ANTITRUST ECONOMICS 2013
David S. Evans
University of Chicago, Global Economics Group
TOPIC 14:
Date
Elisa Mariscal
CIDE, Global Economics Group
VERTICAL RESTRAINTS
Topic 14| Part 2
21 November 2013
Overview
2
Part 1
Part 2
Vertical Restraints
Overview
Vertical Restraints
and Efficiency
Single-Monopoly
Profit Theorem
Using Vertical
Restraints to
Foreclosure
Competition
Procompetitive
Tying Theories
Multi-Sided
Platforms
Anticompetitive
Tying Theories
3
Vertical Restraints and Efficiency
Resolving Conflicts Among Firms
4
Firms have “vertical relationships” with each other on a “supply
chain” with one being “upstream” and the other “downstream”.
In general what is best for one firm in this relationship may not be best
for the other.
Kelloggs would like to sell Cornflakes to Tescos for a price close to the
price it is sold in the shops (keeps most price for itself).
Tescos would like to buy Cornflakes from Kelloggs for a price close to
its manufacturing cost (keeps most price for itself).
Vertical restraints help resolve these conflicts and thereby reduce
“transactions costs”.
Overview of Vertical Restraints
Vertical Restraints Help Resolve Conflicts
5
Vertical restraints are contracts and agreements that place
restrictions on the actions of buyers and sellers in a vertical
chain.
One firm may try to influence (restrain) the other through
contract terms.
E.g. Kelloggs’ tells Tesco that it can’t charge more than £3.75
for Cornflakes (vertical maximum price fixing).
E.g. Tesco tells Kelloggs that it can’t sell Cornflakes to any
other retailer at a lower price.
Overview of Vertical Restraints
Purpose of Vertical Restraints
6
Making the profit pie as big as possible by aligning incentives
between participants in vertical chain.
Splitting the pie up among members of the vertical chain
each of whom would like more of the profits.
As with other business relationships how the pie is split
depends on bargaining power, market position, and so forth.
Major Contract Instruments for Maximizing
and Splitting the Pie
7
Direct methods for determining price—e.g. two-part tariffs.
Indirect methods for determining price—e.g. exclusive
territories.
Service and marketing requirements—e.g. aisle placement,
displays, exclusivity.
Overview of Vertical Restraints
Direct Pricing Methods
8
Non-linear prices (volume discounts, bundled prices).
• Example: 3M give volume discounts for selling many of
of its office-supply products.
• (what’s the difference between package sales?).
Two part tariffs (fixed fee+variable price):
• Example: McDonald’s sells the right to supply
McDonald’s products for a “franchise fee” (partly fixed),
and also supplies the inputs (variable).
Overview of Vertical Restraints
Indirect Pricing Mechanisms
9
Exclusivity (dealings, territories): The contract specifies exclusivity
agreements between the retailer and the producer. It might
take different forms as exclusive territory, selective distribution.
• Example: British Airlines can only serve Coke. FaceBook only has
Microsoft ads
Resale Price Maintenance (Floor prevents discounts, or ceiling
prevents price gouging).
• Example: Retailers must sell book for list price.
Quantity forcing (quotas):
• The contract specifies a fixed quantity the retailer has to buy from
the manufacturer; also quantity rationing (the retailer cannot
exceed a determined quantity) and minimum quantity
requirement (retailer must pay for minimum).
Bundling or full-line forcing.
• The contract requires taking multiple products or to carry a “full
line” of manufacturers products.
Pro-Efficiency Reasons for Vertical Restraints
Efficiency Reasons for Vertical Restraints
10
Double marginalisation
Sales Effort
Retail Free Riding
Externalities
Risk Sharing
Note: In all these cases firms in a vertical chain could obtain the efficiency through
vertical integration; vertical restraints solve market coordination problem through
contractual mechanisms that fall short of full integration. Why do firms choose
vertical restraints rather than full integration?
Pro-Efficiency Reasons for Vertical Restraints
Vertical Restraint and Double Marginalisation
11
Vertical restraints might be able to replicate results of vertical
merger or encouraging downstream competition, through:
• Two Part Tariff.
• Resale Price Maintenance.
• Quantity forcing.
Pro-Efficiency Reasons for Vertical Restraints
Two Part Tariff
12
Sell product at manufacturing cost so that the downstream firm sets
the “single monopoly” profit-maximizing price.
Recover the full monopoly profit by charging a fee (assumes you
can predict optimal output).
Example: Franchise Fee. A company grants the right to sell its
product for a fixed fee (equal to monopoly price). Then the product
is sold at a price equal to marginal cost.
