Vertical and Horizontal Integration.
Mergers
1
Vertical Integration
•Vertical relationships: relations between firms involved in sequential steps
of production
Example:
Upstream firm
Wholesaler
Downstream firm
Retailer
Intermediate good
Subcontractor
Final good
General contractor
•Vertical Integration: organization of more than one sequential stages of
production within one firm
•Firms integrate or not
“make or buy” decision
2
Why integrate?
•
Eliminate Transaction costs
1.
2.
Contracting costs
Opportunities for “holdup”=opportunism* by one party to a relationship when other
party is in a weak bargaining position (e.g. auto manufacturer buys parts from
specialized parts supplier. Key: part supplier has invested in “relationship-specific
capital”)
*It makes sense in asymmetric info. Otherwise you can write down everything (for every
possible contingency in the contract)
•
Coordinate production
1.
2.
Physical condition issues
Avoid inventory costs (“just in time production”)
•
Exert markets power in the downstream market
3
Vertical restraints
•
•
Restriction by upstream firm on behavior of downstream
firms
Motivation for vertical restraints:
1.
2.
3.
Vertical externalities
Double marginalization problem
Vertical service externality (part of the benefit of providing good service
goes to manufacturer)
•
Horizontal externalities
1.
2.
Horizontal price externality (usual oligopoly competition)
Horizontal service externality (e.g. high street store with trained sales staff,
customers come and check out product, but buy online)
4
Horizontal mergers
• Mergers of competitors
• Unilateral Effects (as opposed to Coordinate Effects):
Concerned with effects of changing market shares on price
and welfare
• Antitrust (Competition) Policy in the EU and the US
5
Strategic Investment
and Non-Price Competition
6
Research and Development
7
Introduction
• Technical progress is the source of rising living
standards over time
• Introduces new concept of efficiency
– Static efficiency—traditional allocation of resources to
produce existing goods and services so as to maximize
surplus and minimize deadweight loss
– Dynamic efficiency—creation of new goods and services
to raise potential surplus over time
8
Introduction 2
• Schumpeterian hypotheses (conflict between static
and dynamic efficiency)
– Concentrated industries do more research and
development of new goods and services, i.e., are more
dynamically efficient, than competitively structured
industries
– Large firms do more research & development than small
firms
9
A Taxonomy of Innovations
Product versus Process Innovations
• Product Innovations refer to the creation of new goods and
new services, e.g., DVD’s, PDA’s, and cell phones
• Process Innovations refer to the development of new
technologies for producing goods or new ways of
delivering services, e.g., robotics and CAD/CAM
technology
• We mainly focus on process or cost-savings innovations but
the lines of distinction are blurred—a new product can be
the means of implementing a new process
10
A Taxonomy of Innovations 2
Drastic versus Non-Drastic Innovations
• Process innovations have two further categories
• Drastic innovations have such great cost savings that they
permit the innovator to price as an unconstrained
monopolist
• Non-drastic innovations give the innovator a cost
advantage but not unconstrained monopoly power
11
Drastic versus Non-Drastic Innovations
• Suppose that demand is given by: P = 120 – Q and all
firms have constant marginal cost of c = $80
• Let one firm have innovation that lowers cost to cM = $20
• This is a Drastic innovation. Why?
– Marginal Revenue curve for monopolist is:
MR = 120 – 2Q
– If cM = $20, optimal monopoly output is:
QM = 70 and PM = $70
– Innovator can charge optimal monopoly price ($70)
and still undercut rivals whose unit cost is $80
12
Drastic versus Non-Drastic Innovations 2
• Now consider the case if cost fell only to $60,
innovation is Non-drastic
– Marginal Revenue curve again is: MR = 120 = 2Q
– Optimal Monopoly output and price: QM = 30; PM = $90
– However, innovator cannot charge $90 because rivals
have unit cost of $80 and could under price it
– Innovator cannot act as an unconstrained monopolist
– Best innovator can do is to set price of $80 (or just
under) and supply all 40 units demanded.
13
Drastic vs. Non-Drastic Innovations 3
Innovation is drastic if monopoly output QM at MR = new marginal
c’ exceeds the competitive output QC at old marginal cost c
$/unit = p
$/unit = p
QM
Drastic Innovation:
>
QC so innovator can
charge monopoly price
PM without constraint
c
PM
NonDrastic Innovation: QM
< QC so innovator cannot
charge monopoly price PM
because rivals can undercut
that price
PM
c
c’
Demand
c’
Demand
MR
QC QM
MR
Quantity
QM QC
Quantity
14
Innovation and Market Structure
• Arrow’s (1962) analysis—
– Innovative activity likely to be too little because innovators
consider only monopoly profit that the innovation brings and not
the additional consumer surplus
– Monopoly provides less incentive to innovate that competitive
industry because of the Replacement Effect
• Assume demand is: P = 120 – Q; MC= $80. Q is initially 40.
