PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
The “Boundaries” of the Firm
• Why are some tasks organized within firms and others
across firms?
• Hayek – Transacting across firms reveals price information
that is useful for decision making
• Coase – When costs of transacting between tasks too high
and benefits too small, then include both tasks within the
firm
• Costs include the costs of “making a market” discussed earlier
• Benefits include competition, price information: but these may
have little value across some tasks
• Firm boundaries where these two forces are equal
Econ 5313
UC Power and Light
• UC P&L sells electricity to customers at rates regulated by
the state Public Utility Commission
• UC P&L is allowed to earn a nine percent return on
invested capital
• The UC decided to buy its coal mine supplier
• They formed a multi-divisional company, a regulated
Power division, and an unregulated Coal mine
• By raising the transfer price of coal sold to the Power
Division, they Coal division evade the regulation that limits
profit for the Power division
• An increase in the price of coal raises the marginal cost of
producing electricity (and Coal profit)
Econ 5313
UC Power and Light
• Under the profit regulation, this allows the Power Division
to raise electricity prices
• As a result, Coal earns more on the coal it sells; and Power
is allowed to raise the regulated price of electricity so that
its profit does not fall
• In other words, the Coal Mine is more valuable as a sister
division to the Power Company than it is as an
independent company
• This is an example of vertical relationships that can
increase profit by giving firms a way to “evade regulation”
Econ 5313
Managing Vertical Relationships
Vertical relationships can increase profit through:
1. Giving firms a way to evade regulation
2. Eliminating the double-markup problem
3. Better aligning the incentives of manufacturers and
retailers
4. Facilitating price discrimination
5. Solving holdup problems (discussed earlier)
Econ 5313
Caveat: Beware of Acquisitions
• Do not buy a customer or supplier simply because they
are profitable
• Your profit will not necessarily increase because the acquired
firm’s profits are capitalized into the purchase price
• Without some kind of synergy, the value of the upstream
supplier or competitor is exactly equal to the size of its
profit stream – not moving assets to higher value uses
• In 1999 AT&T bought TCI’s cable TV assets for $97 Billion;
then in 2002, they sold the cable assets to Comcast for
$60 Billion
• They destroyed $37 Billion in value
Econ 5313
Evading Regulation
• If unrealized profit exists at one stage of the vertical
supply chain — as often happens when regulations limit
profit — a firm can capture some of the unrealized profit
by integrating vertically, by tying, by bundling, or by
excluding competitors
• How can you evade rent control?
• Tying – must buy furniture from me
• Bundling – comes with bundled furniture
• Exclusion – prohibiting rival furniture companies
Econ 5313
Evading Regulation
• How can Multi-National companies evade national taxes
using transfer pricing?
• A company manufacturing in Mexico, for example, can
transfer them at a low price to a sister division located in
the Cayman Islands, and then to the United States at a
high price, where they are sold to final consumers
• The tax burden is reduced by realizing most of the profit in
the Cayman Islands, which has lower taxes than Mexico
• Regulators in Mexico anticipate this strategy, and force
goods to be sold for at least a five-percent mark-up over
cost before they are transferred out of the country
Econ 5313
The Double Markup Problem
• The double-markup problem occurs when firms selling
complementary products set price in competition with
each other
• Vertical integration is one way of addressing the double
marginalization problem – commonly owned firms can
coordinate more easily on lower prices to raise profit
• Recall the efficient transfer price across divisions does not
include a margin so that the final good price can be
“marginalized” just once
• Same is true in the supply chain across firms
Econ 5313
The Double Markup Problem
• Upstream and downstream firms are supplying
complementary services
• Both processes needed to complete the final good
• Double marginalization can occur for any two
complementary goods – not just in the supply chain
Econ 5313
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The Double Markup Problem
Gasoline refiners both refine and retail gasoline
Both “processes” are complementary
There is a refining margin and a retailing margin
Refiners purchase gas stations for this reason
Vertical integration is one way of addressing the double
marginalization problem – commonly owned firms can
coordinate more easily on lower prices to raise profit
Econ 5313
The Double Markup Problem
• Gasoline refiners sell branded gasoline and convenience
store items
• Consumers demand the gas, as well as the retail items
• When firms selling complementary products compete
with each other, they price too high – not capturing profits
of the other
• Gas prices at stations with markets tend to be lower
Econ 5313
Aligning Incentives
• Getting retailers to invest in demand-enhancing services
• With a smaller profit slice, retailers may under-invest in
services that help enhance a brand name
• Especially new products about which the customer is
unaware
• Need a way to compensate retailers for investing in pointof-sale services
• This guarantees retailers a higher profit level creates
incentive to provide demand-increasing services
Econ 5313
Aligning Incentives
• Limiting intra-brand competition also helps reduce freeriding, e.g., PING golf clubs require custom fitting
• Tried to control level of intra-brand competition so as to
give retailers incentive to do custom fitting
• Prohibit sale over the Internet
• Many of these tactics may be illegal under antitrust laws
• Especially for companies with dominant market shares
Econ 5313
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Aligning Incentives
Kreepy-Krauly introduced first automatic pool cleaners
Pool owners need to be convinced to spend thousands
Set up displays in pool stores takes floor space
Must compensate with higher margins
Set minimum retail price – Resale Price Maintenance
(RPM)
• No worry that a discounter without the display will
undercut you
• Unfortunately, illegal
Econ 5313
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Aligning Incentives
Alternative strategies:
Pay for in-store service separately (shirking?)
