1
1
Section 1. Demand in Factor and Product Markets................................................................................ 2
Section 2. Transmission of Demand Shifts from Product to Factor Markets ...................................... 5
(b) Transmission of Demand Shifts Up the Vertical Chain................................................... 5
(a) Transmission of Supply Shifts Down the Vertical Chain ................................................ 5
Section 3. Supply and Supply Shifts in Factor and Product Markets ................................................... 7
Section 4. Equilibrium in Product and Factor Markets ......................................................................... 8
Section 5. Supply And Demand Transmissions Through Vertical Chains ......................................... 11
A. Basic Market Conditions ................................................................................................................ 12
B. Market Structure and Conduct ...................................................................................................... 14
1. Market power ............................................................................................................................ 14
2. Inventories ................................................................................................................................. 14
Section 6. Market Power of the Buyer: Monopsony and Oligopsony .................................................. 14
Section 7. Bilateral Monopoly ................................................................................................................. 17
Section 8. Vertical Integration: Pros and Cons. .................................................................................... 19
A. Forward Vertical Integration ......................................................................................................... 21
B. Backward Vertical Integration ....................................................................................................... 22
Vertical relationships focus on the interactions by a firm with its buyers and suppliers. By monitoring what is happening to buyers and suppliers, a company can anticipate major changes to a market. By ignoring such relationships, a firm is in danger of losing its market. An understanding of vertical relationships can prove to be a valuable forecasting tool.
To analyze vertical relationships it is important to view both the product market and a factor market simultaneously. To analyze relationships with sellers it is useful to view one’s own firm as being in a product market and the sellers are viewed as an upstream factor market.
To analyze relationships with buyers it is useful to view one’s own firm as being the factor market and the buyers are viewed as a downstream product market. Analysis of vertical markets requires the analysis of at last two markets simultaneously. In this chapter, the analysis of demand, supply, equilibrium, transmission of shifts, and market power will generally involve an analysis of what is happening both in a product and factor market.
The key link between a factor and a product market is embodied in a production function . The production function describes how the inputs bought in a factor market are transformed into the output produced for a product market. Armed with a production function, we can find (a) how a firm’s demand curve in the product market is transformed into the demand curve in the factor market and (b) how the supply curve in the factor market is transformed into a

2 firm’s supply curve in the product market. The production function also describes how changes in demand and supply are transmitted between factor and product markets.
Section 1. Demand in Factor and Product Markets
The concept of demand in the factor market can also be formulated from information in the product market. The demand in the factor market is a derived demand . In other words, the demand for a factor depends on the demand for the product made from the factor. Economists define derived demand with the concept of the marginal revenue product (mrp) . The marginal revenue product is the additional revenue that a buyer receives from using an additional amount of a factor, ceteris paribus.
The name, marginal revenue product , reminds us that derived demand reflects both demand in the product market and the marginal productivity of a factor. Specifically, the marginal revenue product (MRP) can be derived from the marginal revenue (MR) in the product market and the marginal product (MP) of a factor:
(12-1) MRP = MR * MP
Since the marginal product is computed from a production function, this equation provides the relationship between the demand in a competitive product market and the price at which the factor is demanded. It derives the demand in the factor market from the demand in the product market.
The concept of a marginal revenue product places a maximum limit on how much any factor of production should receive for services. No firm wants to pay more to a factor than what the factor earns for the firm in revenue. On the other hand, many employees realize they are bringing in far more money to a firm than they are being paid. Suppose you are flipping one hundred hamburgers in an hour and each hamburger brings a fast food establishment $5. There can be a big difference between the $500 you are making for the firm and the $10 you earn.
Implicitly you are calculating your marginal revenue product- the additional revenue you are bringing to a firm. While you might be disturbed at receiving such a small percentage of your marginal revenue product, you are much better off than if no one is ordering hamburgers and you are therefore being paid more than your marginal revenue product. If such a circumstance persists the firm will have to eliminate your job.

3
EXAMPLE. Physician Services in a Small Town
We will follow a small town that is barely capable of supporting three physicians. There are two different markets as shown in Figure 12-1. The factor market is the market for doctors’ services and the quantity of the factor (the number of available doctors each day) is the focus of the factor market. By contrast, the product market is the market for health care and the quantity of the product (the number of patients served each day) is the focus of this market. If the doctors are working for clinics, then clinics are the buyers in the factor market and sellers in the product market as shown in Figure 12-1.
Table 12-1 presents a hypothetical production function for doctors that shows how many patients (column 2) can be served each day depending upon the number of physicians (column 1) who are available in the town. The difference in product represented by each additional doctors is called the marginal product.
It is calculated as shown in column 3 of Table 12-1.
The market for health care measures the number of patients who are taken care of. In this market the demand relationship shows the relation between the price of health care services and the quantity of patients taken care of . Now suppose that the doctors are serving medicare patients. The federal government has set a $100 limit (referred to as “diagnostic related groups”
(DRGs)) for each patient. The demand relationship implied by such a fixed price is shown in column 4 of Table 12-1. For each number of patients taken care of in a day (column 2), the demand relationship shows a constant price of $100.

