Part IV. Theory of competition policy
Chapter 17. Vertically related markets
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Chapter 17 - Objectives
Chapter 17. Learning objectives
• Double marginalization problem within a
monopoly context
• Contracts between the upstream and downstream
firm that differ from linear pricing
• Role of resale-price maintenance and exclusive
territories
• Role of exclusive dealing contracts
• Oligopolistic industry upstream and downstream
• Effects of vertical mergers
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
The double-marginalization problem
• Pricing inefficiency
• In a market with firms operating only at one level of a
vertical supply chain, retail prices are higher than in a
market with vertically integrated firms
• A downstream firm applies a margin to the wholesale price
which includes the margin of an upstream firm
• Retailer does not take into account the externality
exerted on the upstream firm by changing the retail
price
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Linear pricing and double marginalization
• Market demand Q(p) = a – bp
• Marginal costs c < a/b
• Upstream firm called manufacturer, downstream
firm called retailer
• The producer sets the wholesale price w at
stage 1
• At stage 2 the retailer (assumed not to incur any
costs) observes the wholesale price and sets the
retail price p
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Linear pricing and double marginalization (cont’d)
• By backward induction max  p  wa  bp
•
a  bw
p w  
2b
 a bw 
max w  c  

w
2 2 
p
• First-order condition equivalent to
c a

2 2b
Retail price
w
•
3a c
p 

4b 4
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Linear pricing and double marginalization (cont’d)
• A vertically integrated firm would max
 p  wa  bp
p
• pm = a/(2b) + c/2
• pm < p*
• Lesson: In a vertically related industry with an upstream
and a downstream monopolist in which each firm
maintains the price-setting power of its product, the retail
price is above the monopoly price set by a vertically
integrated firm.
• Double marginalization is most pronounced in
successive monopoly
• Insight remains relevant under imperfect competition
• As one layer of the market loses its market power,
double marginalization becomes less pronounced
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Contractual solutions to the doublemarginalization problem
• Mimic the monopoly solution of the vertically
integrated firm by a profit-sharing agreement
• But
• Retailer’s price not easily observable
• Retailer has nonobservable marginal costs
• Thus informational problems between the two
parties would lead to divergence from the
vertically integrated solution
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Contractual solutions to the double-marginalization
problem (cont’d)
• Result under the assumptions that there is a single
retailer and manufacturer is fully informed
• Two-part tariff consisting of a wholesale price per unit and a fixed
•
•
•
fee
• Wholesale price equal to marginal manufacturer costs
• Manufacturer makes profits from a fixed fee
Profit-maximizing level equal to the profit of the retailer gross of
this fee
Upstream firm absorbs all profits
Fee can be understood as a franchise fee
• Several retailers
• Retailer has to set the fixed fee equal to the gross profit of the
•
smallest retailer to ensure that all retailers participate
Manufacturer optimally set its unit price above marginal costs to
extract profits from all retailers
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Contractual solutions to the doublemarginalization problem (cont’d)
• Lesson: Nonlinear pricing and other contracts
can solve the double-marginalization problem.
• Resale-price maintenance
• Upstream firm mandates prices downstream
• Presence of local monopolists in the
downstream market who can become active in
resale
• may make it optimal for manufacturer not to use
nonlinear pricing
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Double marginalization and retail services
• In retailing downstream firms often provide
complementary services
• Explain to consumers the functioning of a product
• Thus increase the consumer’s willingness-to-pay or
• Hold excess sales staff to keep lines short
• Moral hazard problem
• manufacturer would like to compensate the retailer for such
efforts but does not observe them
• Market demand Q(p,s) depends on
• The retail price
• Service level or quality provided by the retailer
• Retailer incurs a cost ψ(s) per unit of output
• Under vertical integration maximizes  p  c  sQ p, s
• Solution of this vertically integrated structure pm and sm
© Cambridge University Press 2009
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Chapter 17 – The double-marginalization problem
Double marginalization and retail services
(cont’d)
• Linear wholesale price
• Manufacturer maximizes
w  cQ pw, s
with respect to w at stage 1
• Retailer maximizes
 p  w  sQ p, s
with respect to p and s at stage 2
• With the retail price we have again a doublemarginalization problem
• Retailer distorts its service provision
• Does not take into account that an increase in
services also increases the manufacturer’s profit
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance
• In markets in which retailer’s investments are of
little relevance
• Wonder whether resale-price maintenance inflicts any
social harm
• Manufacturers have an incentive to keep retailer
margins small
• Competition at the manufacturer level may be
sufficiently strong to keep retail prices down
• Arguably a much bigger role for retailers beyond
the reduction of transaction costs
• Retailers engage in costly service provision
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• Single manufacturer and two competing retailers
• Retailers are horizontally differentiated on the Hotelling line
• Compete in prices and service
• Retailer profit
 i  p1 , p2 , s1 , s2    pi  wQ p1 , p2 , s1 , s2   K si 
• Manufacturer’s profit w  cq  q 
1
2
• Without RPM linear non-discriminatory wholesale price w
• Total profit of the industry
PS  p1 , p2 , s1 , s2    pi  c Q1  p1 , p2 , s1 , s2    p2  c Q2  p1 , p2 , s1 , s2 
 K s1   K s2 
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• Total industry profits are maximized only if
PS p1  0
and PS s  0
1
• Retailer i’s profit can be written as
 i  p1 , p2 , s1 , s2   PS  p1 , p2 , s1 , s2   w  c Qi  p1 , p2 , s1 , s2 
  p j  c Q j  p1 , p2 , s1 , s2   K s j 
• First order conditions
Q j
 i PS
Qi

