graduate school of management and economics industrial...

In the Name of God

Sharif University of Technology Graduate School of Management and Economics

Industrial Organization 44772 (1392-93 1st term)

Dr. S. Farshad Fatemi

Vertical Relationships

Industrial Organization Dr. F. Fatemi Page 141 Graduate School of Management and Economics – Sharif University of Technology

Vertical relationships: questions

How do input suppliers / manufacturers / retailers affect one

another?

Do incentives of manufacturers and retailers diverge?

How are prices determined?

Wholesale prices

Retail prices

Why do vertically-related firms sign complex agreements? What are

the economic effects of these mechanisms?

Policy towards vertical restraints and vertical merger


Vertical relationships

So far we have thought of firms as single entities which make

products and sell them to final consumers

But most industries involve a chain of production, with a number of

stages which must take place in sequence, e.g.

Raw inputs: energy, raw materials, components

Manufacturing of finished product

Distribution / retailing

Vertical integration: All stages are undertaken by a single firm

Vertical separation: Stages are undertaken by separate firms

Transfers and transactions take place between the firms


Examples of vertically-related industries

Gas production, transportation and supply

Gas production in North Sea by oil companies (BP, Shell, Exxon Mobil)

Transportation within UK by National Grid Transco (NGT)

Supply by Centrica(British Gas), electricity suppliers, Sainsburys

Petrol: oil extraction/refining and service stations

Oil companies produce oil and refine into petrol

Service stations: some controlled by oil companies; supermarkets

Car manufacturing and distribution

Manufacturers: Ford, BMW, Fiat

Distribution: independent chains and individual dealerships


Vertical restraints

In reality, there is not a clear-cut distinction between vertical

integration and separation

Separate but vertically-related firms often use contractual clauses

and practices to restrict one another’s behaviour

These are called vertical restraints. E.g.

Resale price maintenance (RPM)

Quantity forcing

Exclusive distribution/territories and selective distribution

Exclusive dealing

Franchising agreements


Types of vertical restraints

Resale price maintenance (RPM)

Manufacturer imposes conditions on the price at which the retailer sells

the good to final consumers

Pure RPM: manufacturer specifies a single retail price

Maximum RPM: retailer agrees not to sell above a specified retail price

Minimum RPM: retailer agrees not to sell below a specified retail price

Quantity forcing

Similar to maximum RPM, but achieved by specifying a minimum

quantity to be sold rather than a maximum price

May be achieved through bulk discounts or bonus payments


Exclusive distribution / territories

Manufacturer appoints a single, exclusive distributor within a particular

geographic territory

E.g. car manufacturer appoints a single distributor in each area

Typically a contract guarantees the distributor this exclusivity

Selective distribution

Manufacturer only allows its product to be sold by retailers whosatisfy

certain minimum quality or service standards

Tends to restrict number of retailers (due to higher costs):

akin to exclusive distribution

Manufacturer also refuses to supply non-selective outlets


Exclusive dealing

Distributor agrees not to stock rival products

E.g. VW distributor agrees not to sell cars of other makes

Franchising agreements (e.g. McDonalds)

Often involve a number of vertical restrictions

May charge a franchise fee or royalty to extract profits

Forms of bundling

Full-line forcing: retailer must take the whole product line in orderto

obtain any one product

Tie-in sales: cannot buy product X without also buying Y, in fixed

proportions


Vertical and horizontal relationships

Horizontal

Products are substitutes

Each firm would like others to raise price

Vertical

Products are complements: this reverses many interrelationships

Each would like others to reduce price

e.g. manufacturer would like distributor to charge a low retail

price, for a given wholesale price, as this increases demand for

the manufacturer’s product without lowering its profit margin

Thus, agreement between the firms may be a good thing

Other actions of distributor may also affect manufacturer

e.g. investment, advertising, services provided to customers


Issues arising in vertical relationships

Various externalities exist between vertically-related firms

Pricing externality: results in double marginalisation

Other externalities, e.g. service provision and quality

These imply that vertical integration or restraints may be beneficial,

both privately and socially

Other efficiency motives for vertical integration

Foreclosure

A firm with monopoly power at one stage of production may use

vertical integration or restraints to foreclose a related market

Reduce competition, exclude rivals and/or prevent entry

This is the main focus of policy concerns over vertical relationships


Pricing externality

Problem arises when imperfect competition at both stages

Simple framework: one manufacturer and one retailer

Manufacturer M sells its product to the retailer R, charging a uniform

wholesale price w (i.e. no two-part tariffs or bulk discounts)

