Chapter 23:
Managing Vertical
Relationships
Managerial Economics: A Problem Solving Appraoch (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks
used herein under license.
Slides prepared by Lily Alberts for Professor Froeb
Summary of main points
• Do not purchase a customer or supplier merely because
that customer or supplier is profitable. There must be a
synergy that makes them more valuable to you than they
are to their current owners. And do not overpay.
• 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 vertical integration, by tying, by bundling, or by
excluding competitors.
• The double-markup problem occurs when complementary
products compete with one another. Setting prices jointly
eliminates the double-markup problem and is often a
motive for vertical integration or maximum price
contracts between a manufacturer and retailer.
Summary of main points (cont.)
• Restrictions on intra-brand competition like minimum
resale price maintenance or exclusive territories
provide retailers with higher profit, giving them
incentives to provide demand-enhancing services to
customers.
• If a product has two retail uses, a manufacturer may
find it profitable to integrate downstream so that the
firm can capture the profit through price
discrimination. Vertical integration stops arbitrage
between the two products, which allows price
discrimination.
• Outsource an activity if the outsourcer can perform the
activity better or more cheaply than you can.
Intro. anecdote: UC Power & 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 the mine that supplies them
with coal.
• 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).
• Under the profit regulation, this allows the Power
Division to raise electricity prices.
Introductory anecdote (cont.)
• 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 chapter looks at vertical relationships (merger, or
contracts) between upstream suppliers and
downstream customers in same vertical supply chain.
• Vertical relationships can increase profit by giving
firms a way to evade regulation, eliminate the doublemarkup problem, better align the incentives of
manufacturers and retailers, and price discriminate.
Caveat: Beware Acquisitions
• Do NOT buy a customer or supplier simply because
they are profitable
• Purchasing a profitable upstream supplier or
downstream customer will not necessarily increase
your profit.
• 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.
• Discussion: In 1999 AT&T bought TCI’s cable TV
assets for $97 B; then in 2002, they sold the cable
assets to Comcast for $60 B.
Evading Regulation
• One of the simplest and easiest-to-understand
reasons for vertical integration is to evade
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.
• Discussion: How can you evade Rent Control
(HINT: Tying, bundling, or exclusion)
• Discussion: How can Multi-National companies
evade national taxes using transfer pricing?
Solving the Double-Markup Problem
• Discussion: Gasoline refiners selling branded gasoline
• This problem can be analyzed more generally as a prisoners’
dilemma faced by any two firms in the same vertical supply
chain or by any two firms selling complementary goods.
• In this case, consumers demand the gas, as well as the
retail outlet that dispenses it.
• When firms selling complementary products compete with
each other, they price too high.
• 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.
Aligning Retailer Incentives with
Manufacturer Goals
• Discussion: 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.
• Intra-brand competition can be controlled by means such as
granting exclusive territories, or setting minimum retail prices.
• This guarantees retailers a higher profit level creates incentive
to provide demand-increasing services
• Can you think of examples of this?
• Limiting intra-brand competition also helps reduce free-riding,
e.g., PING golf clubs require custom fitting and are not sold
over the Internet.
• BUT, many of these tactics may be illegal under antitrust laws
• Especially for companies with dominant market shares
Aligning incentives (cont.)
• Frequently, practices that limit distribution in an
attempt to enhance demand for a brand may violate
anti-trust laws.
• For example, European authorities have prohibited Coke
from purchasing refrigerators for retail outlets because the
practice may unfairly exclude rival soft drink
manufacturers from retail outlets.
• In Europe this is known as “abuse of dominance” and in
the US as “monopolization” or anticompetitive
“exclusion.”
• To avoid this, remember: If you have significant market
power, you should consider the effect any planned action
will have on competitors.
Price Discrimination
• Vertical integration of downstream products can make it
easier to price discriminate.
• When there are two separate consumer groups who use the
same product in different manners, buying a retailer can
make it easier to price discriminate in a way that wont be
defeated by arbitrage.
• Example: 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.
• Price discrimination at the consumer level is legal; but at
wholesale level is more difficult (and may be illegal).
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.
• 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.
• Outsourcing takes away control of upstream manufacturing
processes or downstream distributors and retailers.
• It may also create a double-markup problem; you may find it
difficult to motivate your downstream customers or upstream
suppliers to invest in activities that benefit you; and you may
find it more difficult to price discriminate.
Alternate Intro Anecdote
• The Aluminum Company of America (Alcoa) was the only
domestic supplier of aluminum ingots prior to 1930, which
were used for a variety of purposes
• An addition to the production process in the iron and steel
industry, used to improve the quality of the final product.
• Manufacture of cooking utensils
• Production of electric cable
• Automobile and aircraft parts constituted the final two end
markets.
• Consumers in these diverse markets varied widely in their
willingness to pay for aluminum ingots.
• Demand for aluminum in the iron/steel industry and in the
aircraft industry was relatively inelastic
• In the other three industries, demand was much more elastic
Alternate Intro Anecdote (cont.)
• The potential for arbitrage created a barrier to
implementing a scheme to increase prices to iron/steel
and aircraft consumers while generally reducing price
to the other three markets.
• To successfully implement its price discrimination
scheme, Alcoa was forced to forward integrate into the
three relatively elastic markets.
• By moving into the cookware, electric cable, and
automotive parts markets, Alcoa prevented potential
re-sale of aluminum ingot and was able to maintain
high prices to the iron/steel and aircraft parts markets.
15
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3.Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7.Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19.The problem of adverse selection
20.The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?