Chapter 23: Managing Vertical Relationshisp 1. Introduction This is Professor Luke Froeb and I, along with Brian McCann, am the author of “Managerial Economics: A Problem Solving Approach.” This video is designed to complement Chapter 19: The Problem of Adverse Selection. 23. MANAGING VERTICAL RELATIONSHIPS Do Not Buy a Customer or Supplier Simply Because They Are Profitable Evading Regulation, Bundling, Tying, and Exclusion Eliminate the Double Markup Aligning Retailer Incentives with the Goals of Manufacturers Price Discrimination Outsourcing 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. • 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. Supplementary Material ManagerialEcon.com (Chapter 23) Written Testimony of Luke Froeb before the House Subcommittee on Courts and Competition Policy on the Ticketmaster/Live Nation Proposed Merger, 26 February 2009, link. HBS Case 9-403-080, Gary Rodkin at Pepsi-Cola North America (A). This case is a good illustration of the principal-agent problems created when Pepsi-Cola North America spun off its bottling unit, Pepsi Bottling Group, into a separate entity. Incentive conflicts between the bottler ad the manufacturer about new products, pricing, and promotion lead to profit and personnel problems. Teaching Note Begin by drawing the link between the previous chapter and this one. Just as there is incentive conflict between sister divisions of the same firm, so too is there incentive conflict between a firm and its upstream suppliers or between a firm and its downstream customers. Think of the firm as a principal, and its upstream supplier or downstream customer as an agent. Figuring out how to minimize the agency costs inherent in the vertical supply chain is the point of the chapter. The opening anecdote is a regulatory evasion story, and I use it because it clearly illustrates why the coal company is more valuable to the power company than it is to its current owners. The general idea is that corporations are assets and for vertical integration, there has to be a synergy that makes the acquired firm more valuable to the acquiring firm; otherwise, the acquisition makes no sense. In general, anytime there is an incentive conflict in the vertical supply chain, and you can control the conflict better, faster, or more cheaply than your rivals, then you have a reason to acquire the asset. One thing that I do NOT cover in the chapter is the exclusionary, or anticompetitive, reasons for vertical integration. This is mostly because the magnitude of the problem appears small (very little empirical support). If you want to emphasize the anticompetitive reasons for vertical integration, you might want to talk about Kodak and its suppliers (Supreme Court ruled that they could not deny crash parts to its suppliers); Dentsply getting sued by its rivals; 3M getting sued by LePages for offering “loyalty” or “all units discounts;” or about Coke being sued by the European Commission for giving away refrigerators to retail outlets. All of these cases are described on the web. Start a debate and then ask who is correct. Make sure to cover the incentive conflict in the vertical supply chain: 1. Pricing conflict (double marginalization); 2. Advertising conflict (retailer prefers lower level of promotional activity than manufacturer). 3. Investment conflict (retailer, or manufacturer, reluctant to make relationship specific investments for fear of post-investment hold up) 4. Price discrimination conflict (sell this as a conflict in that the upstream manufacturer wants to prevent arbitrage between retailers that sell to high value customers and retailers that sell to low value customers, i.e., there is nothing to prevent retailers that buy at a low price from entering the high-priced market segment and undercutting sales by the high priced retailers). Again, I find the most effective way to teach this material is to pose a problem, let the students try to figure out what is wrong by asking yes or no questions, and then suggest solutions. In-class Problem QUESTION: In May, 2006, new financial instruments, the S&P CME Housing Futures, began trading on a single exchange, the Chicago Mercantile Exchange. Institutional investors can hedge against a fall in the price of housing. Why would the owners of the index license it to trade on only one exchange? ANSWER: The owners of the index want to give an incentive to the exchange to educate traders, and promote trading in the new instruments. Without the protection of exclusivity, the exchange would not devote as much effort to educating traders about the instruments because they could move their trades to other exchanges. Exclusivity may also mean more order flow to a single exchange which increases liquidity, the number of traders trading on the index. Additional Anecdotes: Alcoa & TicketMaster / Live Nation ALCOA: Based on Perry, Martin K., “Forward Integration by Alcoa: 1888-1930,” Journal of Industrial Economics, Sep80, Vol. 29 Issue 1, p37-53. Before 1930, the Aluminum Company of America (Alcoa) was the only domestic supplier of aluminum ingots. Aluminum ingots were used for a variety of purposes An addition to the production process in the iron and steel industry (utilized to improve quality of the final product) Manufacture of cooking utensils Production of electric cable Automobile parts Aircraft parts 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, that is, customers were less sensitive to price changes. In the other three industries, demand was much more elastic. In response to price changes, customers might cancel orders or move to substitute products. Given this situation, Alcoa’s preference would have been to increase prices to iron/steel and aircraft consumers while generally reducing price to the other three markets. The potential for arbitrage, however, created a barrier to implementing this scheme. With wide price differences, nothing would prevent a cookware purchaser from undercutting Alcoa and reselling aluminum to an aircraft parts consumer. 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 gained control over potential resales of aluminum ingot and was able to maintain high prices to the iron/steel and aircraft parts markets. TICKETMASTER/LIVENATION; Representative Conyers is holding hearings on the Ticketmaster/Live Nation proposed merger. An obscure Vanderbilt professor is scheduled to testify: Ticketmaster and Live Nation are both part of the vertical supply chain that delivers live performances to fans.The “price” of this service is the difference or “wedge” between what consumers pay and what performers receive. At one end of this chain are firms that interact directly with artists, such as Live Nation. At the other end are firms that interact directly with fans, such as ticketing firms like Ticketmaster who sell tickets on behalf of venues. The merger is interesting because it raises both horizontal (Live Nation has begun ticketing its own events) and vertical (Live Nation is Ticketmaster's largest customer) issues. The potential horizontal costs of the merger will have to be weighed against the potential vertical benefits, including increased coordination across the supply chain. SECTION VII – WRAPPING UP 24. YOU BE THE CONSULTANT Excess Inventory of Prosthetic Heart Valves High Transportation Costs at a Coal-Burning Utility Overpaying for Acquired Hospitals Large E&O Claims at an Insurance Company Losing Money on Homeowner’s Insurance Quantity Discounts on Hip Replacements What You Should Have Learned Supplementary Material Epilog to the text Teaching Note I go through an overview of the material: where have we been; what have we learned and preview the exam. Also give a summary of the final exam—I give them the formulas in advance, and give them a description of the test. Summary of things they should now be able to do: Use the rational-actor paradigm, identify problems, and then fix them; Use benefit–cost analysis to evaluate decisions; Use marginal analysis to make extent (how much) decisions; Compute break-even quantities to make investment decisions; Compute break-even price to make shut-down and pricing decisions; Set optimal prices and price-discriminate’ Predict industry-level changes using demand/supply analysis; Understand the long-run forces that erode profitability Develop long-run strategies to increase firm value; Predict how your own actions will influence others’ actions; Bargain effectively; Make decisions in uncertain environments; Solve the problems caused by moral hazard and adverse selection; Motivate employees to work in the firm’s best interests; Motivate divisions to work in the best interest of the parent company, and Manage vertical relationships with upstream suppliers or downstream customers.