 w  c 
 p j  c
0
pi pi
pi
pi
Q j
 i PS
Qi

 w  c 
 p j  c
0
si
si
si
si
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• Second term: externality with respect to price and
•
•
service level
Third term: horizontal externality
Retailers implement the solution that maximizes total
profits of the full vertical structure if the last two terms in
both first-order conditions cancel out to zero
• Lesson: The use of resale-price maintenance by a
manufacturer leads to higher retail prices and more retail
services if consumers are more sensitive to price
competition than to service competition. Conversely, this
leads to lower prices and fewer retail services if
consumers are less sensitive to price competition than to
service competition.
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• In the Hotelling model outlined above
• Increase in services by the retailer is less effective in
stealing business from the competitor than a
reduction in price
• Retailers are biased towards price competition
• Manufacturer can improve by setting a price floor that
is binding in the equilibrium
• Manufacturer can use two-part tariffs to obtain the full
profit of the vertically integrated solution
• Demonstrates the use of RPM to implement the
vertically integrated solution
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• If one Retailer is engaged in promotional efforts other
retailers may free-ride on its activities
• Additional horizontal externality
• If consumers first seek advice about the usefulness of
product and then shop around for the best price
• Retailer has little incentive to invest in services
• Manufacturer can use resale-price maintenance to
avoid destructive price competition
• RPM protects the profit margin of the retailer
• Since the retailer cannot be undercut, consumers have no
reason to become ‘disloyal’
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Resale-price maintenance (cont’d)
• Possibly anticompetitive effect of RPM
• RPM can affect the sustainability of a cartel in the
upstream market
• Cartels become less stable if wholesale prices cannot be
observed by other cartel members
• Difficult to distinguish between retail price changes due
to cost changes in the downstream market and those
due to individual deviations by cartel members
• RPM eliminates retail price variation
• Price deviations by cartel members are easier to detect
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Exclusive territories
• Increase market power of downstream firms
• Why could upstream firms be interested in granting
market power to downstream firms?
• Exclusive territories may increase downstream investment in
services
• Protects part of the rents that are generated through the investment
• For instance if a car dealer invests in its sales staff to provide
important pre-purchase information, other car dealers who sell
products without these services but at a lower price may undermine
the investment incentives
• Why have upstream firms have an incentive to offer rents
downstream if we abstract from investment decisions
downstream?
• May be in the interest of upstream firms to offer exclusive
territories
• Makes upstream demand less elastic
• Thus reduces competition
• Even though exclusive territories create market power
downstream and thus lead to reduced output in the industry
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Exclusive territories (cont’d)
• Two region model with exclusive territories
Region a
Retailer of product 1
in region a
Retailer of product 2
in region a
Manufacturer 1
Manufacturer 2
Retailer of product 1
in region b
Retailer of product 2
in region b
Region b
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Exclusive territories (cont’d)
• Two-products, two-region price competition model with
•
•
linear market demand in each region
Absent exclusive territories
Pure Bertrand competition between retailers of the same
product
• pia = pib = wi
• Wholesale price wi plus unit cost of retailing, which, for simplicity
•
•
•
•
•
is set equal to zero
Perfectly competitive retailing sector
Two upstream firms set their price as in standard duopoly model
Demand in region k: αk(1 – pik + dpjk), k = a,b , αa+ αb = 1
and 0 ≤ d < 1
Upstream firm maximizes wi (1 – wi + dwj)
p* = w* = 1/(2-d) upstream firm makes profit πc = 1/(2-d)²
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Exclusive territories (cont’d)
• With exclusive territories
• Retailers obtain strictly positive profits under this arrrangement
• Willing to sign contracts which give them exclusivity in their
•
region (under the condition that they do not sell in the other
region)
Timing
• Stage 1: manufacturers set their wholesale price
• Stage 2: after learning the wholesale price of their own supplier,
retailers set retail prices simultaneously
• in region k:
•
•
retailer of product i maximizes
αk(pik – wi) (1 – pik + dpjk)
First-order condition of profit maximization 1 – 2 pik + dpjk + wi = 0
Retailer i does not observe the competing retailer j’s input price
• Has to form an expectation about that price
• Each retailer believes that the competing retailer within the same
region faces the symmetric equilibrium wholesale price w*
© Cambridge University Press 2009
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Chapter 17 – Resale-price maintenance and exclusive territories
Exclusive territories (cont’d)

