Vertical Mergers PDF

Successive monopolies Assumptions Demand: ! " = $ − &" 1 manufacturer Marginal cost of production: $ < &/( 1 retailer No other cost than the unit price paid to the manufacturer Timing 1. Manufacturer sets the wholesale price !; 2. Retailer sets the fina...

Successive monopolies Assumptions Demand: ! " = $ − &" 1 manufacturer Marginal cost of production: $ < &/( 1 retailer No other cost than the unit price paid to the manufacturer Timing 1. Manufacturer sets the wholesale price !; 2. Retailer sets the final price ". What we do We characterize the subgame-perfect equilibrium. We compare the outcome with what would result from vertical integration. 12  Double marginalization Subgame-perfect equilibrium Vertical integration Stage 2. Retailer’s decision The manufacturer and the retailer form a single entity, which chooses the final price. Stage 1. Manufacturer’s decision In a vertically related industry with an upstream and a downstream monopolist in which each firm maintains the price-setting power of its product, the retail price is above the monopoly price set by a vertically integrated firm. 13 Double marginalization. Intuition Pricing inefficiency Retail prices are higher in a market with firms operating only at one level of a vertical supply chain than in a market with vertically integrated firms. Why? The retailer does not take into account the externality exerted on the upstream firm by changing the retail price. A downstream firm applies a margin to the wholesale price, including the margin of an upstream firm. → Addition of 2 margins (“double marginalization”) Extensions The problem is most pronounced in successive monopolies. The insight remains relevant under imperfect competition. As one layer of the market loses its market power, double marginalization becomes less pronounced. 14 Contractual solutions (“Vertical restraints”) Objective Achieve the monopoly solution of the vertically integrated firm through specific contractual arrangements. Key. The final price should be based on the ‘true’ cost (' not ( > '). Simple solutions Franchise fee (or Two-part tariff) Nonlinear price: * + = # + !+ Resale-Price Maintenance (RPM) Provision in the contract dictating the choice of a final price " to the retailer May solve the double marginalization problem in simple environments, but not if: The manufacturer is not fully informed; There are several retailers. 15  Franchise fee Optimum choice of ! " = $ + &" To eliminate the distortion: set ( = ' → The retailer maximizes " − ' $ − &" − + and thus chooses " = "!. The retailer’s profit is equal to ,!∗ − +. The manufacturer can appropriate the retailer’s profit by setting + = ,!∗. Drawbacks Suppose retail cost or final demand is random & retailer is risk-averse. → Retailer bears too much risk (as s/he claims the residual profits). To give some insurance: # ↓ and ! ↑ (but double marginalization is back) Suppose retail cost or final demand is the retailer’s private information. → The manufacturer cannot tailor # to appropriate the retailer’s profit. Suppose there are several retailers. Franchise fees are not enough to realize the vertically integrated profit. Source: Tirole, J. (1990). The Theory of Industrial Organization. MIT Press. Section 4.1 16  Resale price maintenance Optimum contract Set ( = "! and impose " = "!. → The retailer makes no profit and the manufacturer’s profit (= vertical structure’s profit) equals ,!∗. Drawbacks Not a sufficient solution under uncertainty Welfare effects (Franchise and RPM) If the solutions works → Increased welfare Larger total profits Larger consumer surplus (because lower final price) Why? Elimination of double marginalization Source: Tirole, J. (1990). The Theory of Industrial Organization. MIT Press. Section 4.1 17  Multiple retailers. Intrabrand competition Competition among several retailers in the same market Possible contractual solution: Exclusive territories → Each retailer is assigned a different “territory” (geography or type of clients) Manufacturer Manufacturer Retailer 1 Retailer 2 Retailer 1 Retailer 2 Necessitates strong informational requirement The manufacturer must be able to trace the customers’ place of origin (or type). Easier in a digital world (IP addresses) Source: Tirole, J. (1990). The Theory of Industrial Organization. MIT Press. Section 4.1 18  Multiple manufacturers. Several inputs The downstream unit may need several inputs to produce the final good. Possible contractual solution: Tie-in Manufacturer 1 forces the downstream unit to purchase input 2 from him as well. → Manufacturer 1 can charge a price for input 2 that differs from the market price. Manufacturer Manufacturer Manufacturer Manufacturer of input 1 of input 2 of input 1 of input 2 Retailer Retailer Source: Tirole, J. (1990). The Theory of Industrial Organization. MIT Press. Section 4.1 19  Multiple final goods. Interbrand competition The retailer may sell goods that are close substitutes for the good supplied by the manufacturer. Possible contractual solution: Exclusive dealing The manufacturer prevents the retailer from selling goods that compete directly with the manufacturer’s product. Example: Generally seen as an anticompetitive conduct by competition authorities. https://www.twobirds.com/en/insights/2022/australia/heres-the- Source: Tirole, J. (1990). The Theory of Industrial Organization. MIT Press. Section 4.1 scoop-peters-ice-cream-ordered-to-pay-12-million-penalty 20 Retail services Retailers often provide complementary services Examples. Explain a product's functioning to consumers, hold excess sales staff to keep lines short, etc. → Increases the consumers’ willingness-to-pay Moral hazard problem The manufacturer would like to compensate the retailer for such efforts but does not observe them. Model Market demand: !(", /) depends on retail price (") and “service level” (/) Retailer incurs a cost Ψ(/) per unit of output A vertically integrated structure chooses " and / to maximize " − ' − Ψ(/) ! ", /. → Solution: "! and /! 21 Retail services (2) Linear wholesale price Stage 1. Manufacturer chooses ( to maximize ( − ' !(" ( , /). Stage 2. Retailer chooses " and / to maximize " − ( − Ψ(/) ! ", /. Problems with linear pricing With the retail price, we have again a double- marginalization problem. As a consequence, the retailer distorts its service provision. Why? The retailer does not take into account that an improvement in services also increases the manufacturer’s profit. 22 Vertical mergers Positive welfare effects Elimination of double-marginalization ⇒ Consumer surplus ↑ and profits of merging firms ↑ Potential negative welfare effects Input foreclosure The vertically integrated firm stops selling inputs on the market or, at least, restricts their supply. → May lead to higher input prices for competitors. Customer foreclosure Input foreclosure would involve U1 no longer selling a critical input to The vertically integrated firm restricts or suppresses D2, whereas customer foreclosure access by upstream competitors to a sufficient would involve D1 no longer customer base, reducing their ability or incentive to purchasing input and providing its route to market to U2. compete. https://www.oxera.com/insights/agenda/articl Vertical integration can be used as a tool to es/the-ups-and-downs-of-vertical-merger- control-whats-the-current-state-of-play/ increase rival’s costs. 23