4
Table 12-1. Derived Demand for Physician Services
Doctors Patients Marginal Product of Price of served doctors health care per day
(1) per day
(2)
(patients/doctor)
(3)
($/patient)
(4)
Total
Revenue
($/day)
(5)
Marginal revenue
($/patient)
Marginal revenue product
(6) (7)
0 0 - 100 0 100 -
1
2
5
9
5
4 = (9-5)
(2-1)
100
100
500
900=
9*100
1200
100
100
500
400=
4*100
300 3 12 3 100 100
To derive the demand curve in the factor market from the product market, it will be necessary to calculate the total revenue and marginal revenue. In column 5, the total revenue is the price of health care (column 4) multiplied by the quantity of health care (column 2). The change in total revenue (the difference between successive entries in column 5) can then be divided by the change in quantity (the difference between successive entries in column 2) to find marginal revenue (column 6). Not surprisingly, when price is constant, marginal revenue is equal to price at $100 per patient. The marginal revenue product (column 7) is simply the product of the marginal revenue (column 6) and marginal product (column 3). That’s all that equation 12-1 above is saying.
The marginal revenue product is different than marginal revenue only because of marginal productivity . The fact that there is diminishing marginal productivity (namely, the number of patients who can be served (column 3) become smaller as more doctors are hired) guarantees that marginal revenue product is falling (column 7). Notice that the derived demand
(marginal revenue product) can be declining even though the demand for health care services
(column 4) is constant. While marginal revenue examines the change in total revenue from serving more patients, the marginal revenue product examines the change in total revenue for each new doctor who is hired. In the case of marginal revenue, demand is viewed from the point of view of the product market while marginal revenue product is viewing derived demand from the point of view of the labor market.

5
Supply and demand shocks occurring in one market are transmitted through vertical relationships to other markets. A firm sees changes in its demand when its customers experience changes in demand. This apparent truism is the mechanism by which demand changes are transmitted from buyer to seller. Similarly, a firm sees changes in its supply when its suppliers experience changes in supply. This apparent truism is the mechanism by which cost changes are transmitted from seller to buyer. This section and section 4 show how demand and supply shifts are transmitted through vertically related markets.
There are two directions which a shock travels through vertically related markets:
(a) Transmission of Demand Shifts Up the Vertical Chain: A shift occurring in the product market will cause the demand for the factor to shift in an upstream market. A demand shift in the product market results in a shift in the same direction in the factor market. Although it is possible to examine such a shift from the point of view of either the factor or the product market, it is easiest to begin in the product market and then to trace the impact up to the factor market.
(b) Transmission of Supply Shifts Down the Vertical Chain: A shift occurring in the factor market will cause marginal cost curve to shift in a downstream market (as well as the supply curve for competitive markets). A supply shift in the factor market results in a shift in the same direction in the product market. Although it is possible to examine such a shift from the point of view of either the factor or the product market, it is easiest to begin in the factor market and then to trace the impact down to the product market.
The transmission of supply and demand impacts is a matter of definition.
Formula 12-1 of the previous section proves how a shock is transmitted from the product market to the factor market. As long as the production function (and therefore marginal productivity) remains unchanged, a shift in the demand curve in the product market shifts the derived demand curve in the factor market in the same direction.
In 1997, Congress passed the Balanced Budget Act which set limitations on expenditures by the government, including Medicare. Reimbursement rates were lowered for many kinds of medical care. Suppose, in our previous example, that patients are reimbursed $60, not $100 for their visits to physicians. Let’s see how derived demand changes. Table 12-2 shows the changes from Table 12-1 in bold print due to the changes in the reimbursement rates.
A comparison of the two tables shows that a shift downward in demand (column 4) from
$100 to $60 has resulted in a similar downward shift in derived demand at each patient service level (column 7). The shifts are shown in Figure 12-2a for the demand curve in the product market (based on columns 2 and 4 from both Table 12-1 and 12-2) and in Figure 12-2 for the derived demand curve for the factor market (based on columns 1 and 7 from both Table 12-1 and

3
1
2
12-2).
Table 12-2. Derived Demand for Physician Services doctors Patients Marginal Product of Price of served doctors health care per day
(1) per day
(2)
(patients/doctor)
(3)
($/patient)
(4)
Total
Revenue
($/day)
(5)
Marginal revenue
($/patient)
Marginal revenue product
(6) (7)
0 0 - 60 0 60 -
5
9
12
5
3
4 = (9-5)
(2-1)
60
60
60
300
540=
9*60
720
60
60
60
300
240=
4*60
180
6 0 0
Doctor Salary
($ per day) 5 0 0
4 0 0
3 0 0
2 0 0
1 0 0
0
0 1
5 0 0
3 0 0
4 0 0
3 0 0
2 4 0
Doctors per day
2 3
1 8 0
Patient Fee
1 2 0
1 0 0 1 0 0 1 0 0 1 0 0
8 0
6 0
4 0
2 0
0
0
6 0
5
6 0 6 0
Patient per day
9 1 2
6 0
6