Pro-Efficiency Reasons for Vertical Restraints
Resale price maintenance
13
Retail Price Maintenance (ceiling).
Set a ceiling price of pm and sell at a price that equals this minus the
marginal cost of distribution.
Distributor signs the contract because it at least breaks even.
Distributor charges as much as it can—but this is capped at the
profit-maximizing price.
How does quantity forcing achieve the same outcome?.
Encouraging Optimal Sales Effort
14
c
pw
p, effort
Consumers
Q(p,e)
Encouraging Optimal Sales Effort
15
c
pw
Consumers
Q(p,e)
Pro-Efficiency Reasons for Vertical Restraints
Retail Free Riding
16
Pre-sale information helps sell durable goods (I.e.
cameras).
• Retail competition may prevent provision of information.
• Retailers who don’t provide costly information can freeride on those that do. (i.e. John Lewis versus Argos).
• At the extreme (with Bertrand competition) no information
is ever provided.
Solutions:
• Exclusive Territories – Commit not to sell to Argos.
• RPM (price floors) – Manufacturer sets the lowest possible
retail price to ensure information can still be profitably
provided (ie prevent cut-throat competition).
Pro-Efficiency Reasons for Vertical Restraints
Externalities
17
Information creates positive externalities.
Positive retailer externalities (i.e. promotions) not taken into
account and not enough sold.
Solutions: Two part tariff—charge the distributor marginal cost
so that he acts like he’s the monopolist; then take his profit
back through a fixed fee.
Pro-Efficiency Reasons for Vertical Restraints
Risk Sharing
18
Uncertainty and risk aversion can be protected
against by two part tariffs or RPM.
Retailer is risk averse, and demand fluctuates.
c
Manufacturer
Solutions:
• Franchise (two part tariff) exposes retailer to all the
risk of a change in demand.
• RPM gives perfect insurance with demand
fluctuations, as final price is independent of level of
demand.
T=F + cq
Retailer
Retailer is risk averse and cost fluctuates.
• RPM does not work as cost shocks will squeeze the
retailer, and all risk is carried by the downstream
firm.
• Franchise (two part tariff) insures retailer against
changes in cost.
p =RPM
Consumers
Q(p)
19
Using Vertical Restraints to
Foreclosure Competition
Using vertical restraints to foreclosure competition
Essential Facilities and Monopoly Leveraging
20
The “essential facility doctrine” suggests that a firm may use an
indispensable asset to leverage its monopoly from that asset to
adjacent markets.
Bridge over river (US Terminal Railroad Association—Joint Venture of
railroads owned key bridges).
Using vertical restraints to foreclosure competition
Chicago Critique of Monopoly Foreclosure
21
The Single Monopoly Profit Theorem
A monopoly owner of a bottleneck gets highest profit
by charging a monopoly price for bottleneck service.
Can’t do any better than that.
M
He’d prefer competition downstream (because of
double marginalisation). And he’d prefer most efficient
downstream firms.
Same reasoning applies to any adjacent market that
produces a complementary good: more competition
and more efficient firms is better for the monopolist
because it helps him sell more.
R1
R2
Consumers
Vertical restraints might be adopted for efficiency
reasons but not for anti-competitive reasons. The
monopoly profits but in doing so consumers are better
off (remember consumers should prefer one monopoly
in a chain over two.)
Using vertical restraints to foreclosure competition
Summary of Post-Chicago Models
22
Chicago critique doesn’t always hold.
Foreclosure can be used to:
• Get additional monopoly profit in downstream market.
• Prevent entry into monopoly market (more later on this topic).
• Restore monopoly power.
Monopoly leveraging may reduce social welfare.
But the devil is in the details:
• Models find foreclosure anti-competitive only under certain
assumptions; Pro-competitive or uncertain under different
assumptions.
• empirical studies find little support; but those studies themselves
may not be robust.
Overview of Empirical Findings
23
Most studies find evidence that vertical restrains/vertical
integration are pro-competitive;
This efficiency often is plausibly attributable to the elimination of
double-markups or other cost savings;
A number of studies also find evidence consistent with “dealer
services” efficiencies;
Instances where vertical controls were.
