5- Vertical Mergers & Restraints

Question 1

What are the 3 levels of control in Vertical relationships?

Answer 1

-Vertical integration (merger)
-Vertical restraints (contractual relationship)
-Market relationship

Question 2

Describe Vertical integration (merger)

Answer 2

Different production stages occur within one firm

Question 3

Describe Vertical restraints (contractual relationship)

Answer 3

Different firms run different production stages, but Upstream firm controls some factors of final demand.

Question 4

Describe Market relationship

Answer 4

No direct control, firms trade unconstrained

Question 5

What are the 5 main forms of vertical restraints?

Answer 5

-Franchise (2 part tariff)
-Quantity discounts
-Quantity fixing
-Resale price maintenance (RPM)
-Exclusivity clauses

Question 6

Describe Franchise (2 part tariff)

Answer 6

U sells right to sell its products (franchise fee) and charges a per unit price too

Question 7

Describe Quantity discounts

Answer 7

Lower wholesale price for larger quantity

Question 8

Describe Quantity fixing

Answer 8

D is obliged to sell a certain quantity

Question 9

Describe Resale price maintenance (RPM)

Answer 9

U sets retail (consumer) price

Question 10

What are the 3 main Exclusivity clauses?

Answer 10

– 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.

Question 11

What are the 2 main Vertical (negative) externalities?

Answer 11

-Double marginalisation (price externality)
-Investment externalities

Question 12

Describe Double marginalisation

Answer 12

D doesn’t take into account the effect of its price decision on U’s profit

Question 13

Describe Investment externalities

Answer 13

D doesn’t internalise the effect of its investment on U’s profit and typically invests sub-optimally

Question 14

How do you find equilibrium values for a market relationship?

Answer 14

-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

Question 15

How do you find equilibrium values for a vertically integrated firm?

Answer 15

Solve as standard monopoly problem

Question 16

How can you show whether a vertical merger is profitable (firms are better off)?

Answer 16

Vertically integrated profits are greater than sum of split profits: πᵤ* + πₔ* < πᵥᵢ

Question 17

How can you show consumers are better off after a vertical merger?

Answer 17

When price is lower and more is consumed:
pᵛᶦ ≤ p* & Q* ≤ Qᵛᶦ

Question 18

What are the 2 main reasons vertical mergers are potentially welfare increasing?

Answer 18

-No competition harm: Firms produce complements, not substitutes.
-Negative externality disappears: Externality internalised under vertical integration.

Question 19

Why may vertical restraints be preferred over vertical integration?

Answer 19

Mergers can often be costly

Question 20

How does free riding work with Investment externalities?

Answer 20

Retailers can’t differentiate themselves, they free ride on each other’s investment, complete externality in provision of services

Question 21

What are the 3 main ways vertical mergers/restraints can be anti-competitive?

Answer 21

-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.

Question 22

What are the 2 main negative effects of vertical mergers/restraints?

Answer 22

• 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

Question 23

What must the Franchise fee be for a perfectly competitive downstream firm (D)?

Answer 23

Franchise fee must be zero because D makes zero profit and sets P=MC

Question 24

How can you find the quantity sold by a perfectly competitive downstream firm (D)?

Answer 24

Price must equal marginal cost so setup that equation and solve for q

Question 25

What is the profit function for a manufacturer selling to 2 downstream firms (D)?

Answer 25

πᵤ = (w - c)(q₁ + q₂)

Question 26

How do you find the optimal wholesale price (w) set by an upstream firm (U)?

Answer 26

Differentiate the manufacturer’s profit function wrt w

Question 27

How can you show that a manufacturer would prefer to serve both markets instead of one?

Answer 27

Compare one of the D’s profits to U’s profit made by serving both

Question 28

How does a franchise fee (F) change an upstream firm’s (U) profit function?

Answer 28

Added on to the end
πᵤ = (w - c)(q₁ + q₂) + F

Question 29

What franchise fee (F) will an upstream firm (U) charge a monopolist downstream firm (D)?

Answer 29

F will be D’s profit

Question 30

What wholesale price (w) will an upstream firm (U) charge a monopolist downstream firm (D)?

Answer 30

w=c they will extract full profit through franchise fee

Question 31

What wholesale price (w) will an upstream firm (U) charge a perfectly competitive downstream firm (D)?

Answer 31

U will charge the monopoly price
w=pᵐ

Question 32

How do you calculate optimal effort level (e*) with RPM?

Answer 32

-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

Question 33

How do you solve for optimal wholesale price (w*) with RPM?

Answer 33

Equate downstream firm profit to zero and solve for w

Question 34

How do you find equilibrium values for simultaneously competing upstream and downstream firms?

Answer 34

-Start by finding equilibriums for downstream firms
-More competitive upstream firm gets the whole market and its equilibriums follow from the downstream ones

Question 35

How does a vertical merger change the optimisation problem when a downstream is foreclosed?

Answer 35

Optimisation game between downstream firms, merged competes at zero marginal cost other has MC=w2