Retailer R sells to final consumers, setting the retail price P

Integrated firm: set P such that gain from a further increase in price

is exactly offset by the resulting fall in demand

Separation: R takes account of loss of its own profit margin but

ignores impact on M

Retail price will be too high: it will exceed the monopoly price

This problem is known as double marginalisation


Model of double marginalization

M sells product to R who sells to final consumers

Final consumers have demand function Q = 1 –P

M sets wholesale price w; R sets final price P

M has marginal cost c; R has no mc other than w

Assuming profit-maximization by M and R, we can derive

expressions for

P under vertical separation

P under vertical integration

and show that P falls when vertical integration takes place


Overcoming double marginalization

Both firms and consumers would be better served if the retail price

were lower

Possible remedies

Perfect competition downstream

Vertical integration

Resale price maintenance: maximum RPM

But this might be illegal

Recommended retail price (RRP): can have similar effect

Quantity forcing

Two-part tariff: set w = c and charge (lump sum) franchise fee to extract

profit

Problems if demand is uncertain or R has asymmetric information


Service externalities

Demand may depend on services that are provided with the

product (as well as its price)

Advertising and promotional activities

Pleasant surroundings (e.g. pubs)

Information provided by sales staff; customer trials

Delivery speed and area covered

After-sales services and warranties

Key features of these services are that

They are provided and (generally) paid for by the retailer

Higher provision tends to increase sales

When both parties have positive profit margins, this benefits the

manufacturer as well as the retailer

Industrial Organization Dr. F. Fatemi 4 Graduate School of Management and Economics – Sharif University of Technology

Model of service provision

The model will be demonstrated in Lecture

Vertical integration results in a higher level of service provision

Conclusions

Vertical integration tends to raise service provision

Customers benefit from this too

Integrated firm should also choose the correct balance between service

provision and price reduction

Both strategies reduce profit and the integrated firm will choose

whichever increases demand the most


Markets with multiple retailers

Multiple retailers of the same manufacturers product

May be located in different geographical areas(e.g. retailers of books,

electronic equipment, cars)

Price competition between retailers

Intra-brand competition

Good for manufacturer as reduces retailer margins and increases sales:

helps overcome double marginalization

Service provision: spill-overs between firms

Services provided by one retailer may benefit other retailers( e.g. test

drive car at showroom, then buy over the Internet for a lower price)

Positive externality between retailers (as well as to manufacturer)

This is bad for the manufacturer (and for customers)


Overcoming service externalities

Service provision will be too low, for two reasons

Positive externalities between retailer and manufacturer

Positive externalities between retailers

Both tend to reduce service provision, lowering manufacturer’s profits

and consumer welfare

Possible remedies

Integration

Between M and R

Between different R’s

Contractual restraints


Integration to overcome service externalities

Integration between M and R

Internalizes pricing externality, reducing P and increasing Q

Internalizes service externalities, increasing S

Possible disadvantage: retailer is “closer to the market”

R has better information about consumer demand

Vertical integration may weaken this

Integration between retailers

Internalizes service externalities between firms, increasing provision

But reduces competition between retailers: competition would reduce

retail margins and increase sales

Thus, likely to worsen the double marginalization problem

Also may not be permitted by competition authorities!