7
The supply curve for a factor shows the correspondence between different factor prices and the quantities supplied of the factor. By contrast, the supply curve for a firm’s product shows the correspondence between different product prices and the quantities supplied of the product. The relationship between the two supply curves therefore depends on a firm’s production function which matches the quantities of a factor to the quantities of the product.
When a firm faces competitive factor and product markets, the relationship between its two supply curves can be defined in the short run. The supply curve in the product market is identical to the marginal cost curve, as long as the firm does not shut down. Given the change in a factor price, w, with all other factor prices held constant, the marginal product, MP, for the factor is related to the marginal cost, MC, by the following formula:
(12-2) MC = w/MP
The marginal cost is inversely related to the marginal productivity of the factor. With the marginal product computed from a production function, this equation provides the relationship between the supply price (w) for the factor and the marginal cost (MC) at which the product is supplied.
Shifts of supply are transmitted downstream through a vertical chain from the factor market to the product market. Formula 12-2 describes how a shock is transmitted from the factor market to the product market. In other words, as long as the production function (and therefore marginal productivity) remains unchanged, a shift in the supply curve in the factor market (due to changing factor price “w”) shifts the marginal cost curve in the product market (which is the same as the marginal cost, “MC”) in the same direction.
When the government cuts back reimbursement for Medicare, doctors face the decision about whether or not they are willing and able to offer their services to Medicare patients.
Willingness and ability to offer services is represented by their supply curve in the factor market.
To find the supply curve for health care services in the product market, it is necessary to use the production function once again. In our little story of the doctors in a small town the production function was given as shown in the first two columns of Table 12-3. Again from that production function, the marginal productivity of the doctors can be calculated (column 3).
In the factor market the supply shows the relationship between doctors’ salaries and the number of doctors who are willing and able to work at those salaries. Table 12-3 shows that to get one doctor (column 1) for the town it would be necessary to pay a salary of $240 per day
(column 4). But to get the services of the second doctor, it would be necessary to pay that doctor at least $300 per day. Initially, it is assumed there is no third doctor who is willing to work in the market at any price. The supply relationship in the factor market is therefore embodied in columns 1 and 4

0
1
2
Table 12-3. Marginal Cost for Health Care Services
Doctors Patients Marginal Product Doctor Marginal per day
(1) served per day
(2) of doctors
(patients/doctor)
(3)
Salary
($/doctor)
Cost
(4)
($/patient)
(5)
New Dr.
Salary
($/doctor)
(6)
New Mar- ginal Cost
($/patient)
(7)
0
5
9
-
5
4 = (9-5)
(2-1)
0
240
300
0
48
75
=300/4
0
160
240
-
32
60
=240/4
3 12 3 - - 300 100
To find the supply curve in the product market from the factor market, it will be necessary to find the marginal cost of treating each patient. Using equation 12-2, the marginal cost (column
5) can be calculated by dividing the salary of the doctors (column 4) by their marginal productivity (column 3). As long as the product market is competitive (there is a flat demand curve in the product market as in Figure 12-1), the marginal cost curve includes the same points as the supply curve except when a firm shuts down. We can then say that both supply curves in
Table 12-3 are upward sloping but they are measured in different units and they look different because of the diminishing marginal productivity of doctors.
Now suppose a third doctor moves to the town who is willing and able to practice for
$160 per day. Column 6 and Column 1 together represent the new supply curve after the entry of this new doctor. Column 2 and column 7 describe the new marginal cost curve in the product market, which also serves as the supply curve in a competitive product market.
8
In competitive markets an equilibrium occurs where demand and supply are equal. If the equilibrium occurs in the product market, then it must also occur in the factor market. As we have seen in the previous sections, the demand and supply curves are closely related between the factor and the product markets. While the equilibrium curves may look different due to changing marginal productivity, they are providing the same information.
Institutionally the factor markets and product markets often seem quite different to each other. For example, management and workers may negotiate with each other without thinking about how their agreements affect the product market. Nevertheless, any changes that are made

in negotiations will be directly transmitted downstream through a shift in the supply curve in the product market. Similarly, when purchasers negotiate with buyers, any changes will be translated through shifts of derived demand curves to upstream markets. Equilibria in all vertically related markets will adjust to changes in any of the markets in the vertical chain.
9
In our hypothetical example of a town with three doctors, we are now ready to see what would happen due to the Medicare cutback of DRG reimbursements from $100 to $60 per patient. Figure 12-2 represents the same demand shifts that were shown in Figure 12-1.
However, the supply information from Table 12-3 have been included in the diagram. The intersection of the demand curves and supply curves determine the equilibrium in each market.
Both diagrams in Figure 12-2 describe the same equilibrium but they do it from different points of view. When Medicare reimburses at $100 per patient, 12 patients are given service. In the factor market, the $100 reimbursement is enough to cover the services of three doctors.
These two statements say the same thing since 3 doctors serve 12 patients. It’s just a matter of deciding whether we are looking at the equilibrium from the point of view of the doctors in the factor market or from the point of view of the customers in the product market.
Whenever a shift occurs, we should focus on the market in which the shift initially occurs. In this case the initial impact of the change in reimbursement occurs in the product market. When the reimbursement is cut to $60 per patient, then only 9 patients are served instead of 12 patients. The shift in demand in the product market is then transmitted through a shift in derived demand in the factor market. The reimbursement of $60 is now enough to cover the services of only two doctors, not three doctors. Once again, the two statements are the same since two doctors serve 9 patients. In Figure 12-2, even though the two diagrams do not look the same, they are describing the same equilibrium. The only difference occurs because of the production function and differences in marginal productivity.

