Nonprice Vertical Restraints
Chapter 19: Nonprice Vertical Restraints
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Introduction
• Vertical Price Restraints are not the only kinds of
vertical restrictions
• Other common vertical restrictions include
– Exclusive Dealing: Manufacturer restricts retailer’s ability
to buy and sell brands that compete with the manufacturer’s
brand, e.g., Coca-Cola may restrain restaurants or other
vendors from selling Pepsi products (Interbrand
competition)
– Exclusive Selling: Retailer restricts manufacturer from
supplying other dealers, e.g., Lexus dealer obtains promise
from Toyota not to authorize other Lexus dealers to sell in
nearby locations (Intrabrand competition)
Chapter 19: Nonprice Vertical Restraints
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Exclusive Dealing
• Exclusive Dealing as a way to deal with Free-Riding
• Advertising and promotion by a manufacturer spills
over to raise demand for similar products
– Example: advertising Tylenol may raise demand not just
for Tylenol but also for non-aspirin pain relievers in general
– Pharmacist may respond to inquiries about pain relievers by substituting
lower-cost non-aspirin pain reliever
• Substitute costs less because it did not pay for advertising
• Substitute manufacturer free-rides on the advertising of Tylenol
• No manufacturer advertising and so no information provision could
be the result—This is inefficient.
• Exclusive dealing may solve this problem.
• No spillovers if dealer sells no substitute products
Chapter 19: Nonprice Vertical Restraints
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Exclusive Dealing (cont.)
• But exclusive dealing can compound monopoly
problem
• Assume two manufacturers and two retailers
– Retailers (1 and 2) are spatially separated by distance
M along a line
– Consumers are spatially located around a circle at
each retail location of radius r
A
B
Retailer 1
A
M
B
Retailer 2
– Manufacturer’s
(A and B) products located on
circle Given retail location
Chapter 19: Nonprice Vertical Restraints
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Exclusive Dealing (cont.)
• With No Exclusive Dealing, A and B compete at
each location
A
B
A
B
M
Retailer 1
Retailer 2
– Substitutes never more than 2r apart
– Interbrand Price competition is tough
– Retailer 1’s price for B also constrained by
availability of A at Retailer 2 M units away
Chapter 19: Nonprice Vertical Restraints
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Exclusive Dealing (cont.)
• Exclusive Dealing, A and B at separate locations
A
B
M
Retailer 1
Retailer 2
– Interbrand competition greatly reduced
– Retailer 1’s price for A less constrained by
availability of B at Retailer 2 because this is
now M + 4r units away
– Both manufacturers and retailers can gain at
expense of consumers
Chapter 19: Nonprice Vertical Restraints
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Exclusive Selling and Territories
• Again, there is a free-riding issue
– Service and Promotion may benefit other Sellers,
especially nearby ones
– Each dealer may try to “free ride” on service and
promotion of other retailers with result that no services
are provided
• There is also a price externality
– Price cuts by one dealer cut into profits of other dealers
– Each dealer considers only the effect on her own profit
Chapter 19: Nonprice Vertical Restraints
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Exclusive Selling and Territories (cont.)
• Exclusive Selling/Territories may solve these
problems
– With other dealers far away, each dealer can get the full
benefits of her selling and promotional services
– No free riding
• Intrabrand price competition lowers double
marginalization problem. Why should
manufacturer’s want to reduce such competition?
– Intrabrand price competition can intensify interbrand
competition
– (Assume no two-part tariffs)Retailers can only pay high
wholesale price if they can pass it on at retail level
– This requires some monopoly power on part of retailers
– Movements in wholesale price now only partly reflected
in retail price  Wholesale price competition less intense
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization
• Why Are There So Many Franchisees? Why do
Firms Operate Many Different Divisions?
– Recall the Merger Paradox:
In a Cournot or quantity competition setting, the merger
of two firms makes those firms worse off and
remaining firms better off
Why? Because the two merged firms act as one. If there
were originally 6 firms and two merge, these two firms
are now one of five whereas they were two of six.
That is, the merged firms now constitute just one-fifth
of the independent decision making units instead of
one-third.
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• This may be the logic behind franchising and
divisionalization
– By operating many independent divisions or
franchises, firms may avoid the logic of the
merger paradox
• But with each firm doing this, the industry becomes
populated with many divisions and franchises
• Perhaps more than is consistent with either joint
profit maximization or efficiency
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• Assume demand P = A – BQ and Cournot
competition
– Firm j has divisions denoted by i, i = 1,2
– Profit of ith division of jth firm given by:
 ij qij , Qij   [ A  BQij  qij ]qij  cqij
– qij is output of ith division of jth firm; Q-ij is output
of all other divisions of all industry firms; and c is
marginal cost
– Equating marginal revenue and marginal cost
yields:
A  BQij  2 Bq*
ij  c
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• Let n1 and n2 be the number of divisions at firms
1 and 2, respectively. Since all divisions are
alike the , the optimal output of any division is:
*
q ij

Ac
 n 2  1B
n1
• So, solving for industry output Q and price
P, we have:
 n  n2  A  c 

Q   1

 n1  n2  1  B 
and
A  n1  n 2 c
P
n1  n 2  1
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• Given its optimal output, qij*, each division at
each firm will earn profit
 ij 
 A  c 2
Bn1  n2  1
2
• Firm 1’s total profit is: n1i,1 – Kn1 where K
is the sunk cost of setting up each division. So
 1 n1 , n2   n1
A  c2
Bn1  n2  1
2
 K1
Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• Maximizing firm 1’s profit with respect to n1
and recognizing that by symmetry, each firm
must have the same optimal number of divisions
then yields:
 A  c 2


2n1*
1 
K
2 
*
*

*
*
n

n

1
n1  n2  1 
1
2





• Solving for the optimal number of divisions at
any firm we have

2


1 
A

c
n*  
2 
K


1
3





 1


Chapter 19: Nonprice Vertical Restraints
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Franchising and Divisionalization (cont.)
• The implication is that the greater the potential
for monopoly profit (A – c), the greater the
incentive for firms to create more divisions.
But
– More independent divisions brings the industry profit
down
– Firms engaged in a prisoner’s dilemma gain in
which each adds divisions to the detriment of joint
industry profit
– Depending on the nature of the sunk cost of creating
a division, it is even possible that the total surplus
may be reduced by excess divisionalization
Chapter 19: Nonprice Vertical Restraints
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