Chapter 23 Script

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.
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
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 (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
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
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
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
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.
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.
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.