*
pik wi , w
• If
wi

= w*
2

4d2


1  w
1

d

w
i

2


1  w
pik w , w 
2d

*
*

• Manufacturer i maximizes wi[1 – pik(wi ,w*)+ dpjk(wi ,w*)]
• First order condition
p w , w 
1  p w , w   w
 dp w , w   0
w
*
*
ik
i
ik
*
i
i
ik
i
i
• Due to double marginalization, p > pc
• Profit with exclusive territories π* is larger than profit πc without
exclusive territories as long as d is large enough i.e., the two
products are close enough substitutes
•
Lesson: Manufacturers may make higher profits if they sell through
exclusive territories than if they do not. Retailers are also better off.
However, consumers suffer and total surplus is reduced.
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Anticompetitive effects of exclusive dealing
contracts? The Chicago critique
• Exclusive dealing clauses were largely seen as
•
•
anticompetitve according to the antitrust doctrine that
prevailed in the first half of the twentieth century in the
US
View was challenged by Chicago Law School
Argument
• Downstream firm which foresees that more attractive terms are
•
available under competition will demand a compensation from
the proposing upstream firm for signing a long-term contract with
an exclusivity clause
Exclusive dealing, when observed in practice, due to efficiency
gains
• Correct point: incentives of the downstream firm have to
be considered
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Anticompetitive effects of exclusive dealing
contracts? The Chicago critique (cont’d)
• Two sellers, an incumbent and an entrant offer
purchasing contracts for homogeneous product
• Buyer interpreted as a retailer that operates as a monopolist in
its markets with demand Q(p)
• Incumbent faces constant marginal cost of production cI
• entrant more efficient cE < cI but also has to pay entry cost e
• Assume that entry occurs if no exclusive dealing clause
is signed (cI – cE) Q(cI) > e
• Entry is efficient
• Payment m in return for signing a legally binding
exclusive dealing contract
• Buyer decides whether to accept or reject
• After observing whether exclusive dealing will prevail
• Potential entrant decides whether to enter
• Firms in the market set prices simultaneously
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Anticompetitive effects of exclusive dealing
contracts? The chicago critique (cont’d)
• If the potential entrant did not enter
• Incumbent would obtain monopoly profit
• If the entrant does enter
• Asymmetric Bertrand competition: price is equal to cI
• Incumbent makes zero sales
• For obtaining exclusivity, the incumbent is willing to pay up to
πm
to the buyer up-front
• Buyer suffers a loss from accepting exclusivity: has to pay the price
pm instead of cI
pm
• Loss
CS   Q p dp
• ΔCS > πm buyer cannot be compensated by the incumbent
to
m
CI
accept the exclusive dealing clause at payment m ≤ π
• Not profitable for the incumbent to induce the buyer to accept
exclusive dealing
• Exclusive dealing cannot be anticompetitive
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as
partial deterrence devices
• Modifying previous model to show that vertical
•
integration leads to socially insufficient entry
Show that long-term exclusive dealing contracts can
achieve the same outcome
• Wilingness-to-pay for all consumers to be identical and equal to
•
•
•
•
1
Mass of consumers with unit demand
cI = ½,
cE takes a realization between 0 and 1, is uniformly distributed
between 0 and 1
Socially optimal allocation
• Buyer obtains the good from the incumbent if cI < cE
• Initially incumbent does not know the entrant’s cost parameter
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts
as partial deterrence devices (cont’d)
• First: model with entry in the absence of vertical
integration or long-term contracting
• Equilibrium price is ½ if cI > cE and cE if cI < cE
• Incumbent’s expected profit is
1
 c  c dc  8
• Entrant’s expected profit
1