6 0 0
Doctor Salary
($ per day)
5 0 0
4 0 0
3 0 0
2 0 0
1 0 0
0
Derived Demand before Cut
5 0 0
Derived Demand before Cut
3 0 0
Supply of Doctors
0 1
4 0 0
2 4 0
Doctors per day
2 3
3 0 0
1 8 0
Patient Fee
1 2 0
Demand before Cut
1 0 0 1 0 0 1 0 0 1 0 0
8 0
6 0
Demand after Cut
6 0 6 0 6 0 6 0
Marginal Cost=Supply
4 0
2 0
0
0 5
Patient per day
9 1 2
Instead of representing shifts in terms of complicated diagrams of demand and supply, it is possible to abbreviate the impacts through a standard format as shown in Figure 12-3. In this diagram there are four possible shifts of demand or supply ((a) a leftward shift in supply, (b) a rightward shift in supply, (c) a leftward shift in demand, and (d) a rightward shift in demand) which are shown at the top of the table. The demand shift starts in the downstream product market, and is transmitted as a derived demand shift in the factor market.
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11
PARTICIPANT ROLE MARKET
Supply and demand and shocks can arrive from very distantly related markets and completely catch management off guard. Shocks can come from customers of a firm’s customers, or suppliers of a firm’s suppliers or even more indirectly. By knowing the vertical chain upon which a firm depends, a manager may be able to forecast the direction, magnitude and timing with which such shocks will hit a firm and from what direction in the vertical chain those shocks will come.
A vertical chain can be constructed by tracing a good all the way up to its original resource form and then all the way down to the final consumer. The original resource should ultimately be in the form either of labor- which can include entrepreneurial skill as well as manual labor- or land- which can include natural resources as well as real estate. The final consumers include U.S. households, the government, the businesses consumption of capital goods, foreign buyers, and anyone else who effectively makes the good extinct.
The key to placing the markets in the proper order is to make sure that the product or service of any market appearing early in the chain is a component in every market appearing below it. One question that helps to assemble the chain is, “Does the price in

12 each market represent a cost to each succeeding market in the chain?” The answer should be “yes” for every market in the chain. In addition we can ensure that the buyers for each market are the ones who pay money to the sellers who provide the product. Once the chain has been set up properly, it is possible to follow supply and demand shifts from one vertically related market to the other.
A vertical chain shows who ultimately receives the brunt of supply and demand shocks.
When such a shock occurs to a market in a vertical chain, the original resources and the final buyers at either end of the chain are the ones who feel the brunt of the shocks. The transmission of demand and supply changes through vertical chains are damped down and delayed by the basic conditions, structure and conduct within a market, which are viewed here as the shock absorbers within a vertical chain.
TRANS-
MISSION
AS:
Transmission of Transmission of
SUPPLY SHOCKS DEMAND SHOCKS
upstream use choked off
2
1
downstream use choked off
1
2
Downstream price gouging
2
1
INELASTIC
SUPPLY
Upstream price crunch
1
2
NOTE: Elastic (I) demand or (ii) supply translates shocks into quantity changes. Inelastic (iii) demand or (iv) supply translates shocks into price changes.
A.
Basic Market Conditions
The elasticities of supply and demand which involve the slope of the supply and demand curves (see Figure 12-4), transaction costs, institutional delay and the degree of government involvement in a market are key market conditions determining the magnitude and form of transmission effects.
1.
Elasticities of Demand and Elasticities of Supply
Elasticities of demand and supply determine whether shocks are passed on as quantity or

13 price changes and they also determine how much of a shock is transmitted up through a chain to the original factors or down to the consumer. An examination of extreme cases in Figure 12-4 illustrates how the slope of demand and supply curves ( which affect their “elasticities”) distribute the impact of a supply or demand shift:
(a) When either curve is perfectly elastic (ie. Horizontal line), then shocks are transmitted in the form of quantity, rather than price, changes: (I) When demand is elastic, then supply shifts will translate into lower quantity upstream. (ii) When supply is elastic, then demand shifts translate into lower quantity downstream.
(b) When either demand or supply is inelastic (i.e. vertical line), shocks are transmitted in the form price changes. The price changes are transmitted downstream (iii) if demand is inelastic and (iv) upstream if supply is inelastic.
The elasticities of demand and supply determine who will receive the impact of the changes and whether the impact will appear in the form of quantity or price changes.
Basic market conditions which determine elasticities play an important role in determining how transmissions of supply and demand shocks occur. If a resource accounts for only a small portion of the cost of a product, then it may have little impact on product prices.
Similarly if a product is relatively unimportant to a factor market, it should have little impact on the derived demand for resources.
Easy entry and exit in competitive markets and markets for substitutes can also dissipate transmission of supply and demand effects. The production function determines the elasticities of derived demand and determines the degree of substitutability between various factors of production. For example, in World War II when the Japanese cut sugar supplies, the United
States learned to depend more on sugar beets than sugar cane. When OPEC cut oil shipments, the US began work on synthetic fuels and gasahol while Japan engineered its products to conserve on energy.
2. Transaction Costs and Institutional Delays
Transaction costs expected to be incurred from price or quantity changes may prevent or delay the price changes. Such costs arise from the need to inform customers of price changes, contractual procedures for adjusting prices, the material and advertising costs of posting price changes, and the losses of goodwill and business as price changes force customers to rethink the desirability of future purchases.
Related to transaction costs are the institutional delays involved in adjusting price and quantities of a good. Long term contracts, advertising design delays, the infrequency of catalog distribution, the difficulty of reaching customers, and simple habit, all delay or dampen transmission of shocks. In short run decision making a firm leaves unchanged certain factors of production. Even though such factors may vary wildly in price, the firm’s profit maximizing production level in the short run may remain unchanged. Even in long run decisions, a manager

