Vertical Chain

Vertical Integration The degree to which the firm controls the chain.

Vertical Integration Upstream Integration – towards raw materials

Vertical Integration Downstream Integration – towards end customer

Boundaries of the Firm The question for a firm is “Where to draw the boundary.” Expanding is integrating Contracting is outsourcing

Should a firm vertically integrate? Pros of doing it in-house Avoid double markup problem Upstream Firm: MC=10 and No Fixed Cost Downstream Firm: P= 110-Q, MR=110-2Q Only cost to D is price set by U

Double Mark Up Problem $/q q MC U PDPD MR D What will MC to D look like? Given a price set by U, what quantity will D buy?

Double Mark Up Problem $/q q MC U PDPD MR D =P U MR U So MR D =P U MR U =110-4Q What quantity will be traded? How much will each firm earn?

Double Mark Up Problem $/q q MC U PDPD MR D =P U MR U P D = 85 P U = 60 Q D =25 Profits U: 50x25=1250 Profits D: 25x25= 625

Double Mark Up Problem $/q q MC P MR Q =50 P = 60 with Vertical Integration Profits: 50x50 = 2500 & Consumer Surplus Increased

Experimental Gasoline Markets Cary A. Deck University of Arkansas Bart J. Wilson George Mason University

Motivation Federal Trade Commission wanted to know –If Zone Pricing hurts consumers? –If Divorcement helps consumers? We ran a series of laboratory experiments to find out.

Industry Background World Market Price Oil Field Refiners Wholesalers Unbranded Rack PriceBranded Rack Price Wholesalers Unbranded Stations Company Operated Stations (Branded) Lessee Stations (Branded) Dealer Owned Stations (Branded) Transfer PriceDealer Tank Wagon Retail Customers

Treatments Zone Pricing (4 Refiners and 4 Lessee Dealers) –Refiners set DTW prices for each retail location carrying its brand. –Each retailer observes two location specific DTW prices but cannot shift inventory between locations. Uniform Pricing (4 Refiners and 4 Lessee Dealers) –Refiners must set one price for both retail outlets carrying its brand. Company Operated (4 Retailers) –Retailers and refiners merged so that DTW for brand i outlets is c i.

Experimental Design and Procedures

Store 6 P=?

Results: Uniform vs Zone Wholesale Pricing Corner Retail PricesCenter Retail Prices Zone Treatment Uniform Treatment

Who Benefits from Uniform Pricing? Zone PricingUniform Pricing

Results: Company-Operated Corner Retail PricesCenter Retail Prices Zone Treatment Company-Operated Treatment

Who Benefits from Vertical Integration? Zone Pricing Company- Owned

Policy Conclusions Banning Zone Pricing –When zone pricing is banned, consumers in the clustered area pay 11% higher prices than when zone pricing is permitted. –Consumers in isolated areas pay the same prices with zone pricing as they do when it is prohibited. –Banning zone pricing nearly triples average station owner profits, but has no effect on refiner profits. Divorcement –Consumers in the clustered area and isolated areas respectively pay 13% and 17% lower prices with vertical integration than with divorcement.

Other ways to Avoid Double Mark-up Resale Price Maintenance: Up stream firm sets price that downstream firm can charge. Manufactures Suggested Retail Price (MSRP). Two-part Tariff

Should a firm vertically integrate? Pros of doing it in-house No Hold Up Problem ex: U invests ($5M) in equipment and training to produce component (MC= $1) specific to D. The investment becomes a sunk cost for U. D could offer only $2 on 1M units. U would take it as it increases profits, but overall U earns a loss. Therefore, U is hesitant of undertaking this investment.

Should a firm vertically integrate? Pros of doing it in-house Minimize Supply Disruptions Reduced Externalities Monitoring Quality Lower Contracting and Transaction Costs Taxes and Regulation Centralized Decision Making

Should a firm vertically integrate? Pros of outsourcing Flexible Economies of Scale Specialized Knowledge Decentralized Decision Making Focus on Core Competencies

Integration vs Outsourcing choosing along a continuum

Asset specificity, uncertainty, and the procurement decision

Other Vertical Relationships Hybrid Arrangements Strategic Alliances Long Term Contracting Joint Ventures