c

c
dc


8
• Expected price
5
 max c , c dc  8
• Expected net buyer surplus 3/8
1
cI
E
I
E
I
E
E
cI
0
1
0
I
E
E
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as partial
deterrence devices (cont’d)
•
Second: model with vertical integration
• Vertically integrated firm minimizes its expected cost of obtaining
the product
• Internally at cost cI = 1/2
• Externally through the entrant
min p ProbcE  p
p
1
ProbcE  p
2
• Since cE is uniform on [0,1]
min p 2 
p
1
1  p   p  1
2
4
• Incumbent firm offers p = 1/4 to the entrant
•
• Insufficient entry: if cE  (1/4, 1/2), entry does not take place but would
be socially efficient
Lesson: Vertical integration between an upstream and a
downstream seller may lead to an inefficient allocation because the
integrated firm uses its market power to offer too low a price for the
product of the outside seller.
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as partial
deterrence devices (cont’d)
•
Third: long term exclusive dealing contracts
•
•
•
•
At t = 1 the seller proposes a contract to the buyer
At t = 2 the buyer accepts or rejects the contract
At t = 3 the entrant observes its costs and then decides whether
to enter
At t = 4
•
Consider the following contract
• Price competition between sellers if the contract was rejected at t = 2
• The contract applies to the incumbent whereas the entrant sets its price
• Incumbent offers the product at price 3/4
• Sets a penalty for a breach of contract equal to 1/2
•
Suppose the buyer accepts this contract
• Entrant makes an offer to the buyer
3
1
• Buyer accepts any price
p

4
2

1
4
• At stage 4 entrant sets its price equal to 1/4 provided that it covers
cost
• At stage 3 the entrant becomes active if its costs are weakly less
•
than 1/4
Allocation is the same as under vertical integration
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as partial
deterrence devices (cont’d)
• To be checked
1. Buyer must have an incentive to sign the contract
2. Must be profitable for the incumbent seller to propose such a
contract
• On 1
• If the buyer rejects the contract
• Entry takes place if cE ≤ 1/2
•
Price equal to cI = 1/2
• Entry does not take place if cE > 1/2
•
•
The incumbent’s monopoly position allows him to extract the full
surplus
Expected price to be paid by the buyer is
1 1
1
1 1 1
3


Prob cE     Prob cE   1    1 
2 2
2
2 2 2
4


• Buyer has no incentive to reject the contract position by the
incumbent
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as partial
deterrence devices (cont’d)
• On 2
• Show that incumbent is indeed better off with the
long-term contract
• Incumbent seller makes expected profit
p - c I Prob cE