14 may not make adjustments to sudden demand and supply shifts because such shifts are expected only to be temporary.
3. Government Involvement
The government may interfere with market signals in a way that prevents transmission of supply and demand effects. When the government regulates prices or output, it can prevent demand or supply shocks from being transmitted through a vertical chain. Price controls, taxes, subsidies, tariffs, quotas, government stockpiles, and other macroeconomic policies distort the signals from supply and demand shifts through vertical chains.
B. Market Structure and Conduct
It is not surprising that consumers are rarely made conscious of supply and demand shocks to markets. The exercise of market power can alter how demand and supply shocks are transmitted through vertical chains. In addition, company policies on inventories, vertical mergers, entry, and exit can all counteract the transmission of supply and demand changes.
1. Market power
In oligopolistic markets, market power may dampen and delay transmission of demand and supply shifts. Particularly in markets where prices serve as an important symbol of cooperation or aggression, there is likely to be reluctance in raising prices. In such cases, a cost increase may simply be eaten by a firm and will fail to be transmitted down through the vertical chain.
2. Inventories
Managers can make use of knowledge about a vertical chain to make timely adjustment to ease the impact of dramatic changes in market conditions. In a desire not to lose the goodwill with customers, they have an incentive to anticipate market changes. This means they are continually scrutinizing their factor markets to get wind of impending strikes, shortages, or price changes so that they can make early adjustments to insulate their customers. By adjusting inventory levels it may be possible to avoid changing production schedules; inventories serve as a buffer that dampen the transmission of supply and demand shifts through a vertical chain.
Regardless of how small a supply or demand shock becomes as it moves through vertical chains, we have seen there are some basic rules that those shifts follow.
(1) A firm downstream from a market which has experienced a shock can anticipate a shift in factor supply.
(2) A firm upstream from a shock can anticipate a shift in demand.
No matter how small a shift may seem, it still alters the basic underlying conditions of the market.
Buyers have market power when they can change market prices. When buyers have market power, it is no longer adequate to examine the supply curve to find profit maximizing output.
The buyer has an impact on factor price. An additional purchase raises the price of all factors purchased, not just the last unit purchased. When all of the factors must be paid the same price, the supply curve no longer reflects what a buyer must pay for the next unit of a factor. If the

15 next unit of factor costs more than the previous unit, then a buyer must pay the higher price not only for the next unit but an additional amount to cover the higher price for all units. The true factor cost at the margin, which is called the marginal factor cost , includes both the price to purchase the next, marginal unit of factor plus the additional cost from changing the price on all of the previous units.
A buyer with market power must therefore know the marginal factor cost which measures the change in total factor cost for each additional unit. While the factor supply curve shows the price of buying only the next unit of a factor, the marginal factor cost reflects the full additional cost of buying the extra factor. When the factor supply curve is upward sloping, a graph of the marginal factor cost curve lies above it. When the factor supply curve is flat the two are equal.
In a monopsony , there is only one buyer facing many sellers. If a monopsonist must pay the same price for every unit of a factor then the amount of factor that maximizes profit is less than if it were possible to pay different prices. In a normal competitive factor market where there is no market power, the buyer purchases the amount where supply equals the derived demand for the factor. However, in a monopsony where one price must be paid for all units of the factor, the monopsonist purchases the amount at which marginal factor cost just covers the price indicated by derived demand. This means a monopsonist buys less than a competitive buyer purchases under the same market conditions.
However, the monopsonistis buyers does not pay the amount indicated on the derived demand curve. The derived demand curve is used only to figure out how much to buy of a factor, not how much to pay for it. The monopsonist uses market power to drive the factor price all the way down to the supply curve of a factor. Remember that the marginal factor cost consists of price paid for the factor plus an amount to raise all of the other units to the same price. The uniform price paid for each factor is therefore well below marginal factor cost.
In oligopsony , there are many buyers. Each buyer affects the marginal factor costs that are experienced by the other buyers. That means the buyers are interdependent upon each others’ actions which leaves room for many kinds of behavior including cooperation to lower factor prices, raiding of each others’ sources of factor supply, bidding wars for factors, and other interdependent behavior.
EXAMPLE: HMOs as Monopsonists
Small towns are often unable to support more than one medical facility. Suppose an
HMO came to the small town we have been examining above and made to contract to serve all of the patients in the town. The doctors would no longer be able to offer their services in private clinics which they own and run, but would have to work for the HMO for a salary. Typically an
HMO offers a standard contract and attempts to treat all of the doctors equitably. Notice that all three of our doctors are likely to receive the same salaries. Therefore the HMO has to find out, not just the salary at which each doctor is willing and able to work (in other words, the market supply curve), but the marginal factor cost of hiring each additional doctor.

