Vertical Integration and Vertical Restraints By Kevin Hinde

Aims F In this lecture we will explore the competitive effects of vertical integration and vertical restraints. F We will see that, in general, there are positive effects but that where vertical relationships lead to market foreclosure or collusion public policy should be brought to bear.

Learning Outcomes F By the end of this lecture you will be able to F identify the theoretical welfare outcomes associated with vertical relationships. F comment upon the ambiguities associated with public policy decisions in this field using case studies.

Introduction F Most vertical integration and vertical relationships reduces transaction costs. F They may solve economic problems such as double marginalisation, insufficient pre-sale service and inefficient input substitution. F It may lead to improved quality of retail services. F It may also lead to higher barriers to entry, collusion and market foreclosure.

The positive effects of Vertical Integration

Vertical Integration: Competitive Wholesaler (w), Monopolist Retailer (r) Pr P Q Pw MRr Dr MCw =Pw 0 Q Note that Pr is the joint profit maximising price so a profit maximising vertically integrated firm would also charge Pr. So it matters not whether VI takes place or not

Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r) Pr=Pw P Q MRw Dr=Dw MCw 0 Q Dr = Dw because it represents the quantity that retailers are willing to sell at any given wholesale price By maximising profit the wholesaler’s price is retailer’s marginal cost.

Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r) Pr=Pw P Q MRw Dr=Dw MCw 0 Q Again, there is no difference between vertical separation and vertical integration. So vertical integration would only maintain market power.

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) Pw P Q MRr =Dw Dr MCw 0 MRw MCr Pr Because w knows r will restrict output to its MRr the demand curve of w = MRr.

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) Ws demand is determined by anticipation about downstream demand. Pw P Q MRr =Dw Dr MCw 0 MRw MCr Pr

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) The profit maximising w sets MCw = MRw and charges Pw. In effect, w knows what price r will charge and acts accordingly. Pw P Q MRr =Dw Dr MCw 0 MRw MCr Pr

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) Pw P Q MRr =Dw Dr MCw 0 MRw MCr Pr Consumer Surplus Profit for retailer Profit for wholesaler

Vertical Integration: Monopolist Wholesaler (w), Monopolist Retailer (r) Pw P Q MRr =Dw Dr MCw 0 MRw MCr Pr By vertically integrating the firm would consider the internally evaluated marginal cost of the wholesale product to be MCw not Pw. Consumer surplus Abnormal Profit

The positive effects of Vertical Restraints

Maximum Resale Price maintenance F Many products sold by manufacturers require a pre-sales service to avoid the Free Riding Problem

Insufficient Promotional Services Pw =Pr P Q MRw D (P,0) MCw 0 Q Monopolists Wholesaler’s profits if competitive retailers provide no services Retailers have no incentive provide services - they only earn a normal profit.

Insufficient Promotional Services P* P Q MR(P, S*) D (P,S*) MCw = ACw 0 Q MCr = ACrPw Wholesaler’s profits if retailers provide the optimal level of services. Maximum Price reflects pre-sales services per unit MCr + S*

The welfare impact of services P Q D(P, 0) MCw = ACw 0 Pw = MCr =ACrPw=Pns Qns A C B With no service combined consumer and producer surplus = A+B+C

The welfare impact of services P* P Q D(P, 0) D (P,S*) MCw 0 Q Pw = MCrPw=Pns MCr + S* A Qns C B F D E Services shift demand. Consumer surplus changes by D - B. Producer surplus increases by F. Net Effect depends on the size of B

Possible Detrimental welfare effects of Vertical Relationships F Studies show minimum RPM leads to higher retail prices and lower sales to the manufacturer –Case Study of ‘Over the Counter’ Pharmaceuticals F Strategic Use of Vertical Restraints and Integration –Exclusive Dealing Relationships –Price Squeezes

Possible Detrimental welfare effects of Vertical Relationships F Raising the Capital barrier to entry F Collusion F Foreclosure F Case Studies of –Beer, Petrol, Carbonated Drinks, New motor Vehicles and ice Cream

And finally…. F A summary. F Have you covered the learning outcomes? F Any questions? F Additional On-Line References Peeperkorn L (1998), The Economics of Verticals, Competition Policy Newsletter, European Commission,no. 2, June Waterson M and Dobb P (1996), Vertical Restraints and Competition Policy, OFT Research Report 177, December, HMSO London