5- Vertical Mergers & Restraints Flashcards
What are the 3 levels of control in Vertical relationships?
-Vertical integration (merger)
-Vertical restraints (contractual relationship)
-Market relationship
Describe Vertical integration (merger)
Different production stages occur within one firm
Describe Vertical restraints (contractual relationship)
Different firms run different production stages, but Upstream firm controls some factors of final demand.
Describe Market relationship
No direct control, firms trade unconstrained
What are the 5 main forms of vertical restraints?
-Franchise (2 part tariff)
-Quantity discounts
-Quantity fixing
-Resale price maintenance (RPM)
-Exclusivity clauses
Describe Franchise (2 part tariff)
U sells right to sell its products (franchise fee) and charges a per unit price too
Describe Quantity discounts
Lower wholesale price for larger quantity
Describe Quantity fixing
D is obliged to sell a certain quantity
Describe Resale price maintenance (RPM)
U sets retail (consumer) price
What are the 3 main Exclusivity clauses?
– Exclusive dealing: retailer carries only a single manufacturer’s brands
– Exclusive territory: only one retailer can sell in a geographical area
– Selective distribution: only a certain type of retailer is allowed to sell.
What are the 2 main Vertical (negative) externalities?
-Double marginalisation (price externality)
-Investment externalities
Describe Double marginalisation
D doesn’t take into account the effect of its price decision on U’s profit
Describe Investment externalities
D doesn’t internalise the effect of its investment on U’s profit and typically invests sub-optimally
How do you find equilibrium values for a market relationship?
-Maximise as usual for downstream firm (D)
-Use Q* from D to maximise for upstream firm (U)
-Sub equilibriums into each other so there are no choice variables p or w
How do you find equilibrium values for a vertically integrated firm?
Solve as standard monopoly problem
How can you show whether a vertical merger is profitable (firms are better off)?
Vertically integrated profits are greater than sum of split profits: πᵤ* + πₔ* < πᵥᵢ
How can you show consumers are better off after a vertical merger?
When price is lower and more is consumed:
pᵛᶦ ≤ p* & Q* ≤ Qᵛᶦ
What are the 2 main reasons vertical mergers are potentially welfare increasing?
-No competition harm: Firms produce complements, not substitutes.
-Negative externality disappears: Externality internalised under vertical integration.
Why may vertical restraints be preferred over vertical integration?
Mergers can often be costly
How does free riding work with Investment externalities?
Retailers can’t differentiate themselves, they free ride on each other’s investment, complete externality in provision of services
What are the 3 main ways vertical mergers/restraints can be anti-competitive?
-Market foreclosure: Merger between a U and one of Ds firms can lead to U denying input to rival D and thereby limiting downstream competition.
-Collusion: RPM can foster collusion (prices are rigid and transparent).
-Entry deterrence: Exclusive Dealing can prevent upstream firms to enter.
What are the 2 main negative effects of vertical mergers/restraints?
- Price discrimination: One D can sell on its cheap input to other D, which prevents U from price discrimination. A vertical merger with one D can stop this arbitrage and make price discrimination feasible.
- Edgeworth-Salinger effect: 𝐷 sells products A and B, produced by two different 𝑈𝐴 and 𝑈𝐵. Then 𝐷 merges with 𝑈𝐴
What must the Franchise fee be for a perfectly competitive downstream firm (D)?
Franchise fee must be zero because D makes zero profit and sets P=MC
How can you find the quantity sold by a perfectly competitive downstream firm (D)?
Price must equal marginal cost so setup that equation and solve for q
What is the profit function for a manufacturer selling to 2 downstream firms (D)?
πᵤ = (w - c)(q₁ + q₂)
How do you find the optimal wholesale price (w) set by an upstream firm (U)?
Differentiate the manufacturer’s profit function wrt w
How can you show that a manufacturer would prefer to serve both markets instead of one?
Compare one of the D’s profits to U’s profit made by serving both
How does a franchise fee (F) change an upstream firm’s (U) profit function?
Added on to the end
πᵤ = (w - c)(q₁ + q₂) + F
What franchise fee (F) will an upstream firm (U) charge a monopolist downstream firm (D)?
F will be D’s profit
What wholesale price (w) will an upstream firm (U) charge a monopolist downstream firm (D)?
w=c they will extract full profit through franchise fee
What wholesale price (w) will an upstream firm (U) charge a perfectly competitive downstream firm (D)?
U will charge the monopoly price
w=pᵐ
How do you calculate optimal effort level (e*) with RPM?
-Differentiate the Lagrangian wrt eᵢ
-Solve FOC for eᵢ when constraint doesn’t bind (λ=0)
-Sub into qᵢ equation and check whether it violates constraint
-If binding solve demand function for eᵢ
How do you solve for optimal wholesale price (w*) with RPM?
Equate downstream firm profit to zero and solve for w
How do you find equilibrium values for simultaneously competing upstream and downstream firms?
-Start by finding equilibriums for downstream firms
-More competitive upstream firm gets the whole market and its equilibriums follow from the downstream ones
How does a vertical merger change the optimisation problem when a downstream is foreclosed?
Optimisation game between downstream firms, merged competes at zero marginal cost other has MC=w2