16
The very same information that we used before (Table 12-3) in a competitive market can be used for the new monopsony situation when the HMO takes over the health market. Exactly as in Table 12-3, the production function (columns 1 and 2), marginal productivity (column 3), and supply curve of doctors (columns 1 and 4) remain unchanged. But a new column for total factor cost must be added. The doctor salary (column 4) is multiplied by the number of doctors
(column 1) to find the total factor cost (column 5). The marginal factor cost is then the difference in total factor cost divided by the additional factors.
Table 12-4. Marginal Factor Cost for Physicians.
Doctors Patients MP of Doctor Total Marginal per day served per day doctors
(patients
Salary
($/doctor) factor
Cost factor cost
($/patient)
(1)
(2) per doctor)
(4) ($ per day)
(6)
(3)
(5)
Marginal
Revenue
Pro- duct (col.7
Table 12-2)
($/doctor)
(7)
Marginal
Cost
($ per patient)
(8)
0
1
2
0
5
9
-
5
4
0
160
240
0
160
-
160
-
300
480 320=
=2*240 (480-160)
240
900
(2-1)
100 180
-
32
80
=320/4
3 12 3 300 140
When we graph the marginal factor cost ( column 1 and column 6) and the supply curve of doctors (column 1 and column 4) in Figure 12-5, the marginal factor cost is equal to or above the supply curve for doctors. This means that it intersects the derived demand curve for doctors earlier. The HMO hires only one doctor because the marginal revenue product from hiring another doctor is much lower than the marginal factor cost required to hire another doctor. By contrast in a competitive market two doctors would be hired, as indicated by the intersection of the factor supply and derived demand curve.

17
Doctor Salary
4 0 0
($ per day)
3 5 0
3 0 0
2 5 0
2 0 0
1 5 0
1 0 0
5 0
0
4 2 0
Derived Demand Marginal Factor Cost
3 2 0
3 0 0
Factor Supply
2 4 0
1 8 0
1 6 0
Doctors per day
0 1 2 3
Patient Fee
1 6 0
1 4 0
MC for monopsony
1 2 0
1 0 0
8 0
6 0
Demand after Cut
6 0 6 0
8 0
6 0
MC in competition
6 0
4 0
3 2
2 0
Patient per day
0
0 5 9 1 2
As in this case, it is often helpful to diagram the information in the tables to see precisely where the supply curve or marginal factor cost curves intersect demand. These intersections mark the amount of factor or product that will be provided as shown by the arrows in Figure 12-
5. In looking at tables, it may not be easy to see where demand equals supply or where it equals the factor cost.
Let’s reemphasize what has been found out about the effect of gaining market power.
Because of the market power of the HMO, only one doctor is hired and that doctor is the one who works for the least amount of money, $160 per day. The HMO does not pay the marginal revenue product ($300) of the doctor, but the lowest salary at which that doctor is willing to work. The monopsonist always pushes the wage down to the supply curve for the amount of factor where the marginal factor cost and the demand curves intersect.
The monopsony power of the HMO actually gives the appearance of a higher supply curve in the product market. The marginal factor cost (column 6) is divided by marginal productivity (column 3) in Table 12-4 to find the marginal cost in the product market (column 8).
In a comparison with the marginal cost curve in a competitive labor market, a higher marginal cost curve results than if the HMO did not have any market power. The two marginal cost curves are compared to each other in the downstream product market in Figure 12-5.
When both buyer and seller have market power, price and output are indeterminate. Such markets may require government interference or other outside intervention.In the special case of bilateral monopoly in which there is only one buyer and one seller, both the monopoly and the

18 monopsony models can provide an idea of the boundaries within which price and output are likely to be negotiated. But together the two models do not provide a consistent solution. Both the buyer and the seller wish to restrict output. However, the seller wants a price that is higher than the competitive price and the buyer wants to drive the price lower than the competitive price. There is no definite outcome; it must be determined by negotiation or arbitration.
Furthermore, in labor markets, the monopoly model may not accurately characterize the goals of the sellers. Labor unions have many different objectives, and profit maximization may not accurately characterize those goals. If a union wishes to maximize dues it may behave like a revenue maximizer. If it is trying to maximize political goals, it may want voters and may set targets for maximizing its membership. Either revenue or membership maximization places employment (production) on the agenda for bargaining.
If the buyer and the seller can coordinate and agree about how to apportion profits, there is a most profitable rate at which to produce. It occurs at the choice which would occur if the market were competitive. The competitive solution marks where the price just equals marginal cost of producing the good. If the buyer and the supplier are vertically integrated, they would find that they could maximize their profits in the downstream market at this competitive solution.
However, when the buyer and seller are independent of each other, they may find negotiation impossible over the way to apportion their joint profit. They may end up with an inferior joint profit position if either player can find a way to gain a superior profit position for itself, such as the monopoly or monopsony position.
i
If the outcome is difficult to determine in bilateral monopoly it is even harder to determine in bilateral oligopoly where there are a few buyers and a few sellers and where the strategies can become very complex. However, when bilateral monopoly or bilateral oligopoly appear in a vertical chain, it may prove to be a bottleneck. When bargaining breaks down in such a market, strikes, lockouts, injunctions, and political controversy may occur. Vertically related markets can be disrupted.
EXAMPLE:
In the summer of 1999, the American Medical Association voted to support unionization initiatives by its membership. Managed care and HMOs had forced doctors to confront the tradeoff between promoting the best health for patients and cost minimization goals.
Furthermore, doctors were finding that their pay was declining. Doctors sought countervailing power through unionization.
If the monopsony and monopoly model were to be superimposed in the same diagram in the example used in this chapter, it would be apparent that both models would favor the use of one doctor only. However, that one doctor would try to negotiate a salary of $300, which would be the first doctor’s marginal revenue product. Such an outcome would not be achievable as long as the two other doctors in town were available to the HMO. On the other hand, the HMO would try to negotiate the doctor’s salary down to $160 and would be likely to threaten to hire other doctors if the $160 offer were not accepted.