Innovator lowers cost to $60 and can sell all 40 units at P = $80.
• Profit Gain is $800–Less than Social Gain
$/unit
120
Initial Surplus is Yellow Triangle--Social
Gains from Innovation are Areas A ($800)
and B ($200)
But Innovator Only Considers Profit Area
A ($800)
80
60
A
B
40
60
120
Quantity
15
Innovation and Market Structure 2
• Now consider innovation when market structure is monopoly
– Initially, the monopolist produces where MC = MR = $80 at Q =
20 and P = $100, and earns profit (Area C) of $400
– Innovation allows monopolist to produce where MC = MR = $60
at Q = 30 and P = $90 and earn profit of $900
– But this is a gain of only $500 over initial profit due to
Replacement Effect—new profits destroy old profits
$/unit
120
100 C
Monopolist Initially Earns Profit C—With
90
Innovation it Earns Profit A—Net Profit Gain
80
is Area A – Area C
60
A
Which is Less than the Gain to a Competitive
Firm
20 30
MR
60
Demand
120
Quantity
16
Innovation and Market Structure 3
• Preserving Monopoly Profit--the Efficiency Effect
• Previous Result would be different if monopolist had to worry
about entrant using innovation
– Assume Cournot competition and that entrant can only enter if it
has lower cost, i.e., if it uses the innovation
– If Monopolist uses innovation, entrant cannot enter and monopolist
earns $900 in profit
– If Monopolist does not use innovation, entrant can enter as lowcost firm in a duopoly
• Entrant earns profit of $711
• Incumbent earns profit of $44
– Gain from innovation now is no longer $900 - $400 = $500 but
$900 - $44 = $856
– Monopolist always has more to gain from innovation than does
entrant—this is the Efficiency Effect
17
Advertising, Competition and
Brand Names
18
Introduction
• Advertising is a weapon in the competition between firms
• Creating & securing a brand identity can be helpful to
consumers
– Consumers may have a taste for variety; each consumer may like
a different version of a particular product
– Advertising can match consumers with the version they most
prefer
– But advertising can also be an uninformative and wasteful form
of competition
• Evaluation of advertising’s competitive role requires an
understanding or clear model of how advertising works
• Consider a simple model where firms can either spend a
little or a lot on advertising
• If advertising by one firm largely cancels the advertising of
its rival, then this can result in an “advertising” war with
both firms spending excessively on advertising
19
Nash Equilibrium is for both firms to choose
the high level of advertising expenditures. This
Advertising
as Wasteful
does not maximize
their jointCompetition
profit. Each
firm’s advertising
undoesAdvertising
the promotional
Example
of a Wasteful
War
efforts of its rival. The result is excessive
advertising that largely cancels
itself out with
Gamma
little gain to consumers and lower profit for
firms
Low Advertising High Advertising
Expenditure
Expenditure
Low Advertising
Expenditure
$450, $450
$375, $500
High Advertising
Expenditure
$500, $375
$400,$400
ZIP
20
Advertising, Information, & Product Differentiation
• Recall the Hotelling Model (Chapter 10)
– N Consumers distributed uniformly along a line
– Two firms—one at each end of the line
Firm X
Firm Y
– Each consumer is willing to pay V for the basic product
– But consumers incur “transport” cost of t per unit of
distance traveled to firm
– Equilibrium prices (with the entire market being served):
p1 = p2 = c + t
21
Advertising, Information,Product Differentiation 2
• Now apply Grossman and Shapiro (1984) approach:
– Each firm chooses advertising expenses aimed at
reaching the fraction X or Y of the N consumers
– From perspective of firm X, a fraction X(1 - Y) (indicated
by “x”)of consumers will know of its product only and a
fraction X Y (indicated by *) will know of both X and Y
x
Firm X
* x
x
*
x
x*
x
*
Firm Y
– Firm X is a monopoly with respect to the uniform but less
dense population of X (1 - X) N consumers who know only X
–Assume that equilibrium pX is low enough that all of these buy
1 unit of X
Firm X
Firm Y
22
Advertising, Information, Product Differentiation 3
• Firm X competes with Firm Y for the also less dense but
uniform population of XY who know of both goods
Firm X
Firm Y
– So, total demand facing firm X is:
 p X  t  pY 
QX   X 1  Y N   X Y 
N
2t


•Firm Y faces a similar demand
• Each firm must choose
– how much advertising to do, i.e., how big  should be
– What price to charge?