Vertical restraints and service provision

Selective distribution

M directly specifies minimum service standards: reduces under-

provision; but

M may be less well-informed than R about effect of S on

demand;

Monitoring difficulties

Exclusive distribution

M appoints a single, exclusive retailer within a particular area: reduces

horizontal spill-overs between retailers

But does nothing to reduce vertical externality between R and M

Resale price maintenance

M specifies a (minimum) retail price

With fixed prices, retailers compete by offering higher quality services

But reduces the benefits of price competition between retailers


Assessing vertical integration & restraints

So far we have seen vertical integration and restraints in a generally

positive light

But we have treated market structure and the degree of

competition as given

Possible anti-competitive effects: vertical structures can be used to

Change market structure

Foreclosure to weaken, exclude or evict competition

Reduce competition between firms

Facilitate (horizontal) collusive by making price cuts more

transparent

Implement (geographic) price discrimination


Case study: New Cars distribution (CC 2000)

SED system: Selective and Exclusive Distribution

Exclusive territories and exclusive dealing

Refusal to supply retailers other than franchised dealers

Prohibition on reselling by dealers except to final customers and

other franchised dealers

Showroom and service standards, staffing and training,

advertising

Requirement to provide after-sales servicing and repairs

List prices; quantity-forcing measures (targets and bonuses)

Detailed business information provided to manufacturer

EU Block Exemption for car distribution agreements

1999: CC investigation following concerns that UK car prices were

high compared to other EU countries


New cars: market definition

Product market definition: new cars

Used cars do not sufficiently constraint new car prices

Geographical market definition

CC regarded geographical market as UK

UK uses right hand drive (RHD) cars, Continent uses LHD

(though can be ordered from dealers elsewhere in EU)

Japanese imports limited by voluntary export restraints (VERs)

(1975-1999)

Tax regime: under EU VAT rules, a car buyer pays the VAT rate

relating to the home country, not country of purchase

VAT rates vary considerably (15% –200% for some models)

Are pre-or post-tax comparisons appropriate?


New cars: market segmentation

Large and persistent differences in EU pre-tax prices

CC compared UK prices with France, Germany and Italy, 1993-9

Found UK prices higher by 3.5-7.1% over the 6 years

Sterling appreciated in 1996-7: in latter half of period UK prices

were higher by 10.1-12.6%

May 1999 (most recent) survey, excluding 3 high-tax countries

For 58 of 71 models analyzed, UK price was at least 20 per cent

higher than in the cheapest country

Sensitive to exchange rates; taxation; differences in discounts,

benefits and trade-ins; differences in specifications

Within UK, big discounts for fleet buyers (17-35% compare to 7.5-8%)

Retail prices to larger fleet buyers lower than wholesale pricesto

dealers (even when dealers purchase similar quantities)


SED system deemed against the public interest

High prices to private buyers attributed to SED

Lack of responsiveness to exchange rates attributed to

restrictions on dealers buying cars from other countries

Pre-registration blamed for inhibiting market-clearing prices

SED also blamed for restricting innovation and choice of type of

retailer

But remedies were restricted by the EU Block Exemption

CC wanted to abolish SED system, ending refusal to supply

(including on service/presentation grounds) and exclusivity

(territories and dealing)


Remedies not restricted by Block Exemption

Dealers to benefit from bulk discounts similar to large fleet

buyers

Manufacturers’ control over dealers’ advertised prices to be

ended;

dealers to be permitted to sell below recommended prices

Dealers to be permitted to import from other EU countries

Agreements to pre-register cars to be prohibited


Since the Competition Commission inquiry New car prices have fallen: by 12.2% in the year to November

2000, and further since

Manufacturers may choose between Exclusive territories, but dealers free to sell to non-franchised

operators

Selective (but not exclusive) distribution, where dealers are

required to meet various criteria, and are prevented from

selling to non-franchisees

Blacklist of “hard core” restrictions that are prohibited

Multi-brand dealerships: manufacturer can only request brand-

specific area within showroom

Measures to facilitate cross-border sales

Dealers may sub-contract repairs

Removal of restrictions on authorized repairers and supply of

spare parts

Minimum 5 year term and restrictions on termination of dealer

agreement

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