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Firms often believe that vertical integration is the answer to the problems they face. In other words, they want to cut some of the vertical links between themselves and their natural resources, called backward vertical integration , or cut some of the vertical links between themselves and the consumers, called forward vertical integration
. Porter’s classification of competitive forces provides a convenient way to organize the discussion of the advantages and disadvantages of vertical integration.
Many of the benefits that incur internally to a firm with vertical integration go hand-in-hand with increased costs. The changes occur in each aspect of a business including the market power, management, production efficiency, and financial performance of the firm:
1. Elimination of Market Power: Vertical integration can eliminate the indeterminacy of bilateral monopoly or bilateral oligopoly. Generally, a firm may be able to reduce risks due to strikes and other potential market disruptions if it can vertically integrate with the firm responsible for the disruptions.
Furthermore, with vertical integration the market power of both buyer and seller of the intermediate (upstream) good disappears. In the analysis in section 3 for a monopolist, the marginal factor revenue curve was substantially below the demand curve. However, through forward integration a firm would receive the full benefit of each extra dollar of revenue and the marginal factor revenue curve would become identical to the factor demand curve.
Similarly, the marginal factor cost curve becomes identical with the supply curve with forward vertical integration. The newly integrated company would only need to examine the marginal cost curve. The intersection of the marginal cost curve with the marginal revenue product curve would indicate the amount of factor that would be bought at the profit maximizing production rate. This production rate occurs at the same level that would occur if the market were competitive ceteris paribus- much higher than under monopsony, monopoly, or bilateral monopoly. There would no longer be a market price but simply a transfer price between divisions of the same company.
2. Management Impacts: Vertical integration provides opportunities to eliminate overlapping functions- such as information retrieval, forecasting, management, marketing, customer services, legal services, and purchasing - between two previously separate organizations.
CEOs announcing mergers often proclaim that the elimination of such overlapping functions generates “syneregies”. However, every firm has a culture of its own. Nothing guarantees that a newly acquired firm will fit into the culture of its buyer. Managers may have to modify their methods radically to manage a vertically related acquisition. Furthermore, they must be successful in managing the acquisition; if any one of the links in the vertical chain fails, the whole chain fails; all of the links depend upon the satisfaction of the same customer.
Vertical integration therefore enhances risk.
Vertical integration may simply substitute friction from interfirm disputes to intrafirm disputes. A management must set up a decision making mechanism that will replace the

20 market mechanism. A highly political or bureaucratic decision making mechanism can add substantial costs to a firm’s responsiveness, as in the case of Xerox or AT&T..
3. Production Impacts: Vertical integration can provide opportunities for more rational ways of producing and ensuring the quality of goods. Adoption of new technologies, coordination of inputs, standardization of production procedures, and the inspection for quality can be managed by one organization rather than two. Furthermore, vertical integration may allow intermediate production steps and handling to be eliminated.
Vertical integration does have a potential downside with respect to production. Complete vertical integration takes the upstream firm out of competition in the market place. The loss of market discipline can allow divisions to become sloppy or lax-a problem compounded by the perceived security of being part of the newly, vertically integrated firm. Furthermore, it may take much longer for the entire company to recognize how inefficient an acquired upstream operation has become or how slow it is in adopting new technologies.
4. Financial Impacts: If a vertically related firm has market power or is able to sustain high profitability, then acquisition may raise the overall return of a firm. However, acquisition of a firm is likely to add both to debt and fixed costs.
Higher fixed cost tends to rigidify the firm’s ability to respond to a changing market.
Adapting to lower demand might result in lower variable costs, but not lower fixed costs.
There is an inherent tradeoff between the economies from vertical integration and the greater leverage and risk from shifts in consumer tastes. The movement to relatively larger fixed costs also rigidifies the firms response to technological change. Because a firm faces heavier costs by moving to outside suppliers, it may reduce its flexibility to choose the most appropriate resources for providing its product.
5. Information Flows: Vertical integration also substantially alters the flows of information.
Sometimes vertical integration can familiarize a firm with new methods of operation, new technologies, or research and development in the market. An acquired firm may have the personnel and the organization to open up these areas to the acquiring firm. On the other hand, vertical integration can place new barriers to the acquisition of such information from the market place. If a firm truly succeeds to insulate itself from dependence on a market for an intermediate good, its loss of contact with that market may cut off an important source of information and new technology.
Vertical integration substantially alters a firm’s external relationships with other firms.
1. Information flows: Vertical integration can freeze the exchange of information outside of the firm. With one firm being able to use the information of other firms without sharing its own, competitors are all likely to be more careful in sharing information.
Security and the protection of intellectual property through copyrights and patents can be used to foreclose competition and obstruct entry.

