L11 - Vertical restraints and conglomerates Flashcards
What does the term diversification refer to? What does it mean if it is related/unrelated diversification?
A situation where firms expand their activities into new business areas
Related diversification strategy - firms enter new product or geographical markets that are related to current business area. If it is new geographical market - we call it market extension
Unrelated diversification strategy - conglomeration. Often happens through acquisition or merger
What are the motives for a diversification strategy?
Market power, reduced costs, non-economic motives
How is market power a motive for a diversification strategy?
Diversified company more robust - not as sensitive to cyclical fluctuations, risk spread across markets, more bargaining power
An opportunity to cross-subsidize its products, use the profits of one market to support another and more difficult market
Opportunity to define predation strategy in a market, can be financed by other profitable markets
The diversified firm is stronger in counter-buying markets - reciprocity. It has a larger commercial area which puts it in a better position on the market for its own product, which is offered in the counter-purchase business.
The possibility of using bundling - if the market for one of its products is characterized by extreme competition it may buy a company that makes a complementary product where the elasticity of demand is low and where the same group of customer buy the product. Then bundle the two products.
Are conglomerate M&A’s normally accepted by competition authorities?
Yes. Concerns about the competitive effects of a diversified merger will under normal circumstances only be present when the products of the merging entities are related or when bundling can be used to exclude competitors
How can cost savings be a motive for a diversification strategy?
Opportunity to exploit resources more efficiently
Easier to take advantage of economies of scope
Having activities on nonrelated markets with different risks, business conditions and economic conditions make the firm more robust resulting in easier access to credit markets and/or maybe lower costs of financing the company.
Speculation smoothing of tax payments
What are some non-economic motives for a diversification strategy?
Status, salary etc.
Gain skills, lower risk of being fired if the shareholders of the company perceive the particular manager as the one who understands the conglomerate
If the diversified firm has more stable earnings than a non-diversified firm, e.g. above it provides larger job security for the management team.
Perhaps life is more comfortable than in a situation where the firm has to grow by challenging its competitors on the existing market.
What is resale price maintenance?
An arrangement whereby an upstream firm retains the right to control the price at which a product or service is sold by a downstream firm
Most commonly involves the fixing of a min price, however, max also possible
How can resales price maintenance be anticompetitive?
Retailer collusion - RPM can facilitate collusion among retailers by eliminating the inherent instability of collusive agreements due to the price discipline
Producer collusion – elimination of price variations among retailers facilitates collusion at the wholesale level (i.e. producers care about wholesale price and collude on that one)
Is RPM always bad?
No according to the service hypothesis
How to justify a fixed (higher) price for retailers? -> (additional) SERVICE
If retailers provide more (pre-sale) services, demand curve shifts outward
Assumption: Demand depends not only on price but also on (pre-sale) services, like convenient location, short waiting times, etc.
How is RMP perceived from a welfare perspective?
Welfare: which area is bigger? CS before or after the introduction of resale price maintenance + additional profit
If the ‘after RPM surplus for both’ - so all things being equal RPM improves welfare -> service hypothesis
But: can we assume that CS after intro of RPM larger than CS before?
Not necessarily the case, depends on how much the price increases relative to the change in consumers’ willingness to pay
What is retailer collusion (RPM)?
Any collusive agreement is potentially unstable, due to the possibility that one or more of the parties decides to take independent action. RPM may be a means by which price discipline, and therefore stability, can be achieved
RPM can protect retailer cartel from entry by other retailers offering price discounts
Questioned by Chicago school – claim retailer cartels rare due to relatively low entry barriers, no reason producer should wish to support retailer cartel possibly working against producer interests
What is producer collusion (RMP)?
Focus on wholesale price, may be effective if retailers’ cost and demand conditions are stable
If they vary – producer may not know whether differences in price are due to genuine demand or cost conditions or due to cheating by one or more of colluding producers
RPM eliminates price variations, since retailers are prevented from adjusting the retail price
One case in point arises when the demand for a product depends not only
on price, but also on associated pre-sales services. Producers have incentive to ensure retailers provide such services. How can they do that?
Producers often set low price floors, to limit the level of discounting without excluding it altogether. By narrowing the price differential between discount store prices and stores offering full service, producers may hope to encourage full-service stores to maximise the quality of their service.