Supply service in-store by manufacturer
Manufacturer supplies service outside of the store setting
Resale Price Maintenance (RPM)
Exclusive Territories
Econ 5313
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Aligning Incentives
Other examples:
Ex Coors requiring refrigeration
Ex Does Coke buying retailers refrigerators exclude rivals?
Ex Medication and blood tests
Econ 5313
Aligning Incentives
• Why are new products introduced to retailers with
exclusive territories and then only later distributed
through many competing retailers?
• Exclusive territory confers market power on retailers
• The higher margin compensates them for the extra sales
effort needed for new products
• After the product is proven, extra sales effort is no longer
necessary and so more retailers are signed up
• Ex iPhone and AT&T?
Econ 5313
Price Discrimination
• Manufacturer sells to two retail channels for two purposes
• The low price channel wants to resell the input to the high
price arbitrage the difference
• Solve this by vertically integrating into low-price channel
Econ 5313
Price Discrimination
• Ex Herbicide users
• Home gardeners are willing to pay $5 per liter for
herbicide.
• Farmers are willing to pay $3 per liter.
• Vertical integration solves the pricing dilemma by
preventing farm retailers from selling to home gardeners
• Ex Aluminum
• For airframes – few alternatives
• For Pots and pans – many alternatives
• Start line of pots and pans
Econ 5313
Outsourcing
• While technically the opposite of vertical integration,
decisions to outsource should employ the same logic as
decisions to vertically integrate
• Outsource an activity to an upstream supplier or
downstream customer if they can do it more profitably
• Better focus on core competencies
• The typical reason to outsource is to gain advantages of
economies of scale or scope
• Remember to consider whether you are sacrificing any
integration benefits before you decide to outsource
Econ 5313
Outsourcing
1. Outsourcing takes away control of upstream
manufacturing processes or downstream distributors and
retailers – harder to evade regulation
2. It may also create a double-markup problem
3. You may find it difficult to motivate your downstream
customers or upstream suppliers to invest in activities
that benefit you
4. You may find it more difficult to price discriminate
5. You may create hold-up opportunities
Econ 5313
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From the Blog
Chapter 23
Buying wedding dresses
Microsoft / Nokia Merger
Wii U Content
Do stock brokers work for clients?
TV programming and distribution
Unwritten (humane treatment) clauses in supplier
contracts
Econ 5313
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Main Points
Regulations may prevent moving an asset from a low
valued use to a high valued use. Vertical integration may
provide a mechanism to evade regulations.
If both upstream and downstream firms have market
power, final prices tend to include an inefficient doublemarkup. These can be reduced through vertical
integration or appropriate contracting.
Typically, manufacturers want retailers to set high quality,
higher sales effort, high levels of promotional activities,
and low prices. Retailers want the opposite. This
incentive conflict can be mitigated through vertical
integration, resale price maintenance, exclusive
territories.
Econ 5313
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Main Points
Often price discrimination schemes fail because
distributers to the low price segment arbitrage the
difference with the high price segment. Vertically
integrating into the low price segment can reduce this
arbitrage.
Vertical contracting and integration can reduce holdup
problems (discussed earlier).
Most countries have laws regarding vertical integration.
They are applied more when decisions by firms with
market power affect competitors.
Do not vertically integrate merely because your customer
or supplier is profitable. Instead, identify if doing so
changes behaviors to significantly address a problem.