Multi-Sided Platforms
Platforms Need Critical Mass to Ignite
25
Critical mass
Critical mass refers to the minimal set of customers on
each side that is large enough to attract more
customers and result in sustainable positive feedback
Critical mass depends on scale and balance
Probability of customers from two sets getting together
and exchanging value increases with the number of
customers on each side
Platforms implode if they can’t reach critical
mass
If there aren’t enough customers on the other side the
probability of advantageous exchange falls and
customers don’t join and the early adopters who have
eventually leave
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25
Critical Mass, Platform Ignition and Growth
26
Catalytic Ignition and Critical Mass
Side A
Ignition
D*- Long-run equilibrium
C`
Points of critical mass
Movements at starting to achieve
critical mass
C*
C``
O
Side B
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27
Making It Harder for Rivals to Reach Critical
Mass
Lock enough demand on either side
• By keeping available demand below the minimal level on either
side the new platform cannot reach the critical mass frontier.
Lock up enough demand on both sides
• By locking up enough demand on both sides the new platform
cannot reach the critical mass frontier.
Lock up key assets needed for ignition
• By locking up customers that account for a disproportionate share
of positive feedbacks, are early adopters, or high value users, or
by preempting exclusive deals, the new platform could be
prevented from reaching the critical mass frontier
These are possibilities. Unclear how significant they are in practice given that
rivals have counterstrategies.
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Vertical Restraints that Might Deter Entry
28
Exclusive Deals.
• Locks up demand on one or both sides of the platform.
Conditional rebates.
• Discourages customers from using rival platform and therefore
engaging in multi-homing or single homing with entrant.
Other restraints.
• Behavioral restraints (tying, pricing restrictions, various behavioral
restraints, etc.) could raise the cost of committing demand to a
rival platform.
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Some Procompetitive Explanations of Vertical
Restraints
29
Exclusivity benefits customers.
• Customers on side B benefit from knowing that when they use the
platform they will be get access to particular customers on side A.
Reduces their search and transactions costs.
Exclusivity reduces platform risks.
• By reducing risk that customers on one side will reduce demand
and thereby jeopardize value of the value to all sides the platform is
able to make greater sunk cost investments including in innovation.
Exclusivity prevents free riding.
• Platform may have incurred significant risks in entering in
developing customer groups to maximize platform value. Exclusivity
agreements prevent copycats from freeriding.
Behavioral restrictions benefit customers.
• Restrictions on side A customers benefit side B customers by
preventing opportunism.
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29
Balancing and Some Complexities
30
Degree of impediment to entry
•Impediment depends on the “type” of customers excluded as well as and
perhaps more so than sheer volume of demand foreclosure. Could prevent
entry by foreclosing some demand on both sides.
Counter strategies
•Can differentiation enable entry despite exclusive deals by incumbent
platforms? Can entrant enter into exclusive deals of its own?
Stage of competition
•Incumbent may have exclusive dealing arrangements as part of entry
strategy to deal with critical mass
Behavioral restrictions
•Vertical restraints may benefit customers that are not subject to vertical
restraints (e.g. the other side of the platform).
Incumbent vs. entrant
•Entrant could be powerful platform in adjacent business while incumbent
could be successful startup. Difficult to assess impact of antitrust restraints on
long run social welfare (Microsoft vs. Netscape).
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Vertical Restraints and Platform Governance
31
Anti-steering/exclusive dealing rules
• Might deter entry, but…
• Give customers on other side assurance that when they use the
platform they will get the platform’s products.
No surcharge rules.
• Might deter entry, but …
• Prevents opportunistic behavior and provides customers price
certainty for platform.
Platform exclusion penalties and rules.
• Might prevent alternative platform from accessing users, but …
• Punishes customers on one side from harming customers on the
other side through fraud, deception, and other bad behavior.
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31
Factors to Consider in Evaluating Vertical
Restraints for Platforms
32
Impact of restraints on achieving critical mass.
•To what extent do restraints preclude strategies necessary for reaching critical
mass and are there effective counterstrategies.
Platform and Industry Stage of Development.
•Restraints more likely to be residue of procompetitive strategy and still provide
efficiencies in earlier stages.
Impact on all sides.
•Benefits and costs should be evaluated by looking at impact on all customer
sides.
Role in managing externalities
•Possible efficiencies from managing positive and negative platform
externalities should be considered.
Robustness of standard economic models.
•No reason to believe that the result of economic models that do not consider
interdependent demand hold for multisided platforms and results of literature
so far show that the results do not in fact hold in important cases.
End of Part 1, Next Class Part 2
33
Part 1
Part 2
Vertical Restraints
Overview
DoubleMarginalization
Single-Monopoly
Profit Theorem
Procompetitive VR
Justifications
Procompetitive
Tying Explanations
Anticompetitive VR
Theories
Anticompetitive
Tying Strategies