The pre-sales service and certification arguments assume producers are unable to contract for the provision of these services directly
RPM can help provide the necessary discipline for a contractual solution to be feasible. If the producer is happy with the level of service provided, retailers earn an abnormal profit, assuming the cost of providing the service is within their margin. However, if the producer is unhappy with the service, the dealer’s quasi-rents would be lost when the producer terminates the contract
RPM makes important contribution to profit
Significant differences in the impact of RPM based on market and firm characteristics; this is consistent with the retailer and producer collusion hypotheses.
The main motives for RPM appear to centre around limiting price-cutting and protecting brand reputation.
What are vertical restraints?
Conditions and restrictions on trade imposed by firms that are linked vertically
Two purposes: enhancement of market power and realisation of cost savings
What is foreclosure?
Practice of refusing to supply a downstream firm or purchase from upstream
Usually prohibited
What are 3 conditions for effectiveness of foreclosure?
A sufficient proportion of upstream or downstream firms are covered by the exclusive agreement.
There are substantial barriers to entry or an inability to expand output internally at the upstream or downstream stage.
The agreements are of relatively long duration
What are the motives for foreclosure?
(More) market power in the downstream market
Signal quality by sales from a few retailers
Less intra-brand and perhaps inter-brand competition for the company’s product
Achieve higher prices
Increasing costs for competitors in the downstream market
If the product can not easily be replaced, the dealers pay extra to obtain substitute products
Which factors can influence the extent to which a firm pursues exclusive dealing strategy?
Firm size - large firms may benefit from economies of scale and scope in distribution by developing exclusive dealerships, or from promotional economies which enhance the reputation of their brands
Enables customers to make informed choice but makes it difficult to compare brands at one location – high search costs
How does the Chicago school perceive foreclosure (and vertical restraints)?
Irrelevant – what matters is degree of concentration in up- and downstream markets
Vertical integration and foreclosure are of little consequence provided downstream markets are competitive.
Refusal to supply or vertical integration does not change the overall monopoly rent for the producer or the combined firm
Three conditions that can be used to determine if competition is harmed by foreclosure:
Is the ability of excluded rivals to compete reduced? E.g. if rivals have to obtain more costly or lower quality inputs
Is market power increased by exclusion? The ability to foreclose need not necessarily increase the firm’s market power, if it has powerful rivals or if entry is possible. Exclusion may harm certain competitors, without necessarily damaging competition.
Is exclusion profitable? Foreclosure implies some sales forgone. The increase in profit from enhanced market power might not be enough to compensate for the loss of revenue.
How can slowing allowances be a vertical restraint?
Occur in retailing when large buyers require fees or other payments from suppliers to place products in prominent positions
What is non-linear pricing?
Two-part tariff – buyer pays fixed franchise fee and price per unit
What is tying and why might it be attractive for a supplier?
The selling of two or more distinct products, where the sale of one good is conditional on purchase of another. Distinct if products would be purchased in separate markets if there was no tying
Evasion of price control – if one product is price controlled, increase the price of the other
Protection of goodwill – insist repairs and spare parts supplied only by itself
Economies of distribution
Price discrimination
Leverage – can extend power of monopolist into related markets, enhance market power in market for tied product
Increase competitor’s sunk costs (entry barriers)
Possibility for market sharing by cartels
What is bundling?
A supplier offers several goods as a single package
Profitable as customers can be sorted into different groups with different willingness to pay – price discrimination
Can be effective barrier to entry - A monopolist operating in two markets can bundle the goods, making it difficult for rivals to enter either market
Useful for marketing, can increase market power and cost advantages are perhaps less prevalent
What are different types of bundling?
Sales bundling: When the selling company that bundles its products.
Buying bundling: When the buyer will only purchase a single package.
Direct bundling (pure bundling), bundling in LWG’s terminology: The purchase of a product conditional on the purchase of second and vice versa - a total package.
Tying
Indirect bundling: When the bundled give a discount is so high that no / or only choose to purchase separately.
Is bundling a violation of the competition act?
Bundling is a violation to Competition Act, §11 and § 6
Vertical restraints: anticompetitive or benign?
Before the views of the Chicago school came to prominence, it was widely believed that vertical restraints, by their very nature, reduce the independence of distributors and are therefore anticompetitive
The Chicago school distinguish between vertical and horizontal restraints. Competition takes place within a market and is therefore impeded by horizontal restraints but not by vertical restraints. Producers do not normally impose restrictions downstream that would reduce the level of demand for their own products. If restrictions are imposed, it is because a potential cost saving or efficiency gain can be realised, perhaps through the elimination of externalities or opportunism
It is now customary to analyse vertical restraints on a case-by-case basis. Restraints may sometimes raise entry barriers or facilitate collusion, leading to a distortion of competition
