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 demandenhancing 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 double-markup
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.
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?
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