23
Advertising, Information, Product Differentiation 4
• Assume that advertising expense TAi for firm i where i
equals either X or Y, depends on the total number of
consumers reached as follows:
TAi 

 i2 N
2
Then the marginal cost of advertising TAi’ is:
TAi'   i N
• Profit maximization at both firms now results in two
best response functions, one for prices and one for
advertising. Solving these jointly then yields the
equilibrium price and advertising expenditures at each
pi  c  2t
2
and  i 
1  2 / t
24
Advertising, Information, Product Differentiation 5
• Note that  must be greater than t/2 in order to maintain
our assumption that i < 1 for each firm, i.e., we must
assume that advertising is a bit expensive relative to
consumer taste for variety in order to have some
consumers uninformed
• In turn, this means that the equilibrium price is now higher
than it was in our benchmark Hotelling case that assumed
all consumers were perfectly informed
Equilibrium Price
Fully Informed Case
Imperfectly Informed Case
pi  c  t
pi  c  2t
Information is costly. The cost of providing it through
advertising has to be reflected in the product price.
25
Advertising, Information, Product Differentiation 6
• Two additional insights also follow
– Advertising as the consumer taste for variety t increases.
• Recall equilibrium advertising level is
2
i 
1  2 / t
• This increases as t increases.
• Product differentiation and advertising are positively linked
NOT because advertising causes product differentiation but
because specialized consumer tastes leads firms to advertise.
• Profits rise as advertising becomes more costly (as  rises).
• Firm profitability is:
i 
1 
2N
2 / t 
2
• As  rises, firms do less advertising and fewer consumers
know about both products  softer price competition/more
profits.
26
Building Brand Value vs Extending Brand Reach
• Advertising in the Grossman and Shapiro model is pure
information. This begs the question as to how advertising
precisely works
• Becker and Murphy (1993) argue that advertising works as a
complement to the product, i.e., it enhances consumer
valuation of the good or service
• Two ways complementary advertising can work
– Consumers prefer to purchase brands that are well known, i.e.,
advertising builds brand value in that consumers are willing to
pay more for a well-known brand. This is close to an
“advertising as persuasion” view
– Advertising provides information that enhances product value,
e.g., where to go for related services such as hotels advertising
nearby tourist sites. Here, advertising is truly informative and
works therefore to bring in new customers, that is, to extend the
brand’s market reach
27
When Advertising Builds Brand
Value it Rotates the Demand Curve
up along theBuilding
price axis from
D1 to vs
Value
D2. For a monopolist, the optimal
quantity does not change but the
price rises.
When Advertising Extends th
Extending
Reach
2 It rotates the
Market
Reach
curve out along the quantity
D1 to D2. For a monopolist, t
$/unit = p
price does not change but the
customers rises.
$/unit = p
P2 *
D2
P1 *
D1
QM
PM
D2
D1
Quantity
Q1*
Q2*
Quantity
28
Building Value vs Extending Reach 3
• The evaluation of advertising efforts from a social
welfare or efficiency point of view requires that we
understand whether advertising predominantly builds
value or extends market reach
• This is even more true when we add in some
competition.
– When there is more than one firm and advertising
extends market reach advertising may well be excessive
• Now advertising works by stealing customers from rivals
• Much greater possibility that game is like the wasteful
advertising game described at start of chapter
– When advertising works to build value, excessive
advertising is less likely because advertising now works
to permit charging existing customers a higher price—
not by taking customers from rivals.
29
Building Value vs Extending Reach 4
• Amount of advertising is also likely to depend critically
on nature of price competition and number of firms
– When price competition is naturally fierce, firms may
advertise a lot to differentiate their product and soften
price competition
– When the number of firms is small, firms may again
advertise more because most of the gains of a firm’s
advertising flow to that firm itself and not to its rivals
– Note the potential interaction of these two effects.
• Since advertising is largely a sunk cost, the need to do a lot of
advertising to soften price competition may limit the
equilibrium number of firms
• As number of firms falls, each one advertises more
• Advertising/sales ratio may be high in concentrated industries
but again causality is not from advertising to concentration
• ReaLemmon Case
30
Cooperative Advertising
• In contrast to analysis so far, much advertising and
promotion is done by retailer on manufacturer’s behalf
• Manufacturer and retailer may therefore wish to act
cooperatively so as to avoid problems of
underprovision of services discussed in Chapter 18
– Retailer may try to free ride on promotional efforts of
other retailers
– Retailer may substitute less-costly brands for
manufacturer’s product
• These cooperative arrangements take a variety of
forms such as slotting fees, “pay-to-stay” fees, and
failure fees
• However, they all result in the manufacturer paying
part of the retailer’s promotional expense
31
Cooperative Advertising 2
• Because cooperative advertising contracts can
resolve many of the manufacturer/retailer conflicts
they have the potential to promote economic welfare.
