Chapter 17: Vertical Integration and Vertical Relationships

Question 1

Reasons for Vertical Integration (7)

Answer 1

1. ) Increasing Market Power
2. ) Market foreclosure
3. ) The Squeeze Play
4. ) Price Discrimination
5. ) Avoid cost of using the market
6. ) Inefficient input substitution
7. ) Double Marginalization

Question 2

Market Foreclosure

Answer 2

(Tied to increasing market power)

• Acquire essential input
• Market foreclosure is the exclusion that results when a downstream buyer is denied access to an upstream supplier (caused from an Upstream foreclosure) or when an upstream supplier is denied access to a downstream buyer.

Question 3

The Squeeze Play

Answer 3

• Refiner (gasoline) - also has a retail network (Shell)
• Refiner lowers price at the retail network that it has, but raises the price of wholesale product to the independent stations

Question 4

Double Marginalization

Answer 4

• Double marginalization is the phenomenon in which different firms the same industry that have their respective market powers but at different vertical levels in the supply chain (example, upstream and downstream) apply their own markups in prices
• Vertical integration would likely improve economic welfare

Question 5

Input Substitution

Answer 5

• Good X uses only two inputs, input M and input C. Input M is produced by another monopolist, and input C is produced in a perfectly competitive market.
• The monopolist producer of good X would choose an inefficient combination of inputs, using “too much” of input C and “too little” of input M, to produce any given output of good X. Vertical integration can solve this problem.

Question 6

Resale Price Maintenance (RPM)

Answer 6

• The practice whereby a manufacturer and its distributors agree that the distributors will sell the manufacturer’s product at certain prices (resale price maintenance), at or above a price floor (minimum resale price maintenance) or at or below a price ceiling (maximum resale price maintenance). If a reseller refuses to maintain prices, either openly or covertly (see grey market), the manufacturer may stop doing business with it.

Question 7

Free Riding

Answer 7

• In economics, the free rider problem occurs when those who benefit from resources, goods, or services do not pay for them, which results in an under-provision of those goods or services.
• Ex.) Customer gets pre-sale service at one store, but buys for cheaper price at another store

Question 8

Quality Certification

Answer 8

• Consumers collect information from high quality store, and buy the product from Wal-Mart.
• Mitigated by manufacturer saying that both prices must be equal

Question 9

Exclusive Dealing

Answer 9

• In competition law, exclusive dealing refers to an arrangement whereby a retailer or wholesaler is ‘tied’ to purchase from a supplier on the understanding that no other distributor will be appointed or receive supplies in a given area.

Question 10

Why a firm would want exclusive dealers? (4)

Answer 10

1. ) Distribute product with maximum effort
2. ) Dealers of superior ability
3. ) If margins are sufficient, they will invest in inventory and sales promotion
4. ) High quality maintenance and repair service

Question 11

Benefits of Exclusive Dealing (

Answer 11

1. ) Lower distribution costs
2. ) Possibly lower retail prices
3. ) Retailers can exploit scale economies
4. ) Increase specialization
5. ) Avoid duplication of marketing efforts

Question 12

Free Riding - Will Fit Parts

Answer 12

Dealer buys CAT machines and parts from other authorized dealers at a higher price. They then sell will fit parts that cost less than CAT parts and free ride on CAT’s reputation for quality parts.