ECONOMICS 3200M Lecture 16 March 17, 2005

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ECONOMICS 3200MLecture 16March 17, 2005
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Vertical Controls

• Vertical restrictions
• Types of contracts
• Franchise fee upstream firm charges downstream
  firm a fixed charge plus a per unit price
• Resale price maintenance upstream firms
  dictates selling price for downstream firm (price
  ceilings, price floors)
• Quantity fixing upstream firm dictates amount
  to be bought by downstream firm (quantity forcing
  if quantity greater than free contracting
  quantity quantity rationing if quantity lower)
• Exclusive territories geographic market divided
  into non-overlapping segments with minimal degree
  of substitutability along and near borders
• Exclusive dealing
• Tie-in sales buyer must purchase a
  complementary product from supplier in order to
  buy another product form the supplier
• Royalty

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Vertical Controls

• Vertical restrictions
• Chicago School observed vertical restraints
  meant only to improve efficiency of real-world
  vertical relations and not exercise monopoly
  power
• Address externality and free rider problems
• Store with reputation for stocking high quality
  products provides signal to consumers and thus
  helps overcome lemons/moral hazard problems
• If certain of these products available at
  discount store, reputation suffers and store no
  longer as valuable a signal of quality
• Consider case of WalMart
• Cost advantages of vertical integration

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Vertical Controls

• Vertical restrictions
• Consider case of double monopoly
• M charges R a per unit price of C and charges a
  franchise/license fee of ?M PM (C)
• P PM (C) and total profits ?M PM (C)
• Quantity forcing M requires R to buy Q1 units at
  P PM (C)
• Resale price maintenance (RPM) M requires R to
  set a maximum price equal to PM (C)
• If demand at retail level depends upon services
  provided, R may provide sub-optimal level of
  services

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Vertical Controls

• Vertical restrictions
• Case of services provided by downstream
  retailer(s)
• Too high a price and sub-optimal level of
  services
• Franchise fee single monopoly profit
• Quantity forcing sufficient to encourage R to
  charge correct price and provide optimal level of
  services

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Vertical Controls

• Vertical restrictions
• Multiple inputs case M sells product which is
  combined with another input (produced by
  competitive industry) to produce final product
  sold by monopolist
• Franchise fee and unit price set at Ms MC(C)
  no distortion in input use
• Tie-in with RPM M sells both inputs to
  downstream firms, sets prices of both inputs so
  as to not distort relative prices and extract
  monopoly profits
• Royalty on number of units sold with input sold
  at MC
• If final product sold by competitive industry
  franchise fee no longer works because profits 0
  for each of the downstream firms

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P
P2
P1
MC(PM, C)
MC(C, C)
D
MR
Q
Q1
Q2
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Vertical Controls

• Vertical restrictions
• Intrabrand competition
• Downstream retailers are in competitive market
• Demand depends upon services (e.g., information
  about product) provided by retailers
• Provision of pre-sale information by one retailer
  to consumers who buys from retailer offering
  lowest price
• No incentive for any one retailer to provide
  information because unable to recover costs of
  doing so
• Contractual solutions
• RPM sufficient to guarantee price to cover costs
  of optimal level of services free rider problem
  still exists
• Exclusive territories
• M provides information and/or other services
  directly through retailers

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Vertical Controls

• Vertical restrictions
• Interbrand competition
• Contractual solutions
• Exclusive dealing exclusive territories may be
  necessary to get retailers to accept exclusive
  dealing and M may have to provide promotional
  services (e.g. advertising)
• Limits returns to scale for downstream firms
• Increases search costs for consumers since
  retailers do not carry wide range of products
  Internet may overcome this problem in part
• Contractual solution more likely if M can set up
  own distribution network (costs of
  internalization vs. costs of external
  transactions and price competition because of
  interbrand competition)
• Long-term contract to limit shelf space available
  for competing products exclusive territories,
  promotional services provided by M, some sharing
  of monopoly profits

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Vertical Controls

• Market foreclosure
• Commercial practices (including mergers,
  acquisitions) to reduce buyers access to
  supplier(s) upstream foreclosure or reduce
  suppliers access to buyer(s) downstream
  foreclosure
• Exclusive dealing
• Tie-ins and/or products made incompatible with
  complementary products sold by other firms
• Tie-ins pervasive shoes, gloves come in pairs
  cars with engines land with homes
• Tie-ins to protect investments in reputation,
  minimize problems with product liability
  repair/maintenance services to product
• Entry barrier if entrant has to offer both
  products
• One-stop shopping single source of supply of
  entire range of products (savings on search and
  transactions costs, reputation)
• Acquisitions

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Information

• For consumers
• Availability and prices
• Search costs local monopolies
• Quality and other characteristics
• Reliability Jetsgo and provision of services
• Prisoners dilemma
• About consumers
• Preferences, reservation prices
• Demand curve position, shape (price elasticity)
• For rivals
• Competitive advantages cost structures,
  differentiation
• Strategies technology, product development,
  capacity, geographic expansion
• Strategic responses
• Market interaction a game with asymmetric and
  incomplete information

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Information

• Quality
• Lemonsmodel
• Ex ante, consumers expect quality uniformly
  distributed S ? 0, 1
• Ex ante, expected quality is 0.5 maximum price
  consumers willing to pay (P expected S) equals
  expected quality level P 0.5
• Unit costs depend upon quality C(S) S
• Qualities S ? 0.5?, 1 will not be supplied
• P C lt 0 for qualities in this range
• New feasible set S ? 0, 0.5, with expected
  quality 0.25
• Maximum price consumers willing to pay P 0.25
• Market degenerates to S0
• Rational consumers and producers expect only
  lemons to be supplied (moral hazard for
  producers), so only lemons supplied and P0

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Information

• Possible solutions to Lemons problem
• Full warranties provided by producers
• Producer compensates buyer in full if quality
  differs from advertised quality or service not
  provided if Jetsgo re-appears, will company
  have to provide full warranties?
• Quality must be able to be evaluated at low cost
  and high degree of reliability ex post by
  consumers
• Credibility of warranty depends upon reputation
  of producer/provider of warranty (Amex provides
  money back guarantees to card holders for
  products purchased with the card)
• Firms with long history more credible than
  start-ups first-mover advantage entry barrier
• 3rd party providers

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Information

• Possible solutions to Lemons problem
• Moral hazard problem if performance (quality)
  depends upon use by consumers
• Adverse selection case of insurance
• Deductibles, co-insurance
• Less than full warranty
• Warranty applies subject to certain conditions
  regarding use of product
• Consumers may infer this as signal of low quality
• Advertising
• Investment as signal of quality only if quality
  can be evaluated at low cost and high degree of
  reliability ex post by consumers
• Brand names

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Information

• Classification of products according to ex
  ante/ex post information of consumers re. quality
• Search products quality know ex ante
• Experience products quality unknown ex ante (at
  least prior to 1st time consumption/use), but
  known ex post after purchase and use
• Credence products quality unknown ex ante and
  unknown ex post even after purchase and use
  services
• Importance of reputation

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Information

• Experience products no warranties
• One-time purchase e.g.., restaurants in foreign
  cities
• Assume two possible qualities SL, SH with
  corresponding unit costs CL lt CH and consumers
  willingness to pay PL lt PH
• Assume PH CH gt PL - CL
• Consumers imperfectly informed (non-rational
  expectations), buy one unit ( no repeat
  purchases)
• Assume U(SH, PH) gt U(SL, PL)
• Incentive for producers to claim high quality
  product even though low quality PH CL gt PH
  CH
• Lemons model