L10 - Vertical Relationships

Question 1

Different types of vertical relationships?

Answer 1

• usually have contracts to ensure the continuous supply of inputs to firms further down the chain
  
  • These contracts will have clauses (vertical constraints) to affect the behaviour of those further down it
  • this is because a firm decision at the start of the chain can have a causal effect on the profits of those further down it
    
    • These clauses can have both pro and anti-competitive effects
• To simply this we are only going to consider two firms in the vertical relationship –> the upstream and the downstream
• There are two forms of competition
  
  • Intrabrand (between retailer A and B for manufacturer 1) –> competition at the downstream level for the same brand from the upstream
  • Interbrand (competition between the two manufacturers to supply to retailer A downstream)

Question 2

What vertical restraint may be put into contracts between firm in a vertical relationship?

Answer 2

• Linear tariffs: manufacturer charges a fixed unit price per unit of the good (average cost of the good is the same no matter the number of units bought)
• Non-linear contracts: manufacturer charges price per unit and a fixed fee (average price will fall the more the retailer buys)
• Resale Price Maintenance (RPM): manufacturer sets the price of the retailers –> normally gives them a range to choose from
  
  • retailers wanting to maximise profits with high prices but manufacturers want lower price to sell more goods
    
    • Different incentives –> contract helps them bring them closer together
• Exclusive territory: retailer can only sell in a certain area/to certain buyers
  
  • Can help eliminate intraband competition –> anti-competitive
  • Can be pro-competitive as it may lead a retailer to invest more in the quality of the services they are providing
• Exclusive dealing: retailer can sell only the manufacturer’s brand
  
  • Can eliminate Interbrand competition by stopping a store from selling any of their competitor’s products
  • e.g. Only 1 car dealer in an area can sell BMWs
• Selective distribution: manufacturer only allows certain retailers to sell its product
  
  • Have certain criteria to meet, e.g. designer brand don’t sell to supermarkets as they need the retailer to charge a high price to signal quality
• ● (Integration: manufacturer merges with retailer)
  
  • substitute to vertical restraints –> firm can just merge

Policy

• Article 101 (Europe chapter 1): prohibits agreements between firms, unless they are welfare-enhancing
• Typically not per-se illegal (need to check if they will be anti-competitive or not) and a safe harbour if suppliers market share<30%.
• RPM is black listed in Europe and UK (with a few exceptions e.g. the book industry).
  
  • Being allowed in the US as they see it may have welfare-enhancing effects –> may come over to here eventually

Question 3

Vertical Restraints: UK impluse ice cream case?

Answer 3

• 1979-2000: four Monopolies and Mergers Commission investigations
  
  • ● Manufacturers: Bird’s Eye Walls, Mars, Nestlé (CR3 impulse =72%, wrapped = 86%)
    
    • Looked at the market for wrapped (in store) and the broad impulse ice cream (its a hot day let’s get an ice-cream - corner shop, ice cream)
  • ● Retailers: small independent shops, such as newsagents, kiosks…
• Need to preserve the cold chain from manufacture to sale
• Two areas of concern were:
  
  • ● Outlet exclusivity: “… (BEW, Mars and Nestlé) have entered into agreements with some retailers to stock only their respective products, which has adversely affected competition between manufacturers…”
    
    • believe this would lead to limited choice and interbrand competition
    • banned this but said retailers could write to MMC to do this –> didn’t work as market power was upstream and the manufacturers just put pressure on the retailers to write these letters
  • ● Freezer exclusivity: “…the practice of freezer exclusivity particularly by BEW but also by Mars and Nestlé restricts competition between manufacturers…”
    
    • Can only supply our ice cream in a freezer without any of our competitors ice cream
    • this just became outlet exclusivity for small retailers and newsagents who probably only had one or two freezers anyways
      
      • The MMC found no issue because because manufacturers we actually supply retailers with more freezer space at next to zero cost, basically increase the supply anyways
        
        • But later decided this is a problem
• Remedy: Prohibit BEW from entering agreement over freezer space
  
  • “unless 50% of the display space and all of the storage space of the freezer is permitted to be used for other manufacturers’ products

Question 4

What is double marginalisation?