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2. Barriers-to-entry: New strategies can sometimes arise from vertical integration. When market power exists in a vertically related market, integration with a firm may foreclose factor markets or distribution channels to competitors. Even the threat of foreclosure may provide competitors with enough incentive to vertically integrate. Whether occurring through downstream or upstream markets, the foreclosure strategy raises the barriers-to-entry to potential competitors. It raises costs to the competitors as they have fewer sources of supply or distribution and have to work harder to contract for those sources.
However, foreclosure is not the only way to raise barriers-to-entry. If vertical integration permits significant economies of scale or economies of scope, then any potential entrant must also vertically integrate in order to be competitive.
3. Visibility and government interference. Vertical integration can give greater visibility to a firm. Integration abroad may create new markets, provide new opportunities for lowering taxes, hedging exchange rate changes, diversifying against domestic uncertainties, and raising capital. Increased size may provide negotiating power with governments, advertising agencies, suppliers, and buyers. Increased vertical integration may serve to strengthen the identification of the firm with a given product, as
Coke has successfully been able to do.
However, the greater visibility attained through vertical integration can work against a firm, as well as for it. A firm becomes liable for more of what goes wrong with a product. If a vertical merger catches the attention of the antitrust agencies they may initiate costly investigations. If a firm moves operations abroad at the expense of the domestic work force, it may face resentment and mistrust from its domestic work force and a cool reception from its new host. While internationalization of operations may provide some tax benefits, it can also trigger changes in tax law and increasing regulatory uncertainties both from domestic and foreign governments.
There are several considerations which are specific to the type of vertical integration which is undertaken- whether forward or backward vertical integration.
A. Forward Vertical Integration
Vertical integration shortens a vertical chain by eliminating a market. The upstream firm no longer sells an intermediate good to the downstream firm- the bottlers. This means that most transactions costs associated with searching, marketing and negotiating over the sale of the intermediate good are eliminated. It also eliminates any risk arising from the dangers of being cut off from customers.
Forward vertical integration can control pricing, distribution, and advertising strategies.
If a firm must market through a system of independent franchises, customers may be able to
“shop” for the franchise offering the lowest price, and bid prices downward. When customers change their buying procedures, a firm may be unable to alter territories or selling procedures because of the difficulties of negotiating such changes with independent franchises. It may be

22 impossible to take advantage of advertising economies and distribution efficiencies if many small independent firms make the advertising and distribution decisions. These problems can be eliminated by buying out the independent franchises.
Forward vertical integration alters the availability and strategy of using information.
Secrecy on sensitive proprietary matters is much easier to control with vertical integration.
Comprehensive market analyses and planning are also easier to undertake and control. However, the advantages of increased control over internal information may come at the expense of receiving good market information and ultimately market discipline.
B. Backward Vertical Integration
Vertical integration may provide opportunities for more rational ways to purchase inputs and achieve maximum profitability. Economies of purchasing may be achieved by volume purchases in markets that are further upstream. Furthermore, a firm may be able to diversify its sources of supply. When a firm goes multinational by acquiring overseas subsidiaries, the transfer prices between these subsidiaries and the parent enables profits to be taken either abroad or at home, depending upon where they will be taxed the least. However, such advantages can disappear at the stroke of a pen and should not provide the sole reason for backward integration.
Backward vertical integration can ensure sources of supply. A company often develops special relationships to its sellers which are very expensive to change. Transactions costs of changing suppliers might include the opportunity costs of designing new standard operating procedures, new inventory policies, relocation of facilities, transport rerouting, training of purchasing managers, delays, and the loss of goodwill developed with a supplier. With an uncertain source of supply, a firm is always at risk for these costs. Furthermore bottlenecks may exist in the supply of a resource, a firm’s acquisition of an upstream firm may ensure the supply, eliminate the threat of the transaction costs, and may even foreclose sources of supply to competitors.
However, it is rarely possible to acquire the perfect amount of resource to meet the firm’s needs. Two cases of the misfit between needs and availability can occur: (1) the firm may buy too much of a resource and then must depend on its competitors for sales or (2) the firm may not buy enough of the resource and then must still depend upon the market to purchase its remaining needs.
While the benefits of vertical integration appear attractive, they often fall short of their promise, and the costs are likely to prove greater than expected. In our examination of vertical integration, we have seen that a manager must weigh the following tradeoffs before making the decision to vertically integrate:
 whether the intercompany frictions between separate firms offset the intracompany friction after a firm vertically integrates.
 whether the discipline of the firm after vertical integration is adequate to compensate for lost market discipline.
 whether the gains from self reliance outweigh the loss of market information.
 whether the uncertainties of debt and higher fixed costs from vertical integration are less bothersome than the uncertainties of supply or distribution without vertical integration.

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 whether the benefits of economies of scale and scope compensate for any loss of flexibility from vertical integration.
 whether the competitive advantages from vertical integration offset any retaliatory responses from competitors.
The benefits and costs of vertical integration must be weighed. A firm may find that there are other strategies, short of vertical integration that may achieve its goals; tapered integration
(vertical integration for only part of needed supplies or markets), joint ventures, owning the stock of vertically related firms, lending to or borrowing from vertically related firms, or more clever long term contracting.
; tapered integration, 23 factor supply, 15 production function, 1 backward vertical integration, 19
Backward Vertical
Integration, 22
Barriers-to-entry, 21 bilateral monopoly, 17 bilateral oligopoly, 18 derived demand, 2 downstream, 1 elasticities, 12
Elasticities of Demand, 12
Elasticities of Supply, 12 equilibrium, 8 factor price, 7 factor supply curve, 15 forward vertical integration, 19 marginal factor cost, 15 marginal product, 3 marginal product (MP), 2 marginal productivity, 4 marginal revenue, 4 marginal revenue (MR), 2 marginal revenue product
(mrp), 2 monopsony, 15 multinational, 22 oligopsony, 15
Shifts of supply, 7 syneregies, 19 tapered integration, 23 total revenue, 4
Transaction costs, 13 transfer price, 19
Transmission of Demand
Shifts, 5
Transmission of Supply
Shifts, 5 upstream, 1 vertical chain, 11
Vertical Integration, 19
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