1
1 3 13 1 1
5


  penalty Prob cE       
4
4   4 2  4 2 4 16

© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Vertical integration and long-term contracts as
partial deterrence devices (cont’d)
•
If the incumbent seller did not propose any contract
at stage 1, it would sell at cE whenever cI ≤ cE
• The expected profit
1
1

c

dc



12  E 2  E 8
1
which is clearly less than 5/16
• Lesson: Under imperfect competition, exclusive
dealing contracts that are signed before entry
takes place can constitute a barrier of entry. In
effect, there is too little entry from a welfare
perspective.
• General lesson: exclusive dealing can be
anticompetitive
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Full exclusion and multiple buyers
• Potential entrant has known costs cE < cI
• Suppose entrant enjoys increasing returns thus
average cost is decreasing
• If a sufficiently large number of buyers sign up an
exclusive dealing contract with the incumbent, entrant
cannot offer attractive terms to the remaining buyers
• By signing up with the incumbent, buyers exert a
negative externality on other buyers
• Incumbent thus avoids entry if it manages to
convince a sufficiently large number of buyers to
sign the exclusive dealing contract
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Buyer (mis-)coordination
• Two buyers instead of one
• Buyers simultaneously decide whether to sign the
exclusive dealing contract
• Incumbent is assumed to offer the same contract to both buyers
• In the absence of exclusive dealing contracts, entry by
the more efficient firm takes place: 2(cI – cE) Q(cI) > f
• Assume that an entrant who sells to one buyer only
cannot recover its entry costs at price cI , (cI – cE) Q(cI) < f
• If the incumbent can sign the exclusive dealing contract with one
buyer, entry is not viable
• Incumbent is willing to pay up to πm to each buyer
• Suppose that buyer 2 signs
• Entry will not take place
• Incumbent will set the monopoly price pm independent of whether
buyer 1 signs
• For any positive payment buyer 1 has an incentive to sign
(Applies symmetrically to buyer 2)
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Buyer (mis-)coordination (cont’d)
• Lesson: Due to buyer miscoordination, an
incumbent firm can possibly make buyers sign
exclusive dealing clauses. Here, the incumbent
firm is better off with these clauses in place and
the more efficient rival firm is excluded from the
market.
• Another equilibrium in which buyer do coordinate
their decisions
• In this case: back to the original setting in which
exclusive dealing clauses are not anticompetitive
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Sequential contract proposal
• Incumbent can propose contracts sequentially
• Such sequential contracting is more profitable for the
incumbent than a divide-and-conquer strategy
• Incumbent first offers a contract to buyer 1, then to buyer 2
• Under the assumption 2πm – ΔCS > 0
• Profitable to offer a contract to buyer 2 that it prefers over rejecting
the contract in case buyer 1 rejects the contract
• Buyer 1 foresees if it rejects the contract, the incumbent will make
sure that buyer 2 signs it
• Buyer 1 is willing to sign any contract that leaves a nonnegative net
surplus for itself
• Once buyer 1 has signed, buyer 2 also signs any contract that does
not make it worse off than not buying at all
• Incumbent can exclude the entrant at zero cost
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Exclusive contracts and investment incentives
• Investments at the retailer level that affect the value of a
product
• A seller may train the sales staff of a retailer
• In the absence of exclusive dealing the other seller may
reap some of the benefit from the investment
• Sales staff may use their newly acquired skills to increase the
sales of this alternative seller
• Incumbent seller I, buyer B, entrant E (external source)
• Incumbent seller or the buyer decides about an
•
•
investment which is not contractible
In the absence of exclusive dealing, buyer is free to buy
from an external source
With exclusive dealing, buyer needs to obtain the
agreement of the incumbent seller to use the external
source instead
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Exclusive contracts and investment
incentives (cont’d)
• Suppose that the entrant seller does not have
any bargaining power
• Concerning incumbent seller and buyer: the two
parties evenly split the surplus that is achieved
on top of the disagreement value
• First understand
• Exclusive dealing contract does not affect investment
levels if the investment does not affect the surplus
obtained by contracting with the external source, i.e.,
if it leaves disagreement profits unchanged
• Total surplus
TS cI   max r  cI , r  cE 