• But, cooperative advertising can also be used to
suppress or weaken competition
– McCormick Spice may have used slotting fees to buy shelf
space preemptively and foreclose it to rival spice firms
– Slotting and promotional fees can be offered on different
terms to retailers (price discrimination)
•
•
usually large retailers will get a quantity discount
Large retailers (WalMart, Borders) then gain
competitive advantage over small ones (independent
retailers and bookstores)
– Slotting fees may be paid to retailer in return for keeping
retail price high (Resale Price Maintenace)
32
Empirical Application: Information versus
Prestige in Advertising
• Can we devise clear empirical tests that truly identify
the precise role of advertising?
• Ackerberg (2001) is an effort to do just that. He
looks at the impact of advertising that accompanied
the introduction of a new, low-fat yogurt product by
Yoplait in 1987-88.
• Specifically, Ackerberg tests whether this advertising
was primarily informative or instead worked by
appealing to the status consciousness of the
consumer
33
Empirical Application: Information versus
Prestige in Advertising 2
• The Data
– In April of 1987, Yoplait made its first entry into the
low-fat, low-calorie yogurt category with Yoplait 150.
– This corresponds to the time period in which A. C.
Nielsen collected information on about 2,000
households split between Sioux Falls, South Dakota
and Springfield, Missouri
• Monitors were attached to the TV’s in these households;
• Scanner data was used to monitor their trips to the
supermarket and what they bought
34
Empirical Application: Information versus
Prestige in Advertising 3
– The Nielsen data cover 12 months starting three
months after the April intro of Yoplait 150
– Thus these data give Ackerberg measures of the
exposure of these housholds to Yoplait 150
television commercials as well as records of
their Yoplait 150 purchases (if any)
– In particular, Ackerberg can measure whether
the consumer is a first-time or previous user of
Yoplait 150 and how many ads they have seen
35
Empirical Application: Information versus
Prestige in Advertising 4
– For each town or market, Ackerberg creates two time
series from the data covering specific market days over
the 12-month period
• One series is the number of first-time purchases of Yoplait 150
as a fraction of the number of shopping trips that day
• The other is the number of repeat purchases of Yoplait 150 as a
fraction of the number of trips that day
• He also has data on the Yoplait 150 price (PRICE)for each day
in each market as well as for the number of television
advertisements (ADS) for Yoplait 150 to which the buyer had
been exposed
36
Empirical Application: Information versus
Prestige in Advertising 5
• As a preliminary step, Ackerberg (2001) runs two
separate OLS regressions
First time purchases = a0 + a1PRICE + a2ADS + a3MARKET +ei
Repeat purchases = b0 + b1PRICE + b2ADS + b3MARKET + ui
• Here, MARKET is a dummy variable equal to 1 is the data
are from Springfield but 0 if from Sioux Falls
• Ackerberg’s argues that if advertising is mainly
information, it will have a much bigger effect on first time
buyers than on experienced ones
• In other words, a2 should be larger than b2
37
Empirical Application: Information versus
Prestige in Advertising 6
Ackerberg’s preliminary results are shown below
Dependent Variable
Initial Purchases
Repeat Purchases
Coefficient Std. Error Coefficient Std. Error
PRICE
-0.038
(0.013)*
-0.029
(0.014)*
ADS
0.030
(0.015)*
0.014
(0.017)
MARKET 0.002
(0.001)*
0.006
(0.001)*
*Indicates significant at the five percent level.
38
Empirical Application: Information versus
Prestige in Advertising 7
Ackerberg’s preliminary results thus show:
1) Yoplait 150 price increases reduce demand significantly
2) Springfield consumers like Yoplait 150 more than Sioux
Fall consumers
3) Advertising only raises demand significantly for first
time buyer
The last finding is the important one. It confirms the
view that advertising is mostly informative and, in
particular, informative about the product’s
existence and its primary characteristics
39
Empirical Application: Information versus
Prestige in Advertising 8
Since any purchase is a 1,0 decision, Ordinary
Least Squares (OLS) is not the best estimation
technique.
Instead, one needs to use a probit or logit approach
Also, one should in principle allow for other
factors such as the price of rival yogurts.
Ackerberg (2001) makes all these modifications but
still finds his basic result. Advertising has by far
its biggest and most statistically significant effect
on first-time buyers.
Advertising is primarily information
40