1. Vertical Relations and Restraints Many transactions take place between two firms, rather than between a firm and consumers Key differences in these types of transactions: –Demand for an intermediate good being sold by an upstream company to a downstream company is derived from the demand curve the downstream company faces. –The buyers of the intermediate good, the downstream companies, compete with one another.

2. Types of Vertical Relationships/Restraints Relationships –Franchise –Licensed/authorized dealer –Agent Restraints –Exclusive territories –Royalty agreements –Resale price maintenance

3. Double Marginalization Assume there is an upstream firm, the manufacturer of the product, and a downstream firm that sells the product in a retail outlet. Assume retailers have no costs, just buy the product and then resell it costlessly. Also assume that the marginal cost of manufacturing the product is constant, c. Consumer demand for the product is P = a - bQ.

4. Double Marginalization, cont If the manufacturer and retailer were an integrated company, the firm would set MR=MC to maximize profit: a-2bq = c or q = (a-c)/2b Price = a - b*(a-c)/2b = (a+c)/2 Profit = [ (a+c)/2 - c ]*(a-c)/2b = (a-c) 2 /4b

5. a (a+c)/2 c MR Demand (a-c)/2b Monopoly Solution

6. Double Marginalization, cont If the manufacturer and retailer are separate companies: –Assume that the price the retailer pays the manufacturer is r. –To maximize profit, the retailer sets r = MR: a-2bq = r or q = (a-r)/2b Price = a - b(a-r)/2b = (a+r)/2 Profit = [ (a+r)/2 - r ]*(a-r)/2b = (a-r) 2 /4b

7. Double Marginalization, cont Thus the retailers demand for the manufacturers product is q = (a-r)/2b. The inverse demand curve for the manufacturer is thus r = a-2bq. –Note that this is the same as the retailers marginal revenue curve. So the manufacturers MR curve = a - 4bq.

8. Double Marginalization, cont Setting MR=MC: a - 4bq = c, or q = (a-c)/4b Price = a - 2b (a-c)/4b = (a+c)/2 (Be sure to use the manufacturers demand curve to get price, not the consumers demand curve) Profit = [(a+c)/2 - c]*(a-c)4b = (a-c) 2 /8b The retailer pays (a+c)2 and sells (a-c)/4b at P = a-b*(a-c)/4b = (3a+c)/4.

9. Double Marginalization a (3a+c)/4 (a+c)/2 c MR for retailer Demand (a-c)/2b MR for manufacturer

10. Double Marginalization, cont Double Marginalization: both firms mark the price up above their own costs. Both cosumers and firms are better off if the two firms act in concert to maximize joint profits.

11. Double Marginalization a (3a+c)/4 (a+c)/2 c MR for retailer Demand (a-c)/2b MR for manufacturer

12. Vertical Restraints as a Response to Double Marginalization Two-part tariff: Fixed cost of F to sell the good, then goods sold to retailer at marginal cost. –Retailer sets MR = MC, so the joint profit maximizing quantity is sold. –F can be set so that both the manufacturer and the retailer share profits. –Classic franchise arrangement. Royalty arrangement: Goods sold to retailer at MC, manufacturer gets percentage of profits.

13. Level of Competition To understand vertical relations and restraints, need to distinguish between two levels of competition: –Intra-Brand competition: competition between two different retailers of the same brand of the product. –Inter-Brand competition: competition between two different manufacturers/retailers with different brands the same or similar product.

14. Retail Services Retailers can invest in advertising, customer service, consumer education, all of which enhance consumer willingness to pay. Positive externalities from these services (to other retailers as well as to the manufacturer), thus the services generally will be underprovided. Vertical restraints can ensure the optimal level of services.

15. Vertical Agreements to Ensure Provision of Services Could specify contractually what services should be provided, but determining the right level of services is hard and monitoring the level of services is very difficult. Classic example of the principal-agent problem: the manufacturer is the principal, the retailer is the agent. Solution: Align the agent's payoff function with the principle's payoff function.

16. The Principal-Agent Problem Assume Q = (A-P)s where s is the service level, then P = A - Q/s. Assume the cost of s is increasing (diminishing marginal returns to service). To maximize joint profits, there is an optimal level of service and an optimal price to the consumer. On his own, the retailer will set price is too high (due to double marginalization) and the service too low (due to free riding).

17. Possible Solutions to the P-A Problem Resale Price Maintenance: Establish a minimum price that the retailer can set. –Retailers cannot use price to increase consumer demand, so they must increase service to compete with other retailers. –Works for some services, although not for advertising. Exclusive territories: Designate one retailer for a certain area. –Retailer gets all the benefits from services provided.

18. Manufacturer Competition Vertical restraints can help manufacturers compete against rivals. –Slotting allowances: fixed fee paid to retailers to obtain shelf space. Two-part tariff in reverse. –Exclusive dealing: if the manufacturer provides services (e.g., training) to retailer which could benefit other manufacturers.

19. Pro-competitive Effects of Vertical Restraints Exclusivity: gain economies of scale, lower distribution costs, achieve optimal level of services. Resale price maintenance: achieve optimal level of services. Royalty and franchise agreements: overcome double marginalization.

20. Anit-competitive Effects of Vertical Restraints Exclusivity: facilitate collusion, foreclose markets to competitors. Resale price maintenance: facilitate collusion. Royalty and franchise agreements: foreclose markets to competitors.

21. Antitrust and Vertical Restraints Exclusivity. –Evaluated under rule of reason: do they harm welfare/consumers overall. Takes into account differences between intra- and inter-brand competition. Resale price maintenance. –Per se illegal. Royalty and franchise agreements. –Some limits on these agreements, evaluated under rule of reason.