1. Economics of Management Strategy BEE3027 Miguel Fonseca Lecture 8

2. Recap Whenever you… –… phone your mum, or switch on the light, or buy health insurance… … you purchase a service or product from a chain of vertically related industries. We’ve looked at vertical integration in the context of firm boundaries.

3. Recap Today, we focus on the strategic aspect of vertical integration. We will start by looking at the potential for efficiency gains in a vertical merger. We will finish by looking at the potential for the welfare losses with vertical foreclosure.

4. Why should a firm acquire a supplier? If markets are efficient, firms will sell their output at marginal cost. That means that it is just as cheap to buy from an external supplier as producing in-house. Several problems do occur in the real world: –Incomplete contracts; –Hold-up; –Supplier market may not be perfectly competitive.

5. Double marginalisation Let’s consider the case of an upstream firm (supplier) producing an intermediate good, and a downstream firm (retailer) producing a consumer good. Demand for the final good is linear: P = a - bQ The marginal cost of producing a unit of the intermediate good is constant and equal to c. Let’s first consider if the two firms merge and act as a single company.

6. a (a+c)/2 c MR (a-c)/2b Monopoly Solution Q P

7. The case of separate companies Now let’s assume both firms are separate monopolies. Lets call the price the retailer pays the supplier for each unit be equal to r. The retailer will maximise profits: –Π r = (P- r)Q –Q* = (a-r)/2b, P*= (a+r)/2.

8. Double marginalisation (cont.) So the demand for the intermediate good is –Q = (a-r)/2b Inverting it as a function of the price of the intermediate good gives: r = a – 2bQ (note that this is the same as the retailer’s MR curve) So the supplier maximises her profits [Π s = (r-c)Q] with respect to Q: This gives Q = (a-c)/4b. r = (a+c)/2.

9. Double marginalisation (cont.) Recall the optimal output and price by retailer: Q* = (a-r)/2b, P*= (a+r)/2. Plugging r = (a+c)/2 into the equilibrium output and price of the retailer, we get: Q* = (a-c)/4b and P* = (3a+c)/4. Both the consumer surplus AND the sum of firms’ profits are lower with separate companies!

10. Double Marginalization a (3a+c)/4 (a+c)/2 c MR for retailer (a-c)/2b MR for manufacturer P Q

11. Double marginalisation (cont.) How can this be tackled? Two-part tariff (franchising): –Supplier charges a Fixed fee F to sell the good to retailer and sells each unit at marginal cost. –F should not affect retailer price, as the key condition is that MR = MC. Royalty arrangement –Supplier sells goods at MC but earns a percentage of profits.

12. Vertical Foreclosure Consider a market in which an upstream firm, U, produces an input at MC = 0. Each unit of input is costlessly converted into a homogenous unit of a final good by downstream firms D1 and D2. The final good is sold to consumers with demand function given by: P = a – bQ, Q =q1+q2

13. Vertical Foreclosure

14. Let’s also assume firms engage in Cournot competition. U sells input goods to D1 and D2 by proposing contract of the form (x, T), where –x is amount of input, and –T is payment for bundle.

15. Vertical Foreclosure There are two important cases to consider in this case: –Public contracts; –Secret contracts. Public contracts are those in which D1 knows contractual terms of D2 and vice-versa. Secret contracts are those in which neither firm knows what terms were offered to rival.

16. Vertical Foreclosure If contracts are public, the subgame-perfect equilibrium of this game is: –U offers to both D-firms –Both D-firms accept. Under this offer, both firms: –Make zero profits net of payment to U if all input is turned into output and sold at monopoly price. If firms reject offer, they also make zero profit.

17. Vertical Foreclosure If contracts are secret, it may not be possible for U to achieve monopoly profit. Suppose D2 accepts offer from U. If so, it is in U’s and D1’s to agree to a contract (x*,T*), such that. D2 anticipates this and rejects contract.

18. Vertical Foreclosure The only possible equilibrium is for U to offer contract, where firms make Cournot- Nash profits. In this contract, neither D-firm has an incentive to raise outputs. The solution for U to achieve maximum profit is to merge with one of the D-firms.

19. Vertical Foreclosure

20. Firm U-D1 sells monopoly quantity through its downstream subsidiary. Since it already captures full monopoly profits, it has no incentives to supply D2.

21. Vertical Restraints Let’s broaden our analysis further and consider two possibilities: –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.

22. Vertical Restraints Retailers can invest in advertising, customer service, consumer education, all of which enhance consumer willingness to pay. Such investments benefit retailer but also its competitors and the manufacturer; –Thus the level of investment will be insufficient. Vertical restraints can ensure the optimal level of services.

23. Vertical Restraints Could specify contractually what services should be provided, –How does one determine the right level of services? How does one monitoring the level of services? This is an 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.

24. 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).

25. 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.

26. 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.

27. 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.

28. Anti-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.

29. 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.