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TRANSCRIPT
In the Name of God
Sharif University of Technology Graduate School of Management and Economics
Industrial Organization 44772 (1392-93 1st term)
Dr. S. Farshad Fatemi
Vertical Relationships
Industrial Organization Dr. F. Fatemi Page 141 Graduate School of Management and Economics – Sharif University of Technology
Vertical relationships: questions
How do input suppliers / manufacturers / retailers affect one
another?
Do incentives of manufacturers and retailers diverge?
How are prices determined?
Wholesale prices
Retail prices
Why do vertically-related firms sign complex agreements? What are
the economic effects of these mechanisms?
Policy towards vertical restraints and vertical merger
Industrial Organization Dr. F. Fatemi Page 142 Graduate School of Management and Economics – Sharif University of Technology
Vertical relationships
So far we have thought of firms as single entities which make
products and sell them to final consumers
But most industries involve a chain of production, with a number of
stages which must take place in sequence, e.g.
Raw inputs: energy, raw materials, components
Manufacturing of finished product
Distribution / retailing
Vertical integration: All stages are undertaken by a single firm
Vertical separation: Stages are undertaken by separate firms
Transfers and transactions take place between the firms
Industrial Organization Dr. F. Fatemi Page 143 Graduate School of Management and Economics – Sharif University of Technology
Examples of vertically-related industries
Gas production, transportation and supply
Gas production in North Sea by oil companies (BP, Shell, Exxon Mobil)
Transportation within UK by National Grid Transco (NGT)
Supply by Centrica(British Gas), electricity suppliers, Sainsburys
Petrol: oil extraction/refining and service stations
Oil companies produce oil and refine into petrol
Service stations: some controlled by oil companies; supermarkets
Car manufacturing and distribution
Manufacturers: Ford, BMW, Fiat
Distribution: independent chains and individual dealerships
Industrial Organization Dr. F. Fatemi Page 144 Graduate School of Management and Economics – Sharif University of Technology
Vertical restraints
In reality, there is not a clear-cut distinction between vertical
integration and separation
Separate but vertically-related firms often use contractual clauses
and practices to restrict one another’s behaviour
These are called vertical restraints. E.g.
Resale price maintenance (RPM)
Quantity forcing
Exclusive distribution/territories and selective distribution
Exclusive dealing
Franchising agreements
Industrial Organization Dr. F. Fatemi Page 145 Graduate School of Management and Economics – Sharif University of Technology
Types of vertical restraints
Resale price maintenance (RPM)
Manufacturer imposes conditions on the price at which the retailer sells
the good to final consumers
Pure RPM: manufacturer specifies a single retail price
Maximum RPM: retailer agrees not to sell above a specified retail price
Minimum RPM: retailer agrees not to sell below a specified retail price
Quantity forcing
Similar to maximum RPM, but achieved by specifying a minimum
quantity to be sold rather than a maximum price
May be achieved through bulk discounts or bonus payments
Industrial Organization Dr. F. Fatemi Page 146 Graduate School of Management and Economics – Sharif University of Technology
Exclusive distribution / territories
Manufacturer appoints a single, exclusive distributor within a particular
geographic territory
E.g. car manufacturer appoints a single distributor in each area
Typically a contract guarantees the distributor this exclusivity
Selective distribution
Manufacturer only allows its product to be sold by retailers whosatisfy
certain minimum quality or service standards
Tends to restrict number of retailers (due to higher costs):
akin to exclusive distribution
Manufacturer also refuses to supply non-selective outlets
Industrial Organization Dr. F. Fatemi Page 147 Graduate School of Management and Economics – Sharif University of Technology
Exclusive dealing
Distributor agrees not to stock rival products
E.g. VW distributor agrees not to sell cars of other makes
Franchising agreements (e.g. McDonalds)
Often involve a number of vertical restrictions
May charge a franchise fee or royalty to extract profits
Forms of bundling
Full-line forcing: retailer must take the whole product line in orderto
obtain any one product
Tie-in sales: cannot buy product X without also buying Y, in fixed
proportions
Industrial Organization Dr. F. Fatemi Page 148 Graduate School of Management and Economics – Sharif University of Technology
Vertical and horizontal relationships
Horizontal
Products are substitutes
Each firm would like others to raise price
Vertical
Products are complements: this reverses many interrelationships
Each would like others to reduce price
e.g. manufacturer would like distributor to charge a low retail
price, for a given wholesale price, as this increases demand for
the manufacturer’s product without lowering its profit margin
Thus, agreement between the firms may be a good thing
Other actions of distributor may also affect manufacturer
e.g. investment, advertising, services provided to customers
Industrial Organization Dr. F. Fatemi Page 149 Graduate School of Management and Economics – Sharif University of Technology
Issues arising in vertical relationships
Various externalities exist between vertically-related firms
Pricing externality: results in double marginalisation
Other externalities, e.g. service provision and quality
These imply that vertical integration or restraints may be beneficial,
both privately and socially
Other efficiency motives for vertical integration
Foreclosure
A firm with monopoly power at one stage of production may use
vertical integration or restraints to foreclose a related market
Reduce competition, exclude rivals and/or prevent entry
This is the main focus of policy concerns over vertical relationships
Industrial Organization Dr. F. Fatemi Page 150 Graduate School of Management and Economics – Sharif University of Technology
Pricing externality
Problem arises when imperfect competition at both stages
Simple framework: one manufacturer and one retailer
Manufacturer M sells its product to the retailer R, charging a uniform
wholesale price w (i.e. no two-part tariffs or bulk discounts)
Retailer R sells to final consumers, setting the retail price P
Integrated firm: set P such that gain from a further increase in price
is exactly offset by the resulting fall in demand
Separation: R takes account of loss of its own profit margin but
ignores impact on M
Retail price will be too high: it will exceed the monopoly price
This problem is known as double marginalisation
Industrial Organization Dr. F. Fatemi Page 151 Graduate School of Management and Economics – Sharif University of Technology
Model of double marginalization
M sells product to R who sells to final consumers
Final consumers have demand function Q = 1 –P
M sets wholesale price w; R sets final price P
M has marginal cost c; R has no mc other than w
Assuming profit-maximization by M and R, we can derive
expressions for
P under vertical separation
P under vertical integration
and show that P falls when vertical integration takes place
Industrial Organization Dr. F. Fatemi Page 152 Graduate School of Management and Economics – Sharif University of Technology
Overcoming double marginalization
Both firms and consumers would be better served if the retail price
were lower
Possible remedies
Perfect competition downstream
Vertical integration
Resale price maintenance: maximum RPM
But this might be illegal
Recommended retail price (RRP): can have similar effect
Quantity forcing
Two-part tariff: set w = c and charge (lump sum) franchise fee to extract
profit
Problems if demand is uncertain or R has asymmetric information
Industrial Organization Dr. F. Fatemi Page 153 Graduate School of Management and Economics – Sharif University of Technology
Service externalities
Demand may depend on services that are provided with the
product (as well as its price)
Advertising and promotional activities
Pleasant surroundings (e.g. pubs)
Information provided by sales staff; customer trials
Delivery speed and area covered
After-sales services and warranties
Key features of these services are that
They are provided and (generally) paid for by the retailer
Higher provision tends to increase sales
When both parties have positive profit margins, this benefits the
manufacturer as well as the retailer
Industrial Organization Dr. F. Fatemi Page 154 Graduate School of Management and Economics – Sharif University of Technology
Model of service provision
The model will be demonstrated in Lecture
Vertical integration results in a higher level of service provision
Conclusions
Vertical integration tends to raise service provision
Customers benefit from this too
Integrated firm should also choose the correct balance between service
provision and price reduction
Both strategies reduce profit and the integrated firm will choose
whichever increases demand the most
Industrial Organization Dr. F. Fatemi Page 155 Graduate School of Management and Economics – Sharif University of Technology
Markets with multiple retailers
Multiple retailers of the same manufacturers product
May be located in different geographical areas(e.g. retailers of books,
electronic equipment, cars)
Price competition between retailers
Intra-brand competition
Good for manufacturer as reduces retailer margins and increases sales:
helps overcome double marginalization
Service provision: spill-overs between firms
Services provided by one retailer may benefit other retailers( e.g. test
drive car at showroom, then buy over the Internet for a lower price)
Positive externality between retailers (as well as to manufacturer)
This is bad for the manufacturer (and for customers)
Industrial Organization Dr. F. Fatemi Page 156 Graduate School of Management and Economics – Sharif University of Technology
Overcoming service externalities
Service provision will be too low, for two reasons
Positive externalities between retailer and manufacturer
Positive externalities between retailers
Both tend to reduce service provision, lowering manufacturer’s profits
and consumer welfare
Possible remedies
Integration
Between M and R
Between different R’s
Contractual restraints
Industrial Organization Dr. F. Fatemi Page 157 Graduate School of Management and Economics – Sharif University of Technology
Integration to overcome service externalities
Integration between M and R
Internalizes pricing externality, reducing P and increasing Q
Internalizes service externalities, increasing S
Possible disadvantage: retailer is “closer to the market”
R has better information about consumer demand
Vertical integration may weaken this
Integration between retailers
Internalizes service externalities between firms, increasing provision
But reduces competition between retailers: competition would reduce
retail margins and increase sales
Thus, likely to worsen the double marginalization problem
Also may not be permitted by competition authorities!
Industrial Organization Dr. F. Fatemi Page 158 Graduate School of Management and Economics – Sharif University of Technology
Vertical restraints and service provision
Selective distribution
M directly specifies minimum service standards: reduces under-
provision; but
M may be less well-informed than R about effect of S on
demand;
Monitoring difficulties
Exclusive distribution
M appoints a single, exclusive retailer within a particular area: reduces
horizontal spill-overs between retailers
But does nothing to reduce vertical externality between R and M
Resale price maintenance
M specifies a (minimum) retail price
With fixed prices, retailers compete by offering higher quality services
But reduces the benefits of price competition between retailers
Industrial Organization Dr. F. Fatemi Page 159 Graduate School of Management and Economics – Sharif University of Technology
Assessing vertical integration & restraints
So far we have seen vertical integration and restraints in a generally
positive light
But we have treated market structure and the degree of
competition as given
Possible anti-competitive effects: vertical structures can be used to
Change market structure
Foreclosure to weaken, exclude or evict competition
Reduce competition between firms
Facilitate (horizontal) collusive by making price cuts more
transparent
Implement (geographic) price discrimination
Industrial Organization Dr. F. Fatemi Page 160 Graduate School of Management and Economics – Sharif University of Technology
Case study: New Cars distribution (CC 2000)
SED system: Selective and Exclusive Distribution
Exclusive territories and exclusive dealing
Refusal to supply retailers other than franchised dealers
Prohibition on reselling by dealers except to final customers and
other franchised dealers
Showroom and service standards, staffing and training,
advertising
Requirement to provide after-sales servicing and repairs
List prices; quantity-forcing measures (targets and bonuses)
Detailed business information provided to manufacturer
EU Block Exemption for car distribution agreements
1999: CC investigation following concerns that UK car prices were
high compared to other EU countries
Industrial Organization Dr. F. Fatemi Page 161 Graduate School of Management and Economics – Sharif University of Technology
New cars: market definition
Product market definition: new cars
Used cars do not sufficiently constraint new car prices
Geographical market definition
CC regarded geographical market as UK
UK uses right hand drive (RHD) cars, Continent uses LHD
(though can be ordered from dealers elsewhere in EU)
Japanese imports limited by voluntary export restraints (VERs)
(1975-1999)
Tax regime: under EU VAT rules, a car buyer pays the VAT rate
relating to the home country, not country of purchase
VAT rates vary considerably (15% –200% for some models)
Are pre-or post-tax comparisons appropriate?
Industrial Organization Dr. F. Fatemi Page 162 Graduate School of Management and Economics – Sharif University of Technology
New cars: market segmentation
Large and persistent differences in EU pre-tax prices
CC compared UK prices with France, Germany and Italy, 1993-9
Found UK prices higher by 3.5-7.1% over the 6 years
Sterling appreciated in 1996-7: in latter half of period UK prices
were higher by 10.1-12.6%
May 1999 (most recent) survey, excluding 3 high-tax countries
For 58 of 71 models analyzed, UK price was at least 20 per cent
higher than in the cheapest country
Sensitive to exchange rates; taxation; differences in discounts,
benefits and trade-ins; differences in specifications
Within UK, big discounts for fleet buyers (17-35% compare to 7.5-8%)
Retail prices to larger fleet buyers lower than wholesale pricesto
dealers (even when dealers purchase similar quantities)
Industrial Organization Dr. F. Fatemi Page 163 Graduate School of Management and Economics – Sharif University of Technology
SED system deemed against the public interest
High prices to private buyers attributed to SED
Lack of responsiveness to exchange rates attributed to
restrictions on dealers buying cars from other countries
Pre-registration blamed for inhibiting market-clearing prices
SED also blamed for restricting innovation and choice of type of
retailer
But remedies were restricted by the EU Block Exemption
CC wanted to abolish SED system, ending refusal to supply
(including on service/presentation grounds) and exclusivity
(territories and dealing)
Industrial Organization Dr. F. Fatemi Page 164 Graduate School of Management and Economics – Sharif University of Technology
Remedies not restricted by Block Exemption
Dealers to benefit from bulk discounts similar to large fleet
buyers
Manufacturers’ control over dealers’ advertised prices to be
ended;
dealers to be permitted to sell below recommended prices
Dealers to be permitted to import from other EU countries
Agreements to pre-register cars to be prohibited
Industrial Organization Dr. F. Fatemi Page 165 Graduate School of Management and Economics – Sharif University of Technology
Since the Competition Commission inquiry New car prices have fallen: by 12.2% in the year to November
2000, and further since
Manufacturers may choose between Exclusive territories, but dealers free to sell to non-franchised
operators
Selective (but not exclusive) distribution, where dealers are
required to meet various criteria, and are prevented from
selling to non-franchisees
Blacklist of “hard core” restrictions that are prohibited
Multi-brand dealerships: manufacturer can only request brand-
specific area within showroom
Measures to facilitate cross-border sales
Dealers may sub-contract repairs
Removal of restrictions on authorized repairers and supply of
spare parts
Minimum 5 year term and restrictions on termination of dealer
agreement