Economics of Management Strategy BEE3027 Miguel Fonseca

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Economics of Management StrategyBEE3027Miguel
Fonseca

• Lecture 8

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Recap

• Whenever you
• phone your mum, or switch on the light, or buy
  health insurance
• you purchase a service or product from a chain
  of vertically related industries.
• Weve looked at vertical integration in the
  context of firm boundaries.

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Recap

• Today, we focus on the strategic aspect of
  vertical integration.
• We will start by looking at the potential for
  efficiency gains in a vertical merger.
• We will finish by looking at the potential for
  the welfare losses with vertical foreclosure.

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Why should a firm acquire a supplier?

• If markets are efficient, firms will sell their
  output at marginal cost.
• That means that it is just as cheap to buy from
  an external supplier as producing in-house.
• Several problems do occur in the real world
• Incomplete contracts
• Hold-up
• Supplier market may not be perfectly competitive.

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Double marginalisation

• Lets consider the case of an upstream firm
  (supplier) producing an intermediate good, and a
  downstream firm (retailer) producing a consumer
  good.
• Demand for the final good is linear P a - bQ
• The marginal cost of producing a unit of the
  intermediate good is constant and equal to c.
• Lets first consider if the two firms merge and
  act as a single company.

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P
Monopoly Solution
Q
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The case of separate companies

• Now lets assume both firms are separate
  monopolies.
• Lets call the price the retailer pays the
  supplier for each unit be equal to r.
• The retailer will maximise profits
• ?r (P- r)Q
• Q (a-r)/2b, P (ar)/2.

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Double marginalisation (cont.)

• So the demand for the intermediate good is
• Q (a-r)/2b
• Inverting it as a function of the price of the
  intermediate good gives r a 2bQ (note that
  this is the same as the retailers MR curve)
• So the supplier maximises her profits ?s
  (r-c)Q with respect to Q
• This gives Q (a-c)/4b. r (ac)/2.

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Double marginalisation (cont.)

• Recall the optimal output and price by
  retailerQ (a-r)/2b, P (ar)/2.
• Plugging r (ac)/2 into the equilibrium output
  and price of the retailer, we get Q (a-c)/4b
  and P (3ac)/4.
• Both the consumer surplus AND the sum of firms
  profits are lower with separate companies!

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P
Double Marginalization
Q
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Double marginalisation (cont.)

• How can this be tackled?
• Two-part tariff (franchising)
• Supplier charges a Fixed fee F to sell the good
  to retailer and sells each unit at marginal cost.
• F should not affect retailer price, as the key
  condition is that MR MC.
• Royalty arrangement
• Supplier sells goods at MC but earns a percentage
  of profits.

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Vertical Foreclosure

• Consider a market in which an upstream firm, U,
  produces an input at MC 0.
• Each unit of input is costlessly converted into a
  homogenous unit of a final good by downstream
  firms D1 and D2.
• The final good is sold to consumers with demand
  function given by
• P a bQ, Q q1q2

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Vertical Foreclosure
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Vertical Foreclosure

• Lets also assume firms engage in Cournot
  competition.
• U sells input goods to D1 and D2 by proposing
  contract of the form (x, T), where
• x is amount of input, and
• T is payment for bundle.

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Vertical Foreclosure

• There are two important cases to consider in this
  case
• Public contracts
• Secret contracts.
• Public contracts are those in which D1 knows
  contractual terms of D2 and vice-versa.
• Secret contracts are those in which neither firm
  knows what terms were offered to rival.

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Vertical Foreclosure

• If contracts are public, the subgame-perfect
  equilibrium of this game is
• U offers to both D-firms
• Both D-firms accept.
• Under this offer, both firms
• Make zero profits net of payment to U if all
  input is turned into output and sold at monopoly
  price.
• If firms reject offer, they also make zero profit.

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Vertical Foreclosure

• If contracts are secret, it may not be possible
  for U to achieve monopoly profit.
• Suppose D2 accepts offer from U.
• If so, it is in Us and D1s to agree to a
  contract (x,T), such that .
• D2 anticipates this and rejects contract.

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Vertical Foreclosure

• The only possible equilibrium is for U to offer
  contract , where firms make Cournot-Nash
  profits.
• In this contract, neither D-firm has an incentive
  to raise outputs.
• The solution for U to achieve maximum profit is
  to merge with one of the D-firms.

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Vertical Foreclosure
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Vertical Foreclosure

• Firm U-D1 sells monopoly quantity through its
  downstream subsidiary.
• Since it already captures full monopoly profits,
  it has no incentives to supply D2.

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Vertical Restraints

• Lets broaden our analysis further and consider
  two possibilities
• Intra-Brand competition competition between two
  different retailers of the same brand of the
  product.
• Inter-Brand competition competition between two
  different manufacturers/retailers with different
  brands the same or similar product.

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Vertical Restraints

• Retailers can invest in advertising, customer
  service, consumer education, all of which enhance
  consumer willingness to pay.
• Such investments benefit retailer but also its
  competitors and the manufacturer
• Thus the level of investment will be
  insufficient.
• Vertical restraints can ensure the optimal level
  of services.

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Vertical Restraints

• Could specify contractually what services should
  be provided,
• How does one determine the right level of
  services? How does one monitoring the level of
  services?
• This is an example of the principal-agent
  problem
• the manufacturer is the principal,
• the retailer is the agent.
• Solution Align the agent's payoff function with
  the principle's payoff function.

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The Principal-Agent Problem

• Assume Q (A-P)s where s is the service level,
  then P A - Q/s.
• Assume the cost of s is increasing (diminishing
  marginal returns to service).
• To maximize joint profits, there is an optimal
  level of service and an optimal price to the
  consumer.
• On his own, the retailer will set price is too
  high (due to double marginalization) and the
  service too low (due to free riding).

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Possible Solutions to the P-A Problem

• Resale Price Maintenance Establish a minimum
  price that the retailer can set.
• Retailers cannot use price to increase consumer
  demand, so they must increase service to compete
  with other retailers.
• Works for some services, although not for
  advertising.
• Exclusive territories Designate one retailer for
  a certain area.
• Retailer gets all the benefits from services
  provided.

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Manufacturer Competition

• Vertical restraints can help manufacturers
  compete against rivals.
• Slotting allowances fixed fee paid to retailers
  to obtain shelf space. Two-part tariff in
  reverse.
• Exclusive dealing if the manufacturer provides
  services (e.g., training) to retailer which could
  benefit other manufacturers.

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Pro-competitive Effects of Vertical Restraints

• Exclusivity gain economies of scale, lower
  distribution costs, achieve optimal level of
  services.
• Resale price maintenance achieve optimal level
  of services.
• Royalty and franchise agreements overcome double
  marginalization.

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Anti-competitive Effects of Vertical Restraints

• Exclusivity facilitate collusion, foreclose
  markets to competitors.
• Resale price maintenance facilitate collusion.
• Royalty and franchise agreements foreclose
  markets to competitors.

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Antitrust and Vertical Restraints

• Exclusivity.
• Evaluated under rule of reason do they harm
  welfare/consumers overall. Takes into account
  differences between intra- and inter-brand
  competition.
• Resale price maintenance.
• Per se illegal.
• Royalty and franchise agreements.
• Some limits on these agreements, evaluated under
  rule of reason.