Answer 4

• the inefficiency that can arise from market power in these vertical relationships upstream and downstream
• p is the price downstream and w is the price upstream

Question 5

Double Marginalisation: Solving Diagrammatically?

Step 1: Retailer’s Optimal Price

Answer 5

• left: upstream market, right: downstream market
• Step 1: finding the retailer’s optimal price given a specific level of the wholesale price (w)
  
  • w will be the marginal cost of the retailer

Question 6

Double Marginalisation: Solving Diagrammatically?

Step 2: Manufacturer’s demand curve

Answer 6

• Need to find how much demand the monopoly retailer gets at a given wholesale price –> this we equal the demand for the manufacturer
  
  • No demand when w = chock price (A)
  • if w= 0, MC for the retailer is 0 –> thus the profit maximising quantity level for the retailer is the quantity at which the demand curve for the manufacturer crosses the x-axis
• The monopoly manufacturers’ demand curve is therefore equal to the MR curve of the retailer

Question 7

Double Marginalisation: Solving Diagrammatically?

Step 3: Manufacturer’s and retailer’s optimal outputs

Answer 7

• manufacturer find the wholesale price that maximises their profits
  
  • this becomes the marginal cost for the retailer and we use the MR=MC point on the retailer’s diagram to fine the quantity they will supply to the public
• One thing to note is that both set their prices greater than marginal costs
  
  • Both have positive price-cost margins with profit represented by the orange boxes
  • Two margins on the good hence the name double marginalisation

Question 8

Double marginalisation: solving algebraically?

STEP 1

Answer 8

• Optimal retail price;
  
  • If w =c then p = (A +c)/2 –> only happens when there is a monopoly on the markets

Question 9

Double marginalisation: solving algebraically?

STEP 2

Answer 9

Question 10

Double marginalisation: solving algebraically?

STEP 3

Answer 10

Question 11

Properties of the equilibrium under double marginalisation?

Answer 11

All of the points compare what the double monopolist market is like in comparison to if only one of the two firms in the vertical relationship was a monopolist (say just the retailer)

• the monopoly manufacturer will set their wholesale prices at the retail price that would occur if their was only want monopolist in the market
• The retail price is higher when there are two monopolists in the supply chain rather than just 1
• Despite the prices being higher, the profits of the combined monopolist are lower, why?
  
  • As the retailer is pricing above marginal cost –> it is posing an externality on the manufacturer and this is creating inefficiency in the market
  • the retail price is inefficiently high

Question 12

The efficiency of the vertical restraint of resale price maintenance (RPM)?

Answer 12

• retailer price set at manufacturers price
• Having only one monopolist
  
  • The manufacturer
  • it reduces the deadweight loss caused by the retailer
    
    • Reduces the triangle to the right
    • However, their profits are smaller
  • This situation can arise from a vertical merger between the two monopolists, or having market power upstream but competition downstream
• Vertical mergers are said to be pro-competitive as they get rid of this inefficiency (retailer setting price above marginal costs - double marginalisation)
  
  • Vertical merger internalises this inefficiency which in turn makes the market more efficient

Question 13

What is the benefit of vertical mergers?

Answer 13

• instead of putting two mark upon the good, the merged firms will only put one

Question 14

What is the problem of vertical foreclosure?

Answer 14

Problem with a vertical merger

• if Manufactacturer 1 and retail A merge –> may decide that it’s no longer in their interest to supply retailer B
  
  • This May lead to prices rising in the market
• the merger has a trade-off:
  
  • It gives them market power (increase prices)
  • But it closes off the channel of profit coming from Supplying to B
• It May not be anti-competitive to foreclose on retailer B as the merger itself could reduce costs and eliminate double marginalisation inefficiencies

Question 15

What is an example of an Anticompetitive foreclosure?

Answer 15

• after the merger, manfacturer 1 wont supply retailer B
  
  • Yet now its inputs have become more expensive as they are now being supplied by manufacturer 2
    
    • its is effectively been forclosed
    • Reduced Total welfare reduced
      
      • As totla profits of the retailers may be less because of retailers B increased costs
• Double marginalisation hasnt gone away and the merger leads to foreclosure and it is anticompetitive