Competition Policy
Vertical Restraints
What are vertical restraints?
 In many markets producers sell their goods through
intermediaries: wholesalers and retailerssign contracts
to guarantee supply stability and improve coordination
 These agreements in the vertical chain are called vertical
restraints
 What is optimal for a manufacturer is not necessarily
optimal for the retailer one party can try to use
contracts to restrain choice and induce the best outcome
for itself
 Example: the manufacturer wants to improve the
marketing efforts of the retailer1) it may assign an
exclusive area to the retailer so that the latter will fully
appropriate the results of his efforts 2) It may use a
non-linear wholesale price (the retailer gets a discount if
it buys a large quantity of the goods)
Most common vertical restraints
 Non linear pricing
 Quantity discounts
 Resale price maintenance (makes sense
if the price paid by the consumer is
observable as in the case of consumer
goods
 If the manufacturer finds it difficult to
use contracts then it could resort to
vertical integration  merge with (or
take over) the retailer
Intra-Brand Competition
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Welfare effects of vertical restraints whne they affect
competition between retailers that sell the same product (or
brand)
A manufacturer (monopolist) may sell through one or more
retailers
If both the M and the R have market power, both charge a
positive mark-up the final price is too highDouble
Marginalizationwith vertical restraints or vertical integration
price would decrease and welfare would increase
If several retailers distributed the same brand they would be
unable to appropriate their marketing effortthey reduce their
efforts Underprovision of sales servicesvertical restraints
give incentives to retailers to improve their effortEX.Give
exclusive territories if consumers value these services
welfare increases
The Commitment Problem
 Vertical restraints and vertical mergers may
have an adverse effect on welfare when they
help the manufacturer to keep prices
highwithout them it would not be able to
commit to high prices
 EX.a successful brand has not beeen sold yet
ina region – the expected profit from selling it
is Π – several franchisee are ready to sell the
brandIf the manufacturer offered exclusivity
to one franchisee competitive bidding will lead
the winning bidder to offer Π to the up-stream
firm
The Commitment Problem
 Once it has sold the franchise the up-stream
has an incentive to renege on its exclusivity
promise and offer a second franchisee
(promising there will be no more than two) and
obtain an additional gain Π/2 (the first
franchisee incurs a loss = Π/2 )…then it can
offer a third franchisee…
 Potential franchisee would anticipate this
behaviour and if the manufacturer is unable to
commit on a single franchisee then nobody
wants the licence..
The Commitment Problem
 Because of this problem a firm cannot
appropriate its potential market power in the
example the franchisee could accept to buy the
licence only at a low price and the producer
gains a low profit
 The same commitment problem arises when a
firm has an input to be sold to more than one
buyer incentive to renegotiate the contract
with some buyers after having concluded the
contract with all of them if contracts are not
observable better terms can be renegotiated
with some buyers
Vertical Mergers
 An obvious solution for the manufacturer to commit to
higher prices is to merge with one of the downstream
firmsit internalizes the profit made by its affiliate it
has no incentive to offer better terms to other
downstream firms (it will reduce the profit made by its
affiliate)
 The foreclosure of rival downstream firms will follow as
the upstream unit would not supply the input to rival
retailersmonopoly power is restored! (if there are no
competing suppliers of the input)
 With alternative (less efficient) upstream suppliers prices
will increase but to a less extent, due to the retailers
threat to switch suppliers limit to the exercise of
market powerso vertical restraints may negatively
affect welfare but the nefative effects may be limited by
the existence of competing suppliers
Exclusive territories
 If it is possible to conclude a legal contract that
grant exclusivity to one supplier in each area
then the manufacturer problem is solved
 In the region protected by esclusivity
competition among retailers will bring them to
pay up to the monopoly price to be a
monopolist retailer in the area the
manufacturer restores its market power
 Exclusive territories then harm welfare
consumers pay the monopoly price rather than
the lower price to be set without the esclusivity
clause
Resale Price Maintenance
 Since the problem of the monopolist is to avoid
renegotation that leads to lower prices the
commitment problem is solved if the monopolist commit
to industry-wide prices
 EX.RPM clauses as in the case of books or
pharmaceuticalsthe producer prints the price on the
products that cannot be sold at a discount price (the
retailer can be taken to courts if it did)
 There is no incentive for the producer to cut secretly
wholesale prices  a price cut would not increase final
slaes but worsen the distribution of profits between the
producer and the retailer that receives a discount
Conclusions
 The magnitude of the damage created by vertical
restraints (or a vertrical maerger) depends on the
upstream firm being or not a monopolist  if there are
competing suppliers the damage is lowcompetition
policies should then monitor such practices only when
undertaken by firms with enough market power
The Commitment Problem