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
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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
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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
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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?)
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Exclusive Dealing: Foreclosure
• Possible features
• “Excessively Long” Contracts
• Restricted Number of (Efficient)
Distribution Outlets
• Entry Barriers at Both Levels
• “Dominant” Upstream Firm
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Exclusive Dealing: Market
Division
Possible features
• “Excessively Long” Contracts
• No Switching Encouraged/Tolerated
• Non-Overlapping Geographical Areas
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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
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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)
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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
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Tying: Leverage (Extension of
Monopoly)
• Vertical Merger/Integration & Extensions
of Monopoly Power?
Fixed Proportions Technology: No
Variable Proportions Technology: Yes? (P↑
in general)
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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
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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