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Exclusive contracts and investment
incentives (cont’d)
• Nonexclusive contracts
• Buyer’s profit is
r  cE   max r  cI   r  cE ,0/ 2
• Incumbent seller’s profit is
max r  cI   r  cE ,0/ 2  AI cI 
• The profit maximizing investment level AI(cI)
determined by the solution of TS'(cI)/2= AI'(cI)
© Cambridge University Press 2009
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Chapter 17 – Exclusive dealing
Exclusive contracts and investment
incentives (cont’d)
• Under exclusion
• Incumbent seller and buyer obtain max r  cI ,0/ 2
• Disagreement levels are independent of the
incumbent seller’s investment
• Its investment choice is not affected by the presence of
exclusive dealing
• Lesson: In a bargaining environment in which
incumbent seller and buyer share any surplus above
their disagreement profits and in which profits of any
entrant seller are held down to zero, exclusive
dealing does not affect the surplus that can be
generated by contracting with the entrant seller
instead.
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Chapter 17 – Exclusive dealing
Exclusive contracts and investment incentives (cont’d)
•
•
•
Show that exclusive dealing can be efficiency-enhancing
•
Suppose that there are positive spillovers
• Also cE depends negatively on the investment level:
When reducing cI the incumbent seller also reduces cE
Under an exclusive contract
•
Incumbent seller’s profit is
•
Incumbent seller now obtains
max r  cI   r  cE ,0/ 2  AI cI 
With the nonexclusive contract
max r  cI   r  cE cI ,0/ 2  AI cI 
•
Profit-maximizing investment level determined by solving
 1  c c / 2  A c 
'
E
I
'
I
I
in cI
• Left-hand side is greater than TS'(cI)/2= –1/2
•
Incumbent seller has a stronger incentive to invest under exclusion
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Chapter 17 – Vertical oligopoly and vertical mergers
Exclusionary effects of vertical mergers
• Input foreclosure: vertical integration may lead to
higher input prices for competitors
• Higher price may be due to vertically integrated
•
•
firms not selling inputs on the market or, at least,
restricting their supply
Vertical integration can be used as a tool to increase
rival’s costs
Lesson: Vertical integration may raise the costs of
nonintegrated downstream rivals. A higher
wholesale price may or may not lead to higher retail
prices.
• Such mergers may not hurt consumers (since retail
prices may fall) and often are not profitable for the
firms involved in the merger
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Chapter 17 – Vertical oligopoly and vertical mergers
Coordinated effects of vertical mergers
• Vertical integration may improve the viability of
collusion among competing firms
• Key reason for vertical integration facilitating
collusion: outlets effect
• Vertical integration by an upstream firm reduces the
number of outlets through which its rivals can sell
when deviating
• Reduces their profit from cheating and thus facilitates
collusion
• Counteracting: punishment effect
• If an upstream firm integrates with a downstream firm
these profits now become part of the merged entity
• The merged entity can expect to make more profits in the
non-cooperative punishment phase than the upstream firm
would make alone
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Chapter 17 – Vertical oligopoly and vertical mergers
Coordinated effects of vertical mergers
(cont’d)
• Merged entity suffers less than a stand-alone
upstream firm from a switch from collusive to
punishment phases
• outlets effect outweighs the punishment effect so
that the net effect of a vertical merger is to
facilitate collusion
• Lesson: Downstream vertical integration
reduces the number of outlets through which
upstream rivals can sell and thus reduces profits
if deviating from a collusive outcome. Vertical
integration may then facilitate collusion.
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Chapter 17 - Review questions
Review questions
• Suppose that an industry consists of two upstream
monopolists who exclusively sell at a linear price to one
downstream firm each. What would be the effect of
vertical integration (so that each upstream monopolist
owns its retail outlet) on the final good price?
• What are possible efficiency-defences of the use of
resale-price maintenance?
• For which reasons can it be profitable for manufacturers
to grant exclusive territories to their retailers?
• Provide two reasons why the Chicago school argument
on exclusive dealing (namely that, whenever exclusive
dealing is observed, it must be welfare improving) is
wrong.
• Should competition authorities prohibit vertical mergers
that lead to higher input prices?
• What are possible coordinated effects of vertical
mergers?
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