Vertically related markets

Retail Services

• Retailers often provide services beyond selling products.
• Examples include explaining product functionalities, and managing staffing to maintain short lines.
• This can increase consumer willingness to pay.
• There is a moral hazard problem; manufacturers want to compensate retailers for providing services but cannot easily observe their efforts.
• A model can be used to represent this:
  • Market demand depends on retail price and service level.
  • Retailers incur a cost per unit of output based on service level.
  • Vertically integrated structures maximize profit by selecting the optimal retail price and service level.

Linear Wholesale Pricing

• Manufacturers set a wholesale price to maximize profit.
• Retailers then choose retail prices and service levels to maximize their profit.
• This often results in a double-marginalization problem.
• Retailers may under-provide services because they don't fully consider their impact on the manufacturer’s profit.

Vertical Mergers

• Positive Welfare Effects
  • Eliminates double-marginalization, increasing consumer surplus and profits for merging firms.
• Potential Negative Welfare Effects
  • Input Foreclosure: The vertically integrated firm may restrict or stop the supply of inputs to competitors, potentially raising input prices.
  • Customer Foreclosure: The vertically integrated firm may limit access or restrict upstream competitors’ ability to reach customers, harming competition.

Successive Monopolies

• Assumptions:
  • Demand is linear and depends on the retail price.
  • One manufacturer with a marginal cost of production.
  • One retailer with no costs other than the unit price paid to the manufacturer.
  • The manufacturer sets the wholesale price first, followed by the retailer setting the final price.
• Analysis compares outcomes under vertical integration and separate entities.

Double Marginalization

• Subgame-perfect Equilibrium: Each firm sets its price to maximize profit, taking the other firm’s behavior as given.
• Vertical Integration: Manufacturers and retailers merge, allowing them to set the final price for maximum profit as a single entity.
• Intuition: Retail prices are higher under separate entities in a vertical supply chain than under vertical integration because retailers do not consider the full effect of their pricing decisions on the manufacturer’s profit.

Double Marginalization: Insights

• Pricing Inefficiency: Retail prices are higher due to the "double-marginalization" of adding margins at both the manufacturer and retailer levels.
• Externalities: Retailers do not consider the effect of their pricing decisions on the upstream manufacturer's profit.
• Extensions:
  • The problem intensifies in successive monopolies where each firm sets a monopoly price.
  • Double-marginalization becomes less pronounced as market power decreases in one layer of the supply chain under imperfect competition.

Contractual Solutions: Vertical Restraints

• Objective: Contractual arrangements aim to replicate the monopoly solution of a vertically integrated firm while maintaining separate entities.
• Key: Final prices rely on the true cost of production, not the wholesale price, to achieve the monopoly outcome.
• Intrabrand Competition: Competition among retailers selling the same brand.
  • Exclusive Territories: Assigning specific geographic areas or customer types to retailers can help prevent price competition.
• Multiple Manufacturers/Inputs:
  • Tie-in: A manufacturer might require a retailer to purchase another input from them.
• Multiple Final Goods/Interbrand Competition:
  • Exclusive Dealing: A manufacturer might prevent a retailer from selling competing products.

Example of Exclusive Dealing

• Preventing a retailer from selling competing products can be considered anticompetitive.

Explore the dynamics of retail services and linear wholesale pricing through this quiz. Understand the implications of service levels on pricing strategies and the challenge of double-marginalization. Delve into how retailers and manufacturers interact to